In this article, Mayank Garg who is currently pursuing Diploma in Entrepreneurship Administration and Business Law from NUJS, Kolkata, discusses Five long-term sources of fund for a company.
A company at its initial stage in its Memorandum of Association mentions the amount of authorised capital that is the maximum amount of capital which a company can raise. Once this limit is reached company can alter the amount as per the growth and requirement this is because growing business and increasing sales often requires purchase of assets such as new machinery and vehicles. As company requires a large amount of capital in order to furnish, it thus needs
As company requires a large amount of capital in order to furnish, it thus needs constant source of funding to its entity in order to bring out its efficient and effective production. Company thus uses the following ways in order to increase the fund of the company. It does it either through issuing equity and preference share or through loans and financial institutions or debentures or through retained earnings. These are thus 5 long term sources of fund for a company.
These are thus 5 long term sources of fund for a company. Company, when finds necessary, uses either of them in accordance to the need of capital. Herein below are the sources along with its advantages and disadvantages respectively.
Sources of fund
Sources of fund are classified into three distinct categories on the basis of time-period i.e. short term fund, medium term fund and a long term fund. Herein we are going to discuss the long term source of fund meaning capital requirement for a period of more than 5 yrs to 10, 15, 20 or more depending upon the factors. Expenditures in fixed assets like plant machinery, land, building etc are funded by long term fund. Therefore, long term source of funding can b in the form of Equity shares, Preference share, debentures, loans and financial institution and retained earnings.
5 long term sources of fund
Shares are share in a share capital of a company. It is basically smallest indivisible unit which is issued by the company in order to raise capital. Further equity share capital means all share capital excluding preference share ca voting rights capital. The shareholders of equity shares have voting rights proportionate to the paid up equity capital. A public limited company may raise funds from public or promoters as equity share capital by issuing ordinary equity shares. Ordinary shareholders are those who receive dividend and return of capital after the payment to preference shareholders.
- It is one of the most important long-term sources of fund.
- There are no fixed charges attached to ordinary equity shares. If the there is sufficient profit earned by the company then only the equity shareholders get dividend but there is no legal obligation to pay dividends.
- Equity shares have no maturity date and thus there is no obligation to redeem.
- The firm with the longer equity base will have greater ability to raise debt finance on favourable terms. Thus issue of equity share increases the credit worthiness of the firm.
- The company can further issue share capital by making right issue and bonus issue.
- In India, returns from the sale of ordinary shares in the form of capital gains are subject to capital gains tax rather than corporate tax.
- Once the company earns profit it pays more dividends, thus bringing more investors and leads to appreciate the market value of equity shares of the company.
Preference share means share which enjoys the preferences in the following two rights over equity i.e. right to dividend at a predetermined rate before payment of dividend to equity shareholders and right to receive payment of the capital in the event of winding up before repayment of equity shareholders.
Thus long term funds are raised through preference shares by public share. It does not require any security nor is ownership of a firm affected. It has some characteristics of debt capital and some of equity capital. It resembles equity as preference dividend, like equity dividend is not tax deductible payment. Preferential shares can be cumulative or non-cumulative, participating or non- participating and redeemable or irredeemable.
- Company can issue long term fund by issuing preference shares.
- If the profit is earned, dividend is paid to the preference shareholders but if no profit is earned then the company is under no legal binding to pay preference dividend.
- There is maximum advantage as it has fixed charges.
- Preference share capital is generally regarded as part of net worth. Hence it increases the creditworthiness of the firm.
- Assets are not secured in favour of preference shareholders. The mortgageable assets of the company are freely available.
Debenture is a document given by a company under its common seal as an evident of debt to the holder. It includes debenture stock, bonds and any other security of the company whether charge on assets of the company or not. Company can issue redeemable or irredeemable debentures. Redeemable providing specific date of redemption whereas irredeemable providing no undertaking to repay. It is an instrument for raising long-term debt. Debenture holders are the creditors of the company. They have no voting rights in the company. Debenture may be issued by mortgaging any asset or without mortgaging the asset, i.e., debentures may be secured or unsecured. Therefore, there are different types of debentures as follows,
Unsecured debentures: Such debentures are issued without creating charge on any assets of a company. Therefore, the holders of these debentures do not have any security as to repayment of principal or interest thereon.
Secured debentures: Such debentures are secured by the mortgage of the whole or part of the assets of the company.
Redeemable debentures: A debenture holder receives repayment of amount after the expiry of a certain period.
Perpetual debentures: No specific time is fixed for repayment of loan, thus will be made on the happening of an event. It the above event does not happen then the debenture will continue for the indefinite period.
- Cost of debenture is much lower than the cost of equity or preference share since interest on debenture is a tax-deductible expense.
- Also interest on debentures is charge against profit. It is an admissible expense for the purpose of taxation so tax liability on company’s profit is reduced which results in debenture as a source of finance.
- Investors prefer debenture investment than equity or preference investment as the former provides a regular flow of permanent income. Thus bringing more number of investors to the company resulting as a source of finance.
- Investors prefer debenture investment than equity or preference investment as the debenture provides a regular flow of permanent income.
Loans and Financial Institutions
In India, long term financial assistance is provided to public and private firms through commercial financial institution. Generally, firms obtain long-term debt by raising term loans. Term loans refer to as term finance; represent a source of debt finance which is repayable in less than 10 years. Giving long term is not an easy task. Before giving a term loan to a company the financial institutions must be satisfied regarding the technical, economic, commercial, financial and managerial viability of project for which the loan is needed. Term loans are secured borrowings and a significant source of finance for investment in the form of fixed assets and also in the form of working capital needed for new project.
The following financial institutions provide long-term capital in India
- All Nationalized Commercial Banks.
- Development Banks which include.
- Industrial Development Bank of India
- Small Industries Development Bank of India
- Industrial Finance Corporation of India
- Industrial Credit and Investment Corporation of India
- Industrial Reconstruction Bank of India.
3. Government Financial Institutions which include.
- State Finance Corporation
- National Small Industries Corporation
- State Industrial Corporation
- State Small Industries Development Corporation.
4. Other investment institutes which include.
- Life Insurance Corporation of India
- General Insurance Corporation of India
- Unit Trust of India.
Retained earnings is basically a part of undistributed profit which a company keeps as free reserves and thus is utilized for further expansion and diversification programs. Also known as Ploughing back of profits or retained earnings. It increases net worth of the business because it belongs to equity share holders.
Although it is essentially a means of long-term financing for expansion and development of a firm, and its availability depends upon a number of factors such as the rate of taxation, the dividend policy of the firm, Government policy on payment of dividends by the corporate sector, extent of profit earned and upon the firm’s appropriation policy etc.
- Cheapest method of raising funds.
- Provides sufficient capital for expansion and development.
- Entity does not depend upon lenders or outsiders if retained earnings are readily available.
- It increases reputation of the business, hence promoting investors to influx capital.
Therefore, it can be concluded by an old saying that “you have to spend money to make money” meaning if company has to raise funds at some point to develop products and expand into new markets, it has to find some long term source. The company may sell its products more than its cost to produce which in turn provide fund to a company but such source is not sufficient to provide capital to a company, it has to look for an alternative. The above stated sources are some of those sources which provide long-term fund to a company along with venture funding, asset securitization, international financing etc.