Why business needs funds, how sources are classified, and the main ones: retained earnings, trade credit, factoring, leasing, public deposits, commercial paper, shares, debentures, banks and GDRs.
Key ideas
Business needs funds for fixed capital (long-term assets) and for working capital (day-to-day running).
Sources are classified by period (long term is over five years), by ownership (owner’s funds and borrowed funds) and by source of generation (internal and external).
Owner’s funds (equity shares, retained earnings) need no repayment while the firm lasts; borrowed funds (debentures, loans, public deposits) carry interest and must be repaid.
Equity shareholders are the real owners: their dividend varies with profit and is paid last; preference shareholders get a fixed dividend before them.
Debenture holders are creditors: their fixed interest must be paid even in a year of loss, and it is tax deductible.
Short-term sources include trade credit, factoring (a factor collects the firm’s receivables), commercial paper (an unsecured short-term note) and bank credit.
Lease financing gives the use of an asset for a rent; GDRs and ADRs raise capital abroad through depository receipts.
The choice of source depends on cost, risk, control, purpose and period, flexibility, financial strength and tax benefits.
Remember
Debenture interest
number × face value × rate ÷ 100
Preference dividend
number × face value × rate ÷ 100, paid before any equity dividend
Equity dividend received
shares held × face value × dividend% ÷ 100
Left for shareholders (before tax)
earnings before interest − debenture interest
Factor’s advance
receivables × advance% ÷ 100
After the factor’s commission
debts collected − commission% of the debts
Shares vs debentures
ownership vs loan; varying dividend vs fixed interest; voting rights vs none; repaid on winding up vs after a fixed period
Watch out
Paying debenture interest only in profitable years: it is due even in a loss.
Calling debenture holders owners of the company: they are creditors.
Working out a dividend on the number of shares alone, without multiplying by the face value.
Worked example
A company has 37,000 debentures of ₹100 each at 8% interest. This year it earns ₹740,000 before interest. (a) How much interest is due? (b) What is left for shareholders before tax?