Trade credit is the credit extended by one trader to another for the purchase of goods and services. Trade credit facilitates the purchase of supplies without immediate payment. Trade credit is commonly used by business organizations as a source of short-term financing.
The important merits of trade credit are as follows:
- Trade credit is a convenient and continuous source of funds; in the near future, it may use trade credit to, finance the same;
- It does not create any charge on the assets of the firm while providing funds.
Trade credit as a source of funds has certain limitations, which are given as follows:
- Availability of easy and flexible trade credit facilities may induce a firm to indulge in overtrading,which may add to the risks of the firm;
- It is generally a costly source of funds as compared to most other sources of raising money
Factoring is a financial service under which the 'factor' renders various services which includes of which discounting of bills is a source of finance for the company
Discounting of bills (with or without recourse) and collection of the client's debts. Under this, the rceivables on account of sale of goods or services are sold to the factor at a certain discount There are two methods of factoring recourse and non-recourse. Under recourse factoring, the client is not protected against the risk of bad debts. On the other hand, the factor assumes the entire credit risk under non-recourse factoring i.e., full amount of invoice is paid to the client in the event of the debt becoming bad.
The merits of factoring as a source of finance are as follows:
- Obtaining funds through factoring is cheaper than financing through other means such as bank credit;
- Factoring as a source of funds is flexible and ensures a definite pattern of cash inflows from credit sales. It provides security for a debt that a firm might otherwise be unable to obtain;
- It does not create any charge on the assets of the firm;
The limitations of factoring as a source of finance are as follows:
- This source is expensive when the invoices are numerous and smaller in amount;
- The advance finance provided by the factor firm is generally available at a higher interest cost than the usual rate of interest;
Commercial Paper (CP)
Commercial paper is an unsecured promissory note issued by a firm to raise funds for a short period, varying from 90 days to 364 days. It is issued by one firm to other business firms, insurance companies, pension funds and banks.
- A commercial paper is on unsecured basis and does not contain any restrictive conditions;
- As it is a freely transferable instrument, it has high liquidity;
- Only financially sound and highly rated firms can raise money through commercial papers.
- The size of money that can be raised through commercial paper is limited to the excess liquidity available with the suppliers of funds at a particular time;
LONG TERM SOURCES OF FINANCE
A company generally does not distribute all its earnings amongst the shareholders as dividends. A portion of the net earnings may be retained in the business for use in the future. This is known as retained earnings.
The merits of retained earnings as a source of finance are as follows:
- Retained earnings is a permanent source of funds available to an organization;
- It does not involve any explicit cost in the form of interest, dividend or floatation cost;
Retained earnings as a source of funds has the following limitations:
- It is an uncertain source of funds as the profits of business are fluctuating;
- The opportunity cost associated with these funds is not recognized by many firms. This may lead to sub-optimal use of the funds.
Issue of Shares
The capital obtained by issue of shares is known as share capital. The capital of a company is divided into mall units called shares. Each share has its nominal value. The person holding the share is known as shareholder. There are two types of shares normally issued by a company. These are equity shares and preference shares. The money raised by issue of equity shares is called equity share capital, while the money raised by issue of preference shares is called preference share capital
Euity shares is the most important source of raising long term capital by a company. Equity shares represent the ownership of a company and thus the capital raised by issue of such shares is known as ownership capital or owner's funds. Equity share capital is a prerequisite to the creation of a company. Equity shareholders do not get a fixed dividend but are paid on the basis of earnings by the company. They are referred to as 'residual owners' since they receive what is left after all other claims on the company's income and assets have been settled. They enjoy the reward as well as bear the risk of ownership. Their liability, however, is limited to the extent of capital contributed by them in the company. Further, through their right to vote, these shareholders have a right to participate in the management of the company.
The important merits of raising funds through issuing equity shares are given as below:
- Equity shares are suitable for investors who are willing to assume risk for higher returns;
- Payment of dividend to the equity shareholders is not compulsory. Therefore, there is no burden on the company in this respect;
- Equity capital serves as permanent capital as it is to be repaid only at the time of liquidation of a company. As it stands last in the list of claims, it provides a cushion for creditors, in the event of winding up of a company;
- Equity capital provides credit worthiness to the company and confidence to prospective loan providers;
- Funds can be raised through equity issue without creating any charge on the assets of the company. The assets of a company are, therefore, free to be mortgaged for the purpose of borrowings, if the need be;
- Democratic control over management of the company is assured due to voting rights of equity shareholders.
The major limitations of raising funds through issue of equity shares are as follows:
- Investors who want steady income may not prefer equity shares as equity shares get fluctuating returns;
- The cost of equity shares is generally more as compared to the cost of raising funds through other sources;
- Issue of additional equity shares dilutes the voting power, and earnings of existing equity shareholders;
- More formalities and procedural delays are involved while raising funds through issue of equity share.
2,b Preference Shares
The capital raised by issue of preference shares is called preference share capital. The preference shareholders enjoy a preferential position over equity shareholders in two ways:
- receiving a fixed rate of dividend out of the net profits of the company, before any dividend is declared for equity shareholders; and
- receiving their capital after the claims of the company's creditors have been settled, at the time of liquidation. Preference shareholders generally do not enjoy any voting rights. A company can issue different types of preference shares
The merits of preference shares are given as follows:
- Preference shares provide reasonably steady income in the form of fixed rate of return and safety of investment;
- Preference shares are useful for those investors who want fixed rate of return with comparatively low risk;
- It does not affect the control of equity shareholders over the management as preference shareholders don't have voting rights;
The major limitations of preference shares as source of business finance are as follows:
- Preference shares are not suitable for those investors who are willing to take risk and are interested in higher returns;
- Preference capital dilutes the claims of equity shareholders over assets of the company;
- As the dividend on these shares is to be paid only when the company earns profit, there is no assured return for the investors. Thus, these shares may not be very attractive to the investors;
- The dividend paid is not deductible from profits as expense. Thus, there is no tax saving as in the case of interest on loans.
Debentures are an important instrument for raising long term debt capital. A company can raise funds through issue of debentures, which bear a fixed rate of interest. The debenture issued by a company is an acknowledgment that the company has borrowed a certain amount of money, which it promises to repay at a future date. Debenture holders are, therefore, termed as creditors of the company. Debenture holders are paid a fixed stated amount of interest at specified intervals say six months or one year
The merits of raising funds through debentures are given as follows:
- It is preferred by investors who want fixed income at lesser risk;
- Debentures are fixed charge funds and do not participate in profits of the company;
- As debentures do not carry voting rights, financing through debentures does not dilute control of equity shareholders on management;
- Financing through debentures is less costly as compared to cost of preference or equity capital as the interest payment on debentures is tax deductible.
Debentures as source of funds has certain limitations. These are given as follows:
- As fixed charge instruments, debentures put a permanent burden on the earnings of a company. There is a greater risk when earnings of the company fluctuate;
- In case of redeemable debentures, the company has to make provisions for repayment on the specified date, even during periods of financial difficulty;
- Each company has certain borrowing capacity. With the issue of debentures, the capacity of a company to further borrow funds reduces.
Term Loans from Commercial Banks
Commercial banks occupy a vital position as they provide funds for different purposes as well as for different time periods. Banks extend loans to firms of all sizes and in many ways. Generally such loans are used for medium to short periods. The borrower is required to provide some security or create a charge on the assets of the firm before a loan is sanctioned by a commercial bank.
The merits of raising funds from a commercial bank are as follows:
- Banks provide timely assistance to business by providing funds as and when needed by it.
- Secrecy of business can be maintained as the information supplied to the bank by the borrowers is kept confidential;
- Formalities such as issue of prospectus and underwriting are not required for raising loans from a bank. This, therefore, is an easier source of funds;
- Loan from a bank is a flexible source of finance as the loan according to business needs and can be repaid in advance when funds are not needed.
The major limitations of commercial banks as a source of finance are as follows:
- Funds are generally available for medium term to short term periods and its extension is uncertain and difficult;
- Banks make detailed investigation of the company's affairs, financial structure etc., and may also ask for security of assets and personal sureties. This makes the procedure of obtaining funds slightly difficult;
- In some cases, difficult terms and conditions are imposed by banks. for the grant of loan. For example, restrictions may be imposed on the sale of mortgaged goods, thus making normal business working difficult.