Credit extended for the purchase of goods and services by one trader to another is known as trade credit.
- It is convenient as immediate payment is not required.
- No charge on the assets of the firm while providing funds.
- Company may indulge in overtrading due to easy availability funds and result in increased risk.
- In comparison to most other sources, this is costly.
It is a facility given by banks and a limit is fixed in advance. Such facility is utilized through the current account which the customer is having.
- Limits can be reduced by bank at any time.
- Not suitable for large amount of borrowings.
LONG TERM SOURCES OF FINANCE
Retained earnings are a part of the net earnings retained by the business so that it can be used in future. This is achieved by not distributing all earnings to its shareholders.
The retained earnings as a source of finance has the following advantages.
- To an organization, it is available as a permanent source of funds.
- It is cost effective as there is no fund raising cost or interest etc
- As profits of business fluctuate, this source is uncertain.
- Many firms do not recognize the opportunity cost associated with this source of funds resulting in underutilization of these funds.
Issue of Shares
A company can raise capital by issue of its shares and such capita is referred as share capital. There are equity shares and on issue of equity shares, equity share capital is raised. On issue of preference shares, preference share capital is raised.
For long term capital, equity shares are the most important source of funds. It is also referred to as owners funds or ownership capital.
- This is suitable for investors who believe in comparatively high risk :reward ratio.
- As the dividend payment is not mandatory, company's financial burden is less.
- Investors who want steady income may not prefer equity shares as equity shares get fluctuating returns;
- Cost of raising funds through equity shares is high in comparison to other methods of raising funds.
- Issue of additional equity shares results in dilution of voting power of existing shareholders.
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 (ii) 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.