Financial Planning

Before initiating a new business, the organization puts an immense focus on the topic
of Financial Planning. Financial planning is the plan needed for estimating the fund
requirements of a business and determining the sources for the same. It essentially
includes generating a financial blueprint for company’s future activities. It is typically
done for 3-5 years-broad in scope and generally includes long-term investment, growth
and financing decisions.

Objectives of Financial Planning

 Ensuring availability of funds: Financial planning majorly excels in the area of

generating funds as well as making them available whenever they are required.
This also includes estimation of the funds required for different purposes, which
are, long-term assets and working capital requirements.

 Estimating the time and source of funds: Time is a game-changing factor in any
business venture. Delivering the funds at the right time at the right place is very
much crucial. It is as vital as the generation of the amount itself. While time is an
important factor, the sources of these funds are necessary as well.

 Generating capital structure: The capital structure is the composition of the

capital of a company, that is, the kind and proportion of capital required in the
business. This includes planning of debt-equity ratio both short-term and long-
term.

 Avoiding unnecessary funds: It is an important objective of the company to make

sure that the firm does not raise unnecessary resources. Shortage of funds and
the firm cannot meet its payment obligations. Whereas with a surplus of funds,
the firm does not earn returns but adds to costs.

Process of Financial Planning

 Preparation of sales conjecture.

 Decide the number of funds – fixed and working capital.
 Conclude the expected benefits and profile ts to decide the number of funds that
can be provided through internal sources.
 This causes us to evaluate the requirement from external sources.
 Recognize the conceivable sources and set up the money spending plans
consolidating these variables.
Importance of Financial Planning

Financial Planning is the procedure of confining company’s targets, policies,

techniques, projects and budget plans with respect to the financial activities lasting for
a longer duration. This guarantees viable and satisfactory financial investment policies.
The importance is as follows-

 Guarantees sufficient funds.

 Planning helps in guaranteeing a harmony between outgoing and incoming of

assets with the goal that stability is kept up.
 Guarantees providers of funds to effortlessly put resources into organizations
which provokes financial planning.
 Financial Planning supports development and expansion programmes which
support in the long-run sustenance of the organization.
 Diminishes vulnerabilities with respect to changing business sector patterns
which can be confronted effortlessly through enough funds.

 Financial Planning helps in diminishing the vulnerabilities which can be a

deterrent to the development of the organization. This aids in guaranteeing
security and benefits of the organization.
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Ten benefits of financial planning you may not realize
Financial Planning helps in improving risk management, improve
portfolio ROI, uses metrics to manage money, among other
benefits.

Smitha Hari

To do or not to do- this is the dilemma we all face in many a situation. While there is a yes and no as an answer to every dilemma, when it
comes to financial planning, we would tend to lean towards the 'yes' more than the 'no'. In fact, in today's world, we would consider financial
planning to rank pretty high in Maslow’s Hierarchy, and is as critical as the safety and social needs. Other than the fact that financial planning
helps in bringing about discipline and achieving financial security, there are a few other reasons as well as to why you should do financial
planning. Here are such top reasons:

1.Improves risk management: Taking adequate life cover and health cover is critical. When you do financial planning, you can determine
the amount of cover you need with greater certainty. Thus you do not overpay for unnecessary insurance and also do not end up with a lower
than necessary cover.

2.Improvement in portfolio return on investment (ROI): Financial planning takes into account various aspects like risk management,
investment planning, goal planning, liquidity management and liability management. You are able to design an integrated investment plan
that takes into account goals, available liquidity and risk appetite, thus helps in improving your portfolio ROI.

3.Use the metrics approach to manage your money: When you undertake financial planning, you can measure specific milestones on
what you have achieved. There is a science involved in managing money and financial planning helps you do this with higher efficiency.

4.Identify good and not so good areas:Financial planning helps you bring order to your finances by identifying what is right and not right
for you. For example, you may be low on insurance cover or holding investments which are performing poorly. Financial planning helps you
identify this and take corrective measures.

5.Reduce your cost of personal finance: When you undertake financial planning, you can cut down on many personal finance costs. A
good example is by doing away with expensive ULIP policies or any investment which carries high charges.

6.Discipline in managing money: Financial planning brings in discipline. Also, there are subtle behavioural changes when you undergo
financial planning. For example, when you run a systematic investment plan (SIP), your expenses are automatically curtailed and this goes
towards investments. Similarly, when you do financial planning, you become aware if your lifestyle expenses are above or below what you
can afford. If it is the former, you can take necessary steps to cut back on unnecessary expenses.

7. Measure and improve asset allocation:Asset allocation is a critical element of managing your money. There has to be a fine balance
struck between managing risk and returns, and the right assets need to be chosen for the same. Financial planning helps in selecting the
right asset allocation mix depending on your risk and return preferences.

8. Future visibility: Planning is for the future. While we have often heard quotes saying that you should live the present and not dwell on the
past or worry about the future, when it comes to money, considering the future becomes very important. Financial planning helps you get
visibility for next 15-20 years. You are able to get comfort on retirement and planning your money during emergency situations. This helps in
achieving peace of mind and also helps you plan in case there is a gap.

9. Estate distribution: Will writing and estate planning is an integral part of financial planning. When you do financial planning you can plan
your estate distribution after your time, such that disputes are avoided.

10. Professional approach: There is a professional approach in putting together a plan and tracking it. You can implement best practices
with the help of your financial advisor. All this brings about greater order to your money management practices.

The Golden Rules of Financial Planning

No matter how basic or how sophisticated you are as an investor, there are certain rules of thumb or
guidelines which seem to be timeless. Wise investors take heed:

1. Diversify. Never put all your financial eggs in one basket. (But if you do, watch them very carefully.)

2. Seek a return OF principal before seeking a return ON principal. In other words considered
prioritizing principal and certainty of income before gain on capital. This is another way of saying, "If it
looks too good to be true, it probably is." Don't be greedy or you may lose it all.

3. Cover your assets before taking greater risk. Seek to protect the ground you've gained. Never go to
the next level of financial risk before seeking to protect the gains you've already made. This is what
personal and business risk management is all about. So be sure you've managed the risk in (a) property
(such as fire, storm, loss, and theft), (b) income (such as death, accident, or sickness), and (c) liability.

4. No risk, no reward. The greatest risk of all is doing nothing! Money is made and taxes are saved by
taking prudent risk.

5. Put yourself on your own payroll - at the top! Budget for savings and investment just as you budget
for paying your bills.

6. Capitalize on the miracle of the "forgotten" automatic investment. If at all possible, put money
aside on a regular automatic basis BEFORE you see it and consider it spendable. For example, use
salary savings accounts, 401(k) plans, and similar devices that help you compound money year after
year. And create automatic mechanisms to make money with the money you've made. For instance, most
investment vehicles provide automatic dividend reinvestment plans.

7. Constantly increase the rate of your investing. It is both easier and safer to gradually increase the
percentage of the amount you are saving and investing than to increase investment return by taking
greater risk. A small increase in the input of a regular investment is often equal to or greater than a
dramatic increase in the rate of return on a new investment.

8. Increase your expenditures at a lower rate than you increase your income. Controlling inefficient
spending and debt acquisition is the lowest risk way to increase the dollars you have available for
investment. Eliminating monetary waste and uncontrolled cash flow are essential to financial success.

9. Always maintain a measure of liquidity. Liquidity is the ability to turn assets back into cash quickly
with little or no loss. It is essential to meet an emergency or take better advantage of a financial
opportunity. Insufficient liquidity often translates into a forced (and then a fire) sale or a lost opportunity.
10. Remember that assets and income maintain their utility only to the extent they maintain their
purchasing power. This means that you must consider the ability of any investment to keep pace with or
exceed the rate of inflation.

11. Think of your financial confidence only in terms of "the bottom line". It's not what you earn that
counts; it's what you get to keep. Don't judge the health of your wealth at the top of the line. Be sure to
consider what's left after (a) taxes and (b) slippage. Consider that state and federal taxes and other
"slippage" reduce bottom line spendable income considerably.

12. Always use the lowest risk strategy that meets your investment need.Risk should increase
progressively as each level of need is satisfied. For example, one of the first and most primary financial
needs is for an emergency fund. After this "ground level" need has been met, you can afford to take
greater risk in seeing a greater return.

13. When planning for retirement or for a child's education, assume a lower than hoped for rate of
return on investments, a higher than anticipated level of inflation and cost of living (or education),
and put less reliance on what social security or a company pension will provide. In other words
instead of projecting with just one set of assumptions and thus putting unrealistic reliance on figures that
are mathematically accurate but that are grounded on dubious long-range assumptions, do your planning
on a "worst case", "best case", and "probable case" basis.

The Golden Rules of Financial Planning

No matter how basic or how sophisticated you are as an investor, there are certain rules of thumb or
guidelines which seem to be timeless. Wise investors take heed:

1. Diversify. Never put all your financial eggs in one basket. (But if you do, watch them very carefully.)

2. Seek a return OF principal before seeking a return ON principal. In other words considered
prioritizing principal and certainty of income before gain on capital. This is another way of saying, "If it
looks too good to be true, it probably is." Don't be greedy or you may lose it all.

3. Cover your assets before taking greater risk. Seek to protect the ground you've gained. Never go to
the next level of financial risk before seeking to protect the gains you've already made. This is what
personal and business risk management is all about. So be sure you've managed the risk in (a) property
(such as fire, storm, loss, and theft), (b) income (such as death, accident, or sickness), and (c) liability.

4. No risk, no reward. The greatest risk of all is doing nothing! Money is made and taxes are saved by
taking prudent risk.

5. Put yourself on your own payroll - at the top! Budget for savings and investment just as you budget
for paying your bills.

6. Capitalize on the miracle of the "forgotten" automatic investment. If at all possible, put money
aside on a regular automatic basis BEFORE you see it and consider it spendable. For example, use
salary savings accounts, 401(k) plans, and similar devices that help you compound money year after
year. And create automatic mechanisms to make money with the money you've made. For instance, most
investment vehicles provide automatic dividend reinvestment plans.

7. Constantly increase the rate of your investing. It is both easier and safer to gradually increase the
percentage of the amount you are saving and investing than to increase investment return by taking
greater risk. A small increase in the input of a regular investment is often equal to or greater than a
dramatic increase in the rate of return on a new investment.
8. Increase your expenditures at a lower rate than you increase your income. Controlling inefficient
spending and debt acquisition is the lowest risk way to increase the dollars you have available for
investment. Eliminating monetary waste and uncontrolled cash flow are essential to financial success.

9. Always maintain a measure of liquidity. Liquidity is the ability to turn assets back into cash quickly
with little or no loss. It is essential to meet an emergency or take better advantage of a financial
opportunity. Insufficient liquidity often translates into a forced (and then a fire) sale or a lost opportunity.

10. Remember that assets and income maintain their utility only to the extent they maintain their
purchasing power. This means that you must consider the ability of any investment to keep pace with or
exceed the rate of inflation.

11. Think of your financial confidence only in terms of "the bottom line". It's not what you earn that
counts; it's what you get to keep. Don't judge the health of your wealth at the top of the line. Be sure to
consider what's left after (a) taxes and (b) slippage. Consider that state and federal taxes and other
"slippage" reduce bottom line spendable income considerably.

12. Always use the lowest risk strategy that meets your investment need.Risk should increase
progressively as each level of need is satisfied. For example, one of the first and most primary financial
needs is for an emergency fund. After this "ground level" need has been met, you can afford to take
greater risk in seeing a greater return.

13. When planning for retirement or for a child's education, assume a lower than hoped for rate of
return on investments, a higher than anticipated level of inflation and cost of living (or education),
and put less reliance on what social security or a company pension will provide. In other words
instead of projecting with just one set of assumptions and thus putting unrealistic reliance on figures that
are mathematically accurate but that are grounded on dubious long-range assumptions, do

Home > Senior Experience > Your Finances 19 > FINANCIAL PLANNING

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THE FINANCIAL PLANNING PROCESS
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Freshman Year

 Most people want to handle their finances so that

Sophomore Year they get full satisfaction from each available
dollar. Typical financial goals include such things
as a new car, a larger home, advanced career
training, extended travel, and self-sufficiency
during working and retirement years.
Junior Year  To achieve these and other goals, people need to
identify and set priorities. Financial and personal
satisfaction are the result of an organized process
that is commonly referred to as personal money
Senior Experience
management or personal financial planning.
 Personal financial planning is the process of
managing your money to achieve personal
Post-Graduation economic satisfaction. This planning process
allows you to control your financial situation.
Every person, family, or household has a unique
financial position, and any financial activity
Research Center therefore must also be carefully planned to meet
specific needs and goals.
 A comprehensive financial plan can enhance the
Sound Advice quality of your life and increase your satisfaction
by reducing uncertainty about your future needs
and resources. The specific advantages of
personal financial planning include
New York Times  Increased effectiveness in obtaining, using, and
protecting your financial resources throughout
your lifetime.
 Increased control of your financial affairs by
avoiding excessive debt, bankruptcy, and
dependence on others for economic security.
 Improved personal relationships resulting from
well-planned and effectively communicated
financial decisions.
 A sense of freedom from financial worries
obtained by looking to the future, anticipating
expenses, and achieving your personal economic
goals.

 We all make hundreds of decisions each day. Most of

these decisions are quite simple and have few
consequences. Some are complex and have long-term
effects on our personal and financial situations. The
financial planning process is a logical, six-step procedure:

 (1) determining your current financial situation

 (2) developing financial goals
 (3) identifying alternative courses of action
 (4) evaluating alternatives
 (5) creating and implementing a financial action
plan, and
 (6) reevaluating and revising the plan.

 Step 1: Determine Your Current Financial

Situation

 In this first step of the financial planning process,

you will determine your current financial situation
with regard to income, savings, living expenses,
and debts. Preparing a list of current asset and
debt balances and amounts spent for various
 items gives you a foundation for financial
planning activities.

 Step 2: Develop Financial Goals

 You should periodically analyze your financial

values and goals. This involves identifying how
you feel about money and why you feel that way.
The purpose of this analysis is to differentiate
your needs from your wants.
 Specific financial goals are vital to financial
planning. Others can suggest financial goals for
you; however, you must decide which goals to
pursue. Your financial goals can range from
spending all of your current income to developing
an extensive savings and investment program for
your future financial security.

 Step 3: Identify Alternative Courses of Action

 Developing alternatives is crucial for making good

decisions. Although many factors will influence
the available alternatives, possible courses of
action usually fall into these categories:
 Continue the same course of action.
 Expand the current situation.
 Change the current situation.
 Take a new course of action.

 Not all of these categories will apply to every

decision situation; however, they do represent
possible courses of action.
 Creativity in decision making is vital to effective
choices. Considering all of the possible
alternatives will help you make more effective
and satisfying decisions.

 Step 4: Evaluate Alternatives

 You need to evaluate possible courses of action,

taking into consideration your life situation,
personal values, and current economic
conditions.
 Consequences of Choices. Every decision closes
off alternatives. For example, a decision to invest
in stock may mean you cannot take a vacation. A
decision to go to school full time may mean you
cannot work full time. Opportunity costis what
you give up by making a choice. This cost,
commonly referred to as the trade-off of a
decision, cannot always be measured in dollars.
 Decision making will be an ongoing part of your
personal and financial situation. Thus, you will
 need to consider the lost opportunities that will
result from your decisions.

 Evaluating Risk

 Uncertainty is a part of every decision. Selecting

a college major and choosing a career field
involve risk. What if you don’t like working in this
field or cannot obtain employment in it?
 Other decisions involve a very low degree of risk,
such as putting money in a savings account or
purchasing items that cost only a few dollars.
Your chances of losing something of great value
are low in these situations.
 In many financial decisions, identifying and
evaluating risk is difficult. The best way to
consider risk is to gather information based on
your experience and the experiences of others
and to use financial planning information sources.

 Financial Planning Information Sources

 Relevant information is required at each stage of

the decision-making process. Changing personal,
social, and economic conditions will require that
you continually supplement and update your
knowledge.

 Step 5: Create and Implement a Financial Action

Plan

 In this step of the financial planning process, you

develop an action plan. This requires choosing
ways to achieve your goals. As you achieve your
immediate or short-term goals, the goals next in
priority will come into focus.
 To implement your financial action plan, you may
need assistance from others. For example, you
may use the services of an insurance agent to
purchase property insurance or the services of an
investment broker to purchase stocks, bonds, or
mutual funds.

 Step 6: Reevaluate and Revise Your Plan

 Financial planning is a dynamic process that does

not end when you take a particular action. You
need to regularly assess your financial decisions.
Changing personal, social, and economic factors
may require more frequent assessments.
 When life events affect your financial needs, this
financial planning process will provide a vehicle
for adapting to those changes. Regularly
reviewing this decision-making process will help
you make priority adjustments that will bring
 your financial goals and activities in line with your
current life situation.

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Factors Affecting Financial Planning

Financial planning of a business is determined by the following factors:

(i) Objectives. Objectives of financial planning should be consistent with the overall objectives of the
business. The main objectives of financial planning are to raise funds at reasonable cost and utilize them
in the best possible manner.

(ii) Requirements of the Enterprise. A good financial plan should take care of the present and future
requirements of the business. Provision of or various contingencies, replacement of assets, and growth
and diversification of business enterprise must be made.

(iii) Economy. Case of raising capital should be reasonable. Capital structure should be such as to
create an appropriate balance between the cost of funds and the company’s ability to pay.

(iv) Solvency and Liquidity. The funds should be invested in those ventures which are likely to give
sufficient return on investment. Moreover, adequate cash should always to available to meet the
requirements of the enterprise. The enterprise should be solvent and liquid not only in the short-term but
also in the long-term.

(v) Flexibility. Financial planning should ensure flexibility allow the diversion of funds into more
profitable channels. It should also make provision for raising of additional funds at a short notice.

(vi) Optimum Capital Structure. There should be proper capitallsation of the company. An optimum
mix of equity shares, preference shares and debentures should be kept in mid while raising funds form
different resources.
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Business Organisation & Management

Study Material-1

11 Unit-4 Lesson-3 FINANCIAL MANAGEMENT

Unit-4
Lesson-3
 FINANCIAL MANAGEMENT

Finance is the life blood of any business. Business may be big or small, finance
is needed, the only difference is the amount of finance required. Small sized
business is invariably financed out of the personal savings of the businessman.
But after the industrial revolution the size and complexities of business
increased tremendously, making impossible for a sole trader or partnership
firms to finance such large sized ventures. Joint stock companies filled this
gap and made possible to collect huge funds from a large number of persons
and that too with their liability limited. “The joint stock company form has
proved a flexible and valuable instrument. It joins the venturesome and the
countious, the wealthy and the penniless, the capable and unskillful, the
energetic young and retiring old into a system of contractual relationships
which make it possible for each to make the most appropriate part in those
gigantic business enterprises which strech across the continents and
overseas1.” In our study of financial planning, we shall primarily refer to the
financial planning of joint stock companies because this form of business
organisation dominates the industrial world.
Business finance simply means the provision of money when it is required. In
the present money- oriented economy, we simply cannot imagine any
business without money. It has been rightly remarked by someone that money
is needed to earn money but in order to earn money, the money invested must
be well managed. That is why Wheeler defined business finances as that
activity which is concerned with the acquisition of capital funds in meeting
the financial needs and overall objectives of the business enterprise2.
Finance Function
Finance function is a separate functional area of management like production,
marketing, personnel etc. No doubt, production and marketing are the basic
sub-systems of a business system but finance sub-system is of strategic
importance because their success depends directly upon the efficient
operation of finance sub-system. Finance function is so closely inter-related
with the other sub-systems of a business system that it is almost impossible
to segregate it from the general business management. In fact, so closely are
the financial matters of a business system associated with the plans and
results of every other department that in a sense, every proposal and every
decision involving financial problems has a bearing on financial results. It is
precisely due to the ever increasing importance of finance function in the
business that the role of the finance manager is undergoing a constant change
and the scope of finance function has broadened beyond recognition.
Earlier finance function was concerned with procurement of funds, hence all
the earlier studies were confined to sources of raising finance and the
institutions involved in raising finance. Finance was defined by Paish as the
provision of money at the time it is wanted. Now it is well recognised that
procurement of funds, though an important aspect, covers, only a part of the
finance function. The other important aspect is the wise-use of funds
procured for business.
The primary objective of any business is to earn sufficient profit to pay a
reasonable return to

1. Guthmann and Dougale : Corporate Finance Policy.

2. Wheeler : Business : An Introductory Analysis.
the investors and also to retain a part of the profit for ploughing back into
the business. So the scope of finance function not only covers the task of
fund procurement but also the most suitable allocation of funds so as to
maximise the profits. In the words of Guthmann and Dougale. “Business
finance can broadly be defined as the activity concerned with the planning,
raising, controlling and administering of funds used in the business”.
Objectives of the Finance Sub-system
The objectives of finance section should be so tailored that they fully match
the overall objectives of the business system. It has to maintain a balance
between liquidity of funds and profitability. The objectives of financial
management can be summarised as under :
(1) To procure adequate supply of capital for the business when needed;
(2) To conserve and increase the funds invested through sound
management policies; (3) To ensure a reasonable rate of return to the
suppliers of capital;
(4) To ensure the best utilisation of capital to generate income; and
(5) To coordinate the functioning of finance department with the other
departments of business. In order to achieve these objectives it is expected
of a financial manager to take the following
decisions:
(a) Financial planning : He has to prepare budgets of various financial
requirements in order to avoid the possibility of excess or shortage of funds.
The funds to be collected have to be prudently invested so that the return is
maximised without endangering the solvency of the company. In short he is
responsible for investment decisions.
(b) Financing decisions : Finance manager has to decide a suitable
capital structure or financing mix of owned funds and borrowed funds : short
term and long term debts.
(c) Management of cash : He should see that sufficient supply of cash
is always available to business. For ensuring this, cash flow statements are
prepared from time to time.
(d) Dividend decision : Finance manager has to decide how much
profit should be retained for ploughing back into the business and how much
should be distributed among shareholders.
(e) Financial controls : Finance manager can measure the performance
through appropriate measures like cost control, break even point analysis
and ratio analysis. It can keep additional check by internal audit
programmes, budgetary control etc.
Finance Organisation
Finance department is always organised on functional lines. Though it is
normally regarded as a separate functional area, yet it is closely knit with
the general business management. Every proposal, every decision, directly
or indirectly comes in the fold of financial decisions. Prof. Soloman rightly
remarked that financial management is an integral part of the overall
management rather than merely a staff activity concerned with the fund
raising activity.
Organisation of finance department on functional lines highlights the
importance of this basic activity and provides the scope for the appointment
of experts in the field of financial management and also provides an
opportunity for the training of personnel in the area of management. The
idea of organisational structure of finance department can be made clear by
the following organisational chart :
The organisational structure of finance department differs from company to
company depending upon their size, conventions followed, capability of the
man at the helm of affairs and the policy followed by the top management.
For instance, in some companies, a company secretary may be looking after
all taxation and financial reporting jobs; in others there may be a treasurer
to perform the function of cash and bank balance menegement while in
others these functions may be performed by the Assistant Finance Manager.
But in all organisational charts, one thing is common and that is the presence
of one controller who may be called as Finance Controller or manager or
director or by any other name who has to see that the expenditure is done
within the financial policies laid down by the board of directors. He is
responsible for co-ordinating the financial policies and procedures with the
rest of the organisation.
Financial Planning
Planning is deciding in advance what is to be done. It is a projected course of
action. Financial planning is a vital part of overall planning of any business. A
finance manager has to see that the funds needed are made available from
most appropriate source in the required amounts, at the appropriate time and
at a cost that will make their use in business profitable. Financial planning
pertains to the determination of financial objectives, financial policies and
financial procedures. As far as the overall objective of the company is
concerned, it may be one of the several objectives but the finance manager
has to keep the profit maximisation as an operative objective in his day to
day activities and operations and thus maximisation of the total wealth of
shareholders. In order to achieve this objective, financial resources have to
be properly managed with a systematic planning and control. Financial
planning is necessary both for new as well as existing firms. In fact, the
process of financial planning begins from the day the idea of forming a
company is conceived by the promoters. The task of financial planning is
undertaken by the promoters before the formation of a company and after
that it rests with the top management. Any mistake in the financial planning
in the initial stages is likely to create serious implications afterwards. If a
company is incorporated with inadequate capital, it may not be able to meet
its commitments and its very existence may be endangered. If on the other
hand more capital is collected than warranted in terms of the amount of
capitalisation, it may reduce the rate of earning at the same time pose the
problem of management of surplus funds.
Financial planning aims at solving following three basic problems :
(i) What is the total amount of capital required for the business ? —
Capitalisation
(ii) a. What are the different sources from which funds are to be collected
? —Capital structure
b. What will be the proportion of different types of securities ? —Capital
Gearing.
(iii) What is the suitable time for raising capital from a particular security
and other financial policies ? —Capital Administration.
Principles of Financial Planning
While formulating the financial plans, the following principles should be
kept in mind by the financial planners :
1. Objective : All financial planners should always move with one basic
principle while formulating financial plans that their job is to procure capital
at the lowest possible cost and make the best possible use of funds thus
collected. Their objective must be in line with the overall objective of the
company. For example, if the policy of management is to promote sales at
any cost which may be giving liberal credit facilities, naturally, the financial
planner has to make arrangement for working capital and at the same time
make provision for bad debts.
2. Simplicity : As far as possible the simplicity principle should be adhered-
to while drafting plans. The capital structure should not be unnecessarily
stuffed with a number of securities. A simple plan is easy to understand and
easy to implement.
3. Flexibility : Business is full of uncertainties. So a financial plan must be
capable of being adjusted according to these changes. Even in the initial
stages, promoters must make provision for contingencies and inflationary
pressures. A financial plan should be such that it has scope for raising
additional funds at short notice. There should be such a degree of flexibility
so that it could be adopted with minimum delay to meet the changing
conditions.
4. Liquidity : Adequate cash, bank balances and easily convertible
securities should exist in sufficient amount to ensure liquidity. The term
liquidity, in our context, means the availability of cash to make payments,
whenever so required. But, where, in order to ensure liquidity, funds are kept
idle, profitability is bound to be affected. So, the planners must make a
judicious balance between liquidity and profitability. But at no cost, liquidity
should be secrificed for the sake of profitability because this tendency
endangers the safety of the company. Adequate liquidity enables the company
to meet its commitments in time and face the uncertainities of future.
5. Planning foresight : Good planning needs intelligent imagination.
Capital plans should take care of changes in demand, supply conditions,
trends in capital market and so on. At the same time the plan should be
capable of taking care of future expansion.
6. Economy : Planners must provide the desired capital at the lowest
possible cost of collecting funds. The interest bearing securities should be
used only after considering the rate of return, otherwise the obligation of
fixed payments may erode into company’s rate of return and cause over
capitalisation.
7. Control : The plans are to be governed by the degree of control the
promoters wish to retain over the company. If they wish to maintain control
over the company, naturally they have to rely more on fixed interest bearing
securities because the fixed interest bearing security holders do not enjoy
voting rights.
8. Optimum use of fund : Mere adequacy of capital is not sufficient, its
proper use is equally important. While taking decisions about the funds to
be collected, the planners should continuously bear in mind, the purpose to
which these are to be put. Financial plans should be so drafted that the
funds once collected do not remain idle or used for unproductive purposes.
9. Self-generated growth : A financial plan should be such that it
makes the company least dependable on outsiders. It should ensure
sufficient return on investment so that it could be saved and ploughed back
into the business year after year for the growth and expansion of the
company.
Financial Planning in India
The basic principles of financial planning hold good every where, yet the
capital plans drawn differ from country to country because of the difference
in economic conditions prevailing in those countries. Capital plans formulated
in our country are governed by various Acts, like Securities Contracts
(Regulation) Act, Capital Issues Control Act, etc. The existence of Specialised
finance institutions and institutional investors make marked difference. To
what extent the promoters propose to have assistance from these specialised
finance institutions or what is the attitude of the institutional investors
towards a particular company greatly affect the ultimate plan. The amount
of capital to be collected is further affected by the fact whether the company
is getting any subsidy under the Central and State subsidy scheme.
After considering all the above mentioned factors, the promoters of a
company prepare a financial plan in the form of a capital investment budget.
It is based on the estimates of expenditure on various items and the
contributions to be had from :
(1) Indian promoters, (2) Foreign collaborators, if any; (3) Public issue, (4)
Specialised financial institutions and (5) Availability of any subsidy from the
government.
In order to have clear understanding of financial planning of a new company,
let us take a concrete illustration of the capital plan drawn for a recently
promoted chemical company.
COST OF THE PROJECT
The cost of the project is estimated at Rs. 1,89,00,000 as under
: (Rs. in Lakhs)
1.
Land
9.87
2.
Building
16.50
3. Plant and
Machinery 55.00
4. Misc. Fixed
Assets 44.27
5. Technical know-how
fees 13.00
6. Preliminary and Pre-operative Expenses including share issue
expenses 21.65
7.
Contingencies
14.50
8. Margin money for working
capital 14.10
Total 188.89
Say 189.00
MEANS OF FINANCING
It is proposed to finance the above cost of the project as under :
1. Issue of Equity Capital
(a) Promoters, Collaborators,
Directors and their friends 22
(Rs. in Lakhs)
(b) Public
Issue 33 55.00
2. Rupee Loan From:
(a) ICICI Bank 24
(b) GIIC 60 114
.00 (c) GSFC 30
3. Central and State
Subsidies 20.00
189.00
If we scan the above finance plan, we find that the plan contains the
essentials of a sound capital plan. Adequate provision has been made for
contingencies, and working capital. The plan is simple, it comprises only two
types of securities—equity capital and long term loan from specialised
financial institutions. The plant being located in a notified backward area has
also obtained a Central and State subsidy of Rs. 20 lakhs.
The promoters and their collaborators have contributed hardly 11 per cent of
the total cost of the project. General public has contributed 17 per cent of
the cost of the project. Equity issued to the public is 60 per cent of the total
equity capital issued, hence the shares can be quoted on a stock exchange
because it fulfills the provisions of Securities Contract (Regulation) Act. At
the same time, promoters can safely expect to retain their grip over the
affairs of the company.
Estimating Financial Requirements
After becoming sure of the commercial feasibility of the project, the
promoter has to proceed to make estimates for the total capital needs of the
company. In this exercise of total capital requirement calculations, the two
most important underlying factors are the nature of business and size of
business. These two factors have to be remembered at every step in making
capital calculations. The total capital requirement estimation should include
the present needs and also provision for future developments. The total
capital requirements have further to be estimated from the point of view of
foreign currency. This type of analysis is very significant, especially in a
country like ours where sophisticated machinery and technology has to be
imported.
There are two approaches for estimating the total requirements. The first is
to make detailed item-wise estimates and total them up. This is called
the Estimation Method. The other method is the Comparison
Method. According to this method-calculations are made on the basis of
estimates of some other companies of the same type and same size. In this
method the promoters have to make adjustments for price level changes.
The following items enter into the calculation of total capital estimates :
(1) Promotion expenses : incorporation fee, consultancy fee and other
preliminary expenses. (2) Cost of fixed assets : Land and building,
tools, machinery, equipment, furniture and fixture,
miscellaneous fixed assets.
(3) Working capital : Normal cash balances advisable to be kept in hand;
inventories and funds to be tied in debtors and miscellaneous current assets.
(4) Cost of financing : brokerage and commission.
(5) Cost of establishing the business : operating losses other than
depreciation, up to the time when the business will be financially self-
sustaining.
(6) Cost of intangible assets : patents and goodwill.
(7) In addition to all these, some provision for contingencies.
The estimates for each of these figures should be supported by detailed
schedules carefully and skilfully compiled. The importance of the various
items varies among different types of business. A personal service business
has little or no fixed property or inventory. Merchandising concerns may need
only minor amounts for furniture and fixtures. Fixed investment is likely to be
more important for the manufacturer, partly because of his greater
investment in equipment and partly because of his greater difficulty in
securing efficient housing except by constructing a building adapted to the
particular needs of the enterprise. Fixed assets are particularly important for
heavy industries like steel, fertilisers etc., and often a large percentage
represents the total assets. Financial companies cannot really be said to have
financial requirements in the same sense as other businesses. The bulk of the
assets of such a concern, however, are its investments, which are in
proportion to the volume of business with customers and deposits with the
commercial bank.
From the above discussion, it is clear that every business enterprise will
require capital broadly for the following three purposes :
(i) to finance fixed assets.
(ii) to finance working capital or current assets needs. (iii) to finance
improvements and extensions.
A brief description of these needs is given below :
Fixed capital
Fixed capital consists of land, buildings, plant, machinery, fixtures or any
other property that is permanently committed to the business. (Example for
the last item is the regular working capital). These assets are not fixed in the
sense of their value but fixed in the sense that they are committed to the
business for a long period of time and difficult to be converted into cash in a
short period. Fixed capital is usually highly specialised and if the business does
not earn the minimum required rate of profits, these assets cannot be
disposed of except at a loss. The fixed asset is needed to carry on the
profitable operations over a long period of time.
However, the cost of fixed assets varies from concern to concern depending
upon (i) nature of business, (ii) type of manufacturing (simple process or
complicated round-about process) (iii) the size of business unit, and (iv) the
mode of acquiring the fixed assets. As regards the nature of business
activities, marketing enterprises require a small amount of fixed capital as
compared to industrial concerns in general. Public utilities and capital goods
industry require much greater amount of fixed capital than what is needed
in consumers’ goods industries. Enterprises like railways, tramways, or
electricity companies have to be started at their full size in the very
beginning, and hence the cost of fixed assets becomes comparatively larger.
On the other hand most of the consumer goods industries can be started on a
modest scale and expended gradually for reaching their full growth. The size
of the business is an obvious determinant of the amount of fixed capital.
As regards the mode of acquiring assets they can be purchased outright or on
the basis of instalment payments. Particularly valuable machines can be
acquired on instalment basis. Some other assets like land and building can be
acquired in many cases on the basis of lease agreements. Moreover, in many
concerns tools and equipments are manufactured by the companies
themselves for meeting their own requirements. These different
considerations will affect the amount of fixed capital.
To be on a safe side and prevent possible interruption in the flow of business
operations, fixed capital needs must be properly assessed and financed. These
needs must be financed from permanent sources of finance such as issue of
shares, debentures and long term investments. If fixed capital needs are
financed with short term finance, it may interrupt the business activities and
the rate of return because short term debts fall due very soon and possibly
the firm might be running short of funds at that time. Obviously, failure on
the part of the management may lead banks to stop granting or renewing
credit facilities to the firm.
Working Capital
Working capital is necessary for holding some convertible assets like stock of
materials and finished goods, bills receivables, accounts receivables and cash.
Through the use of these assets the operation or the working of the business
is carried on. These assets rotate around the business activities in a circular
way and are fed again and again but in a circular flow. There is a definite
cycle about which these assets move. For example, materials are processed
or transformed into finished goods which are sold to the customers on credit
for creating bills receivables or accounts receivables, and such bills or
accounts receivables are liquidated into cash that can again be utilised in
purchasing materials for production purposes. But working capital does not
represent the amount invested in these assets. The group name of these assets
is current assets. Corresponding to these assets, there is a group of current
liabilities comprised of bills payables, accounts payables, expenses payable
etc. Working capital is the excess of current assets over current liabilities.
The amount required for current assets should not be confused with the
working capital. Some writers have used the term circulating capital or
revolving capital for it. This is because the working capital is invested,
recovered, and reinvested repeatedly during the life time of the concern. In
other words, it keeps on revolving or circulating from cash to current assets
and back. Apparently, it would appear that working capital requirements can
be met with short term funds but this is not so. Some of its part is permanent
in nature and so we must make a distinction between temporary and
permanent or regular working capital requirements.
At the time of the commencement of business, permanent investment is
needed not only in fixed assets but also in current assets to make production
feasible and this part of initial working capital is permanently blocked in the
enterprise. Amount of working capital needed over and above this level is
temporary working capital. With the passage of time, size of the temporary
and permanent working capital changes.
Importance of Adequate Working Capital
Adequate working capital is one of the pre-requisites for the business to be
continued. Business performance is bound to come down and even to a halt,
in the absence of adequate working capital, no matter how much the concern
has invested in fixed assets. The importance of adequate working capital lies
in the following :
(i) In the first place sufficient funds are necessary for purchasing the
materials, and meeting day to day expenses in the form of salary, wages, rent
and so many others.
(ii) Secondly, payment to sundry creditors is to be made in time for the
maintenance of reputation and credit standing of any company. Moreover,
prompt payments result in cash discounts.
(iii) Thirdly, advances from the banks are conditioned by the availability of
sufficient liquid assets.
(iv) Fourthly, for the payment of dividends in cash to the shareholders, funds
are necessary. All these considerations show the importance of adequate
amount of working capital needed
by any business concern to run the operations of the business uninterruptedly
and smoothly.
Determinants of Working Capital
The working capital needs are not uniform for all the enterprise and
therefore, facts responsible for a particular size of current assets in one
concern are different from the other enterprise. Therefore, a set pattern of
factors determining the size of working capital is difficult to suggest.
However, following are some of the most important factors determining the
size of the working capital in an enterprise:
1. Nature of Business and Length of Operating Cycle
A close relationship exists between the nature of the business and the length
of the operating cycle, in so much so, the length of the operating cycle is a
function of the nature of business. For a vertically integrated manufacturing
firm the operating cycle consists of converting cash into raw materials, raw
materials into finished goods, selling the product or products through its
retailing outlets, and converting the accounts receivables into cash. For an
independent retail trade store, the manufacturing portion of the operating
cycle is eliminated but the conversion of inventories into receivables, and
then into cash remain. For providing those services, the inventory problem is
usually eliminated but the collection of receivables remains. Firms selling
services on a strictly cash basis may be able to disregard working capital
altogether, while cash and carry retail trade outlets eliminate the need to
finance receivables.
Where cost of raw materials to be used in manufacturing is very large
in proportion to total cost, working capital requirements are bound to be
large. For instance, in sugar and, textile mills, raw materials are of prime
importance, hence more working capital needed.
The amount of working capital is also affected by the technique of
production. In labour intensive industry larger working capital is required
than in a highly mechanised one. The latter will have a larger proportion of
fixed capital.
2. Management Attitude Towards Risks
It is generally accepted in principle that greater the risk a management is
prepared to undertake, greater shall be the opportunity for profit or loss to
increase. In the area of working capital, management risk implies operating
with a lesser amount of current assets than are indicated, by a given level of
the firm’s operational activity. Thus, if the management decides to operate
with a lesser amount of working capital in relation to its level of production,
it is carrying greater risk and there is a greater opportunity for its profit or
loss to increase. A mere progressive management may opt for greater risk by
keeping its investment very near the optimum level and thus increase the
chance of a higher rate of return on their investments.
3. Turn Over
By turn over is meant the ratio of annual gross sales to average working assets.
It is this figure which shows how many times the amount invested in working
assets has been treated in or turned over during a year. It must be
remembered that the relation is between gross sales and working assets and
not between gross sales and working capital. The higher the turn-over the
lower the period for which goods remain in the investories. If sales are quick,
there will not be much stock held up in the investories. But if the sales are
not regular and are uncertain, then the inventory will be in the stock and the
amount needed for this will be heavy.
4. Terms of Purchase and Sales
If an enterprise is paying in cash for everything it is purchasing, and selling it
on credit, it will obviously need a working capital sufficient to purchase
outright its entire stock of goods including everything that has been sold but
not yet paid for. On the other hand, if the enterprise is able to buy on long
credit and sell for cash, it can provide for its whole stock with no immediate
outlay and will pay its bills as they mature out of the receipts from its own
sales. But in ordinary course of time neither of these extreme arrangements
prevails. Goods are both bought and sold, atleast in part, on credit basis
although the recent tendency is to reduce the length of the credit period. The
longer the period for credit, the larger will be the working capital needed to
finance the transaction.
5. Cash Requirements
The greater the cash requirements, higher will be the amount of working
capital. If a company has sufficient amount of current assets which can be
easily converted into cash or has good banking connections it will not need
large cash balances.
6. Seasonal Requirements
Seasonal industries like sugar, woollen mills etc. have to buy raw materials in
a particular season as their sales are made largely in that season. So, their
working capital requirements are more during that season in which they have
to buy raw materials for manufacturing.
It would be impracticable to attempt to draw up any formula for calculating
the amount of working capital required in any given concern. We must
content ourselves with the general statement that working capital
requirements vary roughly in proportion to the volume of business, the length
of period of manufacture, and the average length of the credit extended to
customers, and the extent of seasonal variation in volume of business. These
vary roughly inversely to the rapidity of turn-over, length of the credit
obtained in purchase of goods and the facilities available for converting
current assets into cash. These are the factors to be taken into account. Since
the customary units of time used in reckoning most commercial operations is
the month, it is worthwhile to make estimates of the working capital
requirements on a month to month basis.
THE CAPITAL STRUCTURE
Earlier it was shown that every type of business organisation needs finances
for its operations and for its growth. The finance that it needs consists of
various types. e.g., long term, medium term and short term and there are
different sources or channels through which such financial needs are satisfied.
This latter aspect shall be discussed in greater detail in the next chapter.
Another way of looking at the problem of finance is to see the form in
which the total financial requirements are met. That is how much
should be owned funds and how much borrowed funds. Broadly
speaking the composition of liabilities side of the balance sheet is called the
capital structure. According to Gerstenberg, ‘capital structure’ refers to the
make-up of capitalisation. Capital structure involves the selection of
securities and the determination of their proportionate amount. In fact, there
is no such thing as the capital structure which may be regarded as the most
appropriate either for all sorts of companies or even for the same company
for all times.
According to the prospects of earnings, the capital structure of companies
should be devised with different securities in such a way that it would
become safe as well as economical. The general principles that guide
the issues of three different types of securities, viz., debentures, preference
shares and equity shares, may be stated as follows : (a) debentures should be
issued by a concern that is expected to have a stable and sufficient income
to pay the fixed interest charges; (b) preference shares being normally
cumulative in nature can be issued when the average earnings are fairly good,
though annual earnings may be of uncertain character and (c) when there is
no certainty of income, equity shares should be issued. But these general
principles do not help much in determining the actual proportion of different
securities in the capital structure. In fact, every company is required to issue
all the three types of securities and not a particular type alone that is
suggested by the general principles.
The part played by long term debt, preference shares, equity shares and
retained earnings depends upon several diverse factors. It is the job of the
skilled financial manager first to recognise such factors and then to balance
or compromise these factors in order to design the capital structure of the
company under consideration. The problem of deciding the proportion of
various kinds of securities is the problem of Capital Gearing. Capital
gearing means the decision about the ratio of different types of securities to
total capitalisation. That part of capitalisation on which fixed interest or
dividend is to be paid shows gearing. Capital gearing is also called as Leverage
and is the ratio between the borrowed funds (fixed return securities such as
debentures preference shares, loans etc.) and the ownership securities
(equity shares and reserves and surpluses not distributed to shareholders but
belonging to them). Capital structure of a company is said to be ‘highly
geared’ when the proportion of fixed charge bearing securities is relatively
more than the ownership funds. On the other hand, a company is low geared
when it raises its capital primarily by the issue of equity shares.
It is the job of the skilled financial manager to have a judicious mixture of
different types of securities in the make up of capitalisation because the
capital structure suitable for one company may not be suitable for another
company. Gold Smith has suggested certain basic principles which must be
met by every company in deciding its capital make up. Those basic principles
are :
(A) The method of financing must have the power of resistance. It
should be able to face the periods of loss or the gestation period. Undue
dependence on fixed interest securities may endanger the very existence of
a company, if it does not have regular earnings.
(B) While financing, future should not be sacrificed at the cost of present.
The Scheme of financing should not be a hindrance to the fullest
development of the enterprise.
(C) The over-all cost of raising capital should be kept minimum.
(D) The capital structure chosen should be simple because a simple scheme
is easy to manage and avoids unnecessary suspicion in the minds of those who
fail to understand the complexities of capital structure.
The aforesaid considerations are not complementary but competitive and
usually contradictory. In practice, a company has to use different types of
securities so, it is ‘gearing’ that requires great skill and experience in deciding
the capital structure. Guthmann & Dougall have divided the factors affecting
capital gearing into two parts. He terms them as conditioning factors—Internal
factors and External factors. Internal factors can well be in the control of the
management but external factors are normally out of control of a company,
for example, capital market sentiments. In order to have an ideal capital
structure these two factors must be judiciously reconciled. The various
factors grouped under ‘Internal’ and ‘External’ groups are given below :
Factors affecting the Capital Structure Decision
A. Internal Factors B. External Factors
1. Stability of earnings. 1. Attitude of the investors.
2. Expected rate of earnings. 2. Prevailing rates in the capital
market.
3. Expected growth rate. 3. The influence of tax policy.
4. Control 4. Attitude and policies of
institutional investors
5. Types of assets 5. Attitude of specialised
financing institutions.
6. Trading on Equity 6. Condition of the capital
market.
7. State regulation and control.
(A) INTERNAL FACTORS
1. Stability of Earnings
Probably the most important internal factor which influences financial
structure decision is the stability or certainty of expected earnings. The use
of debt implies that earnings are sufficiently predictable to enable the
business to meet its obligations, but because the future is uncertain, opinions
may differ as to how much debt is appropriate. Hence, one has to find out
whether the expected earnings will be stable or unstable.
Instability of earnings may arise either due to changes in the volume of the
business or due to the inability to maintain satisfactory relation between
selling price and expenses. In the matter of volume, the weakness may lie
either in the industry as a whole or within the individual firm. Unstable
earnings (whatever their cause may be) make the use of debt dangerous and
less attractive to investor desiring regular and stable income. Companies
subject to this risk should avoid debentures, keep preference shares at a
minimum and favour equity shares and retained earnings as sources of funds.
Companies that are some-what sheltered, from volume instability by
monopoly or partial monopoly, enjoy a greater freedom in their choice of
methods of financing. But earnings’ instability may also arise from
fluctuations of the profit margin. This potential hazard may result from
recurrent price wars, danger from an unusually heavy burden of fixed costs,
or inadequate rates.
Ordinarily, the past record of stability of earning is regarded as a sufficient
index of ability to bear a burden of fixed interest charge safely. Sometimes,
however, it is necessary to consider the factor of predictability. Thus, a small
business with a record of stable earnings might, because of its peculiar
dependence upon the abilities of a single person, have an unrpedictable
future. Small business, therefore, generally lack appeal for long-term
investment by outsiders. Paradoxically, this limitation puts such business
under the necessity of relying, to a greater extent, upon the short term
credits which have a risk for the business, but permit continuous supervision
and check-up by the bankers, and hence it lessens his risk. Typically, small
concerns have low ratios of long-term debt to total assets but have relatively
large proportions of short-term borrowings.
2. Expected Rate of Earnings
The lower the return earned by a business, the more difficult it will be to
finance any considerable growth out of the earnings. A business that is earning
little but expects a high return in the future has a special incentive to finance
with a prior security, either through preference shares or debentures or long
term loans, with the expectation of retiring them from subsequent earnings
or refinancing with equity shares at a more favourable time. But this is
possible only when management finds that investors are ready to appreciate
and understand its (management) enthusiastic appraisal of the future and the
company can sell the shares at a price that reflects the growing future rather
than the gloomy present.
3. Expected Growth Rate
Securities are sold when growth is expected at a rate more rapid than can be
financed by retained earnings. The choice of security is determined by the
temperament of the management and the comparative costs of debt and
equity shares. But, in general, fast growing companies with great need for
funds are more likely to use debentures or preference shares. In such
situations, management hopes to profit from trading on equity and to be able
to repay such obligations from the profits generated out of expansion. If such
expectations are realised then the existing equity shareholders gain from the
expanded earning power that has not been shared with new cash drain paying
interest and repaying principal that such prior securities require.
4. Control
The desire to retain the voting control of the companies in the hands of a
particular group may also influence the form of financing. The use of
debentures or long term loans avoids the sharing of control with others. After
a company has reached a certain size, however, the issue of additional shares
having voting rights may actually strengthen the hold of the controlling group
upon a corporation by making the total equity larger and the cost of buying a
controlling interest much greater. Small shareholders, widely scattered,
usually ignore their proxies or deliver them to the existing management, at
least so long as the corporation is moderately successful. Thus, the desire to
retain managerial control in its own hands, the existing management may
influence its form of financing.
5. Typs of Assets
Some argue that the nature of assets influence financing. Such people
associate large fixed assets with long-term debt and large current assets with
short-term debt. In fact, this is not a correct fact and a right way of looking
at the problem. It is generally advisiable that a part of financial requirements
for current assets is met by long-term sources. The reason being safety and
uninterrupted working of business. It is a different thing whether such long-
term financing will consist of debentures or loans or equity. Financing through
debentures or loans will depend on the stability of the probable earnings
rather than the probable life of the assets concerned. It other words long
physical life does not ensure either stable capital value or a steady income
flow suitable for long- term financing of the fixed charges.
6. Trading on Equity
When a company raises its capital by the issue of equity shares as well as by
borrowed funds and preference shares, it is said to be trading on equity.
Simply speaking, by the term trading on equity is meant, taking benefit with
equity. This benefit is availed of by equity shareholders at the expense of
other form of fixed income securities. It is the arrangement under which an
enterprise uses borrowed funds, carrying a fixed rate of interest, in such a
way that it increases the rate of return on the equity shares.
Suppose a company needs a capital of Rs 2,00,000 to earn 30,000 every year.
If it collects its entire funds by issuing equity shares, the rate of dividend will
be 15% per annum. If, instead, it decides to trade on equity and collects its
funds in the following manner :
(a) by Issue of 10% Debentures of Rs. 50,000 (b) by raising 12%
loan from Financial Inst. Rs. 20,000 (c) by Issue of
11% Preference shares of Rs. 50,000 (d) by
issuing Equity shares of Rs. 80,000
Now the company has to pay :
(a) Interest on 10% Debentures Rs. 5,000 (b) Interest on
Loan Rs. 2,400
(c) Dividend on Preferance shares Rs. 5,500
Fixed payments to be paid Rs. 12,900
The balance Rs. 17,100 ( 30,000–12,900) is available for equity shareholders
and their rate of dividend will rise to 21.4% ( x100).
Thus, they have gained 6.4% just by trading on equity.
This benefit they have obtained at the cost of fixed income securities, i.e.,
by using their funds and making them fixed payments. Besides, interest on
loans is a deluctable expense and thus it will cause savings on the paymen1t
7o,1f0i0ncome tax. Trading on equity has its own limitations which are given
below :

80,000
(a) Rate of earning must be more than the rate of fixed payments to be
made. As in our example in order to gain by trading on equity the rate of
interest must be less than 15%.
(b) The company must have sufficient assets that can be offered as
security to the lenders. (c) Company should be sure of regular earnings.
There should be minimum fluctuations, if it
is to trade on equity. Too much dependence on borrowed funds may pose
serious problem
during lean periods.
(d) Lastly, there is one inherent limitation in trading on equity. More the
company borrows, higher is the rate of interest, and lesser is the benefit to
shareholders.
7. Purpose of Financing
Where funds are required for betterment, these should be raised through
shares or through retained earnings because betterment expenses invariably
do not increase the earning capacity. But when money is needed for
productive purpose, it may be raised though borrowings.
8. Period of Financing
Long term funds are raised only through equity shares or debentures or
preference shares. Short term needs are met by borrowings and funds
needed for 10 years or so may be raised through redeemable preference
shares.
9. Elasticity
The capital structure should be elastic enough to provide scope for future
expansion. Too much dependenc on fixed interest securities makes it rigid.
In the initial stage debentures should be avoided.
(B) EXTERNAL FACTORS
In the preceding paragraphs, we have examined the various factors which
influence the pattern of financing i.e., the capital structure of the company.
Besides these factors, however, there are other factors which are also
considered while designing the capital structure of the company concerned.
These factors are outside the control of that company and/or the industry,
and hence, these factors have been grouped as external factors.
1. Attitude of the Investors
This is a very important factor which one has to take into account while
determining the form of financing. Prossiblity of savings habits and experience
give rise to investment attitudes. These attitudes become so rigid that many
a times management does not like to deviate from these conventional norms,
though circumstances may reasonably permit such deviations. We also find
that some of the attitudes are like fashions which undergo quick changes and
such changes are not based on logic or reason. But the fact remains that such
attitudes which represent such current whims, should be taken into account
while formulating the financial structure of a company.
2. Prevailing Rates in the Capital Market
The form and the timing of corporate financing are also influenced by the
prevailing rates paid for capital in the securities market. The rate which the
individual corporation must pay is determined by several factors such as the
general level of interest rates that are prevailing at the time of the financing,
the market’s appraisal of the credit standing of the corporation, and the
proposed form of financing. The form of financing, in turn, is determined by
a comparison of the costs of the various alternatives, a consideration of the
risk to the corporation, and its availability in each form. Thus, debt financing
may be chosen because of its cheapness, and its availability in-spite of the
risk that it may lead to. That is, the danger of cash insolvency leading to legal
bankruptcy. The small corporation may choose short-term debt because it is
cheaper or because it is the only credit obtainable, although the continuous
problem of renewal or repayment may require more efforts and it may be a
potential threat to solvency.
3. The Influence of Tax Policy
Tax policies prevailing in the country also influence the form of financing. For
example, it is well-known that company taxation in most of the countries is
at a pretty high level which has put a premium on debt financing as compared
to money from preference shares or through equity shares. Therefore, the
popularity for debt financing arise from the fact that the interest payable on
debt is a deductible item in the profit and loss account for tax purposes while
dividends are not chargeable in the income statement. This is one of the
powerful factors which has created imbalances in the capital structures of
many companies in India. Even the specialised financial institutions have
changed the traditional norms of debt-equity ratios.
4. Attitude and Policies of Institutional Investors
In most of the capital markets of the world today, there is more and more
institutionalisation of savings. This has resulted in the growth of large number
of institutions like life insurance companies, investment trusts, unit trusts,
commercial and savings banks etc., which exert dominant and powerful
influence on the working of the securities markets. These institutions have to
follow a particular type of investment policy either under a specific law which
governs their functioning or by the conventions based on the particular nature
of their work. For example, Life Insurance Corporation of India always prefer
long-term securities with steady return. These institutions control a large
segment of the total demand for securities and hence it is quite obvious that
the company managers will have to take this factor into account while
formulating the form of financing.
5. Attitude of Specialised Financing Institutions
In most of the countries special financing institutions are today exerting a
very powerful influence in the financial markets of that country. This is true-
for our country also. Today in our country these special financial institutions
are playing such an important role that there can hardly be a company which
has not received large financial assistance from these financial institutions in
one form or the other. This point is relevant for us because these institutions
are guided by certain policies and they follow certain norms and hence the
borrowing companies have to fulfil these norms in order to get finance from
these institutions.
6. Conditions of the Capital Market
While determining the form of financing, the financial manager of a company
cannot ignore the conditions prevailing in the capital market of his country.
For example, if the capital market is in the buyont condition it is easy to raise
even large money through equity share but is not so easy to do when the
capital market is in the dull and depressed condition. In the latter situation,
debt financing may be easier. Hence, the financial manager has to read the
pulse of the capital market.
7. State Regulation and Control
In some countries the governments prescribe or lay-down certain guidelines
or regulations regarding the raising of capital from the market in different
forms. For example, in India, the Capital issues Control Act lays down specific-
norms for debt-equity ratios and hence, the manager has to take note of such
factors in finalising the financial plans of his company. For example, a banking
company can issue only equity shares.
CAPITALISATION
The term capitalisation has been defined by different writers in different ways
in different contexts and one finds as many definitions as there are writers on
this subject. Authors like Husband
& Dockeray give a broad interpretation to the term and regard the
term ‘capitalisation’ and
‘financial planning’ as one and the same thing. According to them the
term ‘capitalisation’ is exhaustive in its scope and includes not only the
determination of amount of capital (quantity aspect) but it also includes the
decision regarding type of securities (quality aspect).
The narrow interpretation of the term includes only the quantitative aspect.
Even in the narrow sense different authors have attempted to define it in
different ways but now the meaning of the term capitalisation is generally
understood that‘Capitalisation comprises of a corporation’s
ownership and borrowings as represented by its long term
indebtedness’.
So, capitalisation may be said to be the sum of :
1. The face value of shares of different kinds.
2. The face value of debentures and bonds not yet redeemed.
3. Long term debts.
4. Surpluses not meant for distribution—whether capital-surplus or
revenue-surplus.
The term ‘Capitalisation’ is different from the term ‘share capital’ and
‘capital’ and it can be used only in relation to a joint stock company because
it is only a joint stock company which can issue debentures and bonds. The
term share capital means only the face value of paid up shares and the term
‘Capital’ includes all loans and surpluses but ‘Capitalisation’ includes only
long term loans and surpluses not meant for distribution in addition to share
capital.
To solve the problem of determining the amount of capitalisation is necessary
both for a newly started enterprise as well as for an established concern.
There are two theories of determining the amount of capitalisation, namely,
the Cost Theory and the earnings Theory.
The Cost Theory
In this theory the amount of capitalisation is determined from the summation
of a number of capital expenditures required for putting the company as a
going concern. In simple words, under the cost theory of capitalisation, a
company’s value, worth, or capitalisation is worked out by aggregating the
cost of fixed assets, the amount of regular working capital required to run
the business, the cost of establishing the business and other costs such as
promotion and organisation expenses and to cover possible initial losses.
For example, if investment in fixed assets, current assets, and other items is
made to the tune of Rs. 20 lacs, Rs. 5 lacs and Rs. 2 lacs respectively, the
total amount of capitalisation would be Rs. 27 lacs. Amount of capitalisation
calculated under the cost theory facilitates the calculation of the amount to
be raised.
But this approach although simple to understand and calculate suffers from
certain deficiencies,the main being that there is no provision for
contingencies provided for future. Or if some assets lie idle, or are poorly
employed, will result in low earning and the company will not be able to pay
a fair return on capital invested. The result will be over-capitalisation.
In order to do away with these difficulties and arrive at a proper rate of
capitalisation, earnings approach is used.
The Earnings Theory
Under the earnings theory of capitalisation, two factors are generally taken
into account to determine the capitalisation :
(a) What is the expected volume of earnings. (b) The prevailing rate of
return.
For example, if 10% be the rate of return and Rs. one thousand be the
expected earnings of a business, the amount of capitalistion would come to
Rs. ten thousand in terms of earnings theory. As the earnings theory is based
upon two factors—the fair rate of return and the probable future earnings,
any mistake in calculation in respect of these two factors would lead to the
adoption of wrong amount of capitalisation.
Moreover, the earnings theory is based upon the ‘rate’ by which the earnings
are to be capitalised. But this rate is difficult to estimate as it is determined
by so many factors. But even then it provides a sound basis of capitalisatlon.
OVER-CAPITALISATION AND UNDER-CAPITALISATION
Over capitalisation arises in those cases where the company’s earnings are
too low to give a fair return on shares and debentures issued by the company,
i.e. the company is not earning adequate return on the assets employed. It is
so because the assets employed exceed the actual requirements of the
business. For example, if the actual amount of assets needed is Rs. 2,00,000,
the rate is
10%. But if company raises Rs. 2,40,000. The concern will be over capitalised
to the extent of Rs.
40,000. If the earnings are Rs. 20,000, the rate of return available to equity
shareholders will be 8-
1/3%. So the company would be said to be overcapitalised because the rate
of return is less than the required rate of return. Overcapitalisation should
not be taken as excess of capital. In fact, there may be overcapitalised
companies having shortage of funds.
The overcapitalisation appears from the overvaluation of assets in relation to
the amount of shares and debentures issued by a company. That is the amount
of securities exceeds the value of the assets. Such overvaluation may be
caused by a number of factors like:
(i) The enterprise may raise money by issue of shares and debentures than
it can probably use.
(ii) If the company borrows a large sum of money and has to pay a rate of
interest higher than its earnings.
(iii) When higher amount of goodwill has been paid to the vendor from whom
the asset has been purchased.
(iv) The company might have acquired the assets in the boom period when
the price of the assets were at the peak. But now they may have fallen to a
considerable extent.
(v) The company might have not provided for adequate amount of
depreciation and thus having high earnings, so distributing high rate of
dividend in the initial period but after some time the company may find it
difficult to pay adequate amount of dividend as the actual value of the asset
may have been much lower than as shown in the books.
(vi) High rates of taxation may leave little in the hands of the company to
pay adequate rate of return to the shareholders.
Due to this over-capitalisation, the company may find itself in certain
difficulties like:
(i) The price of its shares in the stock market decline due to lower rate of
dividend and higher rate of interest in the market.
(ii) The company may lose its credit-worthiness and hence the company
may be required to pay a higher rate of interest to the suppliers of funds.
(iii) Moreover, it will be difficult for the company to raise capital in the
market.
(iv) The lower rate of return may induce the company to raise the price of
its product if it is operating on monopoly terms in order to have higher
margin of profit to pay adequate rate of return.
Remedies for Over Capitalisation
The problem of over capitalisation poses certain problems for a company as
well as to the shareholders whose wealth in terms of share market value has
gone down. To overcome these problems and difficulties certain measures
and steps are to be taken, some of which may be listed as follows :
(i) Reduction of interest on debentures which increases the earnings
available to shareholders and thus raising the rate of return.
(ii) Reduction in the number of preference shares.
(iii) Reduction of par value of shares.
(iv) Reduction in the number of equity shares so that the dividend per share
may be increased.
(v) Complete reorganisation of the concern in terms of financial needs,
sources and allied matters.
So, overcapitalisation is very harmful for the company as well as for the
shareholders and for removing this difficulty, the whole thing has to be
reorganised.
Under-Capitalisation
Under-capitalisation is the reverse of overcapitalisation. It may refer to either
the situation where the market value of assets is in excess of the book value
of the assets shown in the books of accounts of the company or the company
might be earning more rate of return as compared to other norms and paying
a higher rate of dividend to its shareholders. In a large well cstablished
concern there may be a very large appreciation in the value of assets
especially of plant, goodwill and the buildings. This appreciation may not be
brought in the books. So under-estimating the value of assets in the books
whereas the actual market value is much more than this. In such cases the
dividends will be much higher and the market quotation for shares will also
be higher than warranted by the book value of the assets.
So, a company is said to be under-capitalised when its actual capitalisation
is less than its proper capitalisation as warranted by its earning capacity.
The different causes of under capitalisation are just reverse to those
responsible for over- capitalisation, namely:
(i) Under-estimation of earnings.
(ii) Capitalising earnings at a higher rate.
(iii) Conservative dividend policy.
(iv) Maintenance of high efficiency.
(v) Increase in price level and so on.
But this under-capitalisation although good for shareholders is detrimental
to the company in the long run. The main consequences of under-
capitalisation may be as follows:
(i) Competition is encouraged by the higher earnings of such companies.
(ii) High dividend rates give an opportunity for workers to ask for increase
in wages.
(iii) It may give the consumers a feeling that they are being exploited by
the company.
(iv) It may limit the marketability of the shares and thus narrow the market
of the shares of the company.
These consequences in the long run will reduce the profit margin of the
company and make it equivalent to the earnings of the other similar
companies. But to remove this problem, following steps may be taken :
(i) Splitting-up of shares.
(ii) Increase in par value of shares.
(iii) Issue of Bonus Shares.
(iv) Re-appraisal of assets upward.
One thing should be noted here that sometimes over-capitalisation and
under-capitalisation are misunderstood in terms of abundance of capital and
shortage of capital, respectively. But in fact this is not so.
COMPARISON BETWEEN OVER-
CAPITALISATION AND UNDER- CAPITALISATION
The comparison between over-capitalisation and under-capitalisation is
difficult to make. Over- capitalisation is a most common feature of the
enterprises whereas the under capitalisation is a rare occurrence. Still, if we
compare their respective pros and cons we can conclude that under-
capitalisation is a lesser evil. Under-capitalisation is more beneficial not only
for the shareholders but also for the society and the economy in so far as it
brings stability in the society, increased prosperity to the nation and high rate
of earnings and increased prices to its shareholders. Besides, the non-
existence of these advantages to an over-capitalised firm, as seen earlier also,
demands as a remedy, a high cost in the form of sacrificing a part of their
interest in the corporation or by bringing more doses of capital in the
enterprise because of a great drain on the financial structure of the company.
Thus to make a logical comparison, the question to be asked would be, which
one is better—
over-capitalisation or under-capitalisation? But which is the lesser evil? The
above details suggest that over-capitalisation should be discouraged and a
fair capitalisation be the attempt of every company.
SOURCES OF FINANCE
The term ‘source’ implies the agencies from which capital is procured in the
business world. For two types of capital, viz., fixed and working, different
sources are tapped by business enterprises. Fixed capital involving long-term
financing is primarily available from two sources—buyers of securities and
lenders of long-term funds. Working capital, on the other hand, involving
partly long- term financing and partly short-term financing, can be procured
from the suppliers of fixed capital as well as from the lenders of short-term
funds. That is to say, the sale of securities and the borrowings of one kind or
another are the principal means of securing capital on the part of business
concerns.
Before going into the details of these sources, the ways in which the money
is actually raised, the various considerations in selecting a source of finance,
the finance manager should have a working knowledge of the mechanism of
financial market as is operating in his country.
Financial market, as the name suggests, consists of various institutions,
intermediaries and the instruments which are needed for the provision of
loanable funds from those who have these to those who need or seek. For
convenience sake, financial market is subdivided into two major groups– the
long term funds market: called as ‘Capital Market’ and the short-term
funds market called as
‘Money Market’. In actual practice, it is very difficult to classify finance
market in such water- tight compartments as Capital Market and Money
Market. In fact, there is lot of overlapping between the two and many a times
we notice the participant of one market is visible in other market. Both these
together are integral parts of one composite financial market.
These words ‘Capital Market’ and ‘Money Market’ have been deliberately
mentioned here to make the reader aware of the fact that the sources of
supply of funds and their significance— whether in long, medium or short term
funds depend largely on the nature of financial mechanism that a country has.
If it has developed one, we find the different relative roles of the different
sources, where as in an underdeveloped financial market, the seekers of funds
have to orient their financial strategy in different ways.
RAISING OF FINANCE
Raising of finance is effected by different means depending upon the forms
of business, the types of capital needed, the nature of financial market
(developed, underdeveloped or undeveloped) as well as upon the size of the
business. Basically, finance for business comes from ownership funds and
borrowed funds. Ownership funds are supplied in the case of unincorporated
enterprises in the form of direct contributions by proprietors and partners. In
corporate enterprises, ownership funds are supplied by the buyers of shares.
Borrowed funds are supplied by a number of lending agencies (individuals and
institutions).
Important sources for raising finance under varying circumstances are
indicated below :
Fixed Capital for large-sized enterprises : (1) sale of securities,
(2) foreign investments, (3) public deposits from the investing public, (4)
term loans from finance and development corporations, (5) retained profits
in the case of existing enterprises, and (6) State assistance in special cases.
Working Capital for large-sized enterprises : (1) commercial
banks, (2) sale of securities, (3) retained profits, (4) private deposits, and
(5) public deposits.
Capital for small enterprises : (1) ownership funds, (2) State
Finance/Development corporations, (3) private deposits from friends and
relatives, (4) commercial banks, (5) indigenous bankers and money lenders,
(6) co-operative banks, and (7) state assistance in different forms.
From the above list of sources of capital accumulations, it is apparent that
many agencies supply funds for meeting both working capital and fixed capital
requirements. These agencies can be divided into two parts – (a) Ordinary
financial institutions such as insurance companies, banks and investment
institutions, (b) Specialised institutions or Development banks. Of these
different sources of supplying finance, State Finance and Development
Corporations have been dealt with separately.
Shares
Shares represent equal portions into which the capital of a company is
divided, each shareholder being entitled to a portion of the company’s profit
corresponding to the number of shares he has in his name.
A company can issue two types of shares namely equity shares and preference
shares. Equity shares or the common stock is regarded as the corner stone of
the financial structure. Both for legal and economic reasons, a company
organised for profit can’t exist without equity shares in so far as they do not
carry with them any fixed commitment charges. If a company is earning large
profits, the shareholders get a higher amount as dividend and if somehow the
profits of the company come down then in that case the equity shareholders
will get lesser amount for their investment. The fact that company does not
have to pay any fixed return on the equity shares is one of the main
advantages of using this method of raising finance. It is in fact the first type
of security to be issued by the corporations and the last to retire in the event
of liquidation, so it occupies primary and residual position respectively in the
two situations. As has been said earlier, one must note that the earnings of
the equity shareholders vary according to the earnings of the company. So it
is said that any change in the business brings corresponding changes in
the fortunes of the equity shareholders. Because of this position equity
capital is said to be the venture capital or risk capital of the company and it
is provided by the ordinary or equity shareholders.
The main feature of the common stock is that it provides a way of raising cash
for the company with no fixed commitment charge attached to it.
From the investor point of view, equity share-holding gives the shareholder
an opportunity to share in the profits when declared as dividends, an
opportunity to make money on appreciation in the value of shares and
opportunity to vote for the directors of the company.
However, equity shares, as a method of providing funds, are not free from
certain problems which can be stated as :
(i) The issue of large proportion of equity shares results in the dilution of
control by the clique of the equity holders.
(ii) Use of more equity share capital deprives right from trading on equity
which results in losing opportunity of using cheap borrowed capital.
(iii) Excessive use of equity may result in overcapitalisation.
(iv) It is having an attraction only for those who can not take risk.
Preference Share Capital
Preference share captital can be defined as that part of the share capital of
the company which fulfils both the following requirements, namely that it
carries preferential rights in respect of dividend and also that it carries
preferential rights in regard to repayment of capital in case of winding up.
The dividend on these shares is fixed. The company may be a prosperous one
but the preference shareholders get a fixed rate of dividend.
It is a hybrid form of financing, in the sense that it combines the features of
debt and equity, i.e, it carries a fixed rate of dividend which is similar to
return on debentures but it does not have a prior change for payment like
debentures. This latter feature is similar to equity shares in terms of return
on capital. In the event of liquidation, a preferred stock holder’s claim comes
after that of company creditors but before that of an equity shareholder.
Usually this claim is restricted to the face value of the shares.
These shares can be divided into different types such as participating,
redeemable categories like cumulative and non-cumulative preference
shares. Participating preference shares have a right to something above their
fixed dividend. Redeemable preference shares can also be issued but they
must be fully paid up.
These preference shares, although have priority above the equity
shareholders but they have a restricted voting power. Preference
shareholders can vote only on resolutions directly affecting their rights. The
management issues preference share capital because the affairs of the
company remain fully in the hands of the present management. From the
investors’ point of view, the preference shares are safer than the equity
share-holdings. But in terms of cost, these preference shares cost more in the
sense that the dividend paid to the preference holders is not a deductible
expense whereas the interest paid on loans is a deductable item to calculate
the tax liability.
Debentures
The other common method to raise finance by a company is through loans.
The loans of long term character can be raised either through transferable
security or through negotiated loans. Debentures belong to the former
category. It is a transferable security under which the company acknowledges
the receipt of money and for a specific period of time (redeemable variety)
or for an infinite period of time (irredeemable variety). The document is
known as debenture. Debenture- holders are the creditors of the company
and get a fixed rate of interest on the stipulated dates. Generally these
debentures are secured. The advantage to the company in raising money
through debentures lies in the fact that the interest payable on such
debentures is a deductable item in the profit and loss account and therefore
the profitable company enjoys the tax benefit (known as tax- shield). This,
therefore, helps in the reduction of cost of finance to the company. The other
important gain to the company is that the debenture-holders being the
creditors to the company are not entitled to participate in the management
of the company. Hence, the management at times likes to retain control by
issuing debentures. Debenture-holders also (conservative type) prefer the
investment of funds in this variety of debentures because it ensures a steady
income and prior claim in the event of company’s winding up. One thing we
should note is that the debentures are commonly regarded as safe securities
but the investors have to depend more on the financial soundness and the
profitability of the venture rather than the mere legal protection offered by
the debenture security.
Debentures have been an important source of financing everywhere but in
India they have not been so popular in the past. Recently, however there has
been a marginal change in this regard on account of the depressed capital
market as well as the special interest shown by special financing institutions
like the Unit Trust of India and the Life Insurance Corporation of India. The
unpopularity of debentures is generally regarded on account of the following
factors. Some of them are felt by the issuing company and some of them faced
by the investors.
Difficulties of the Issuing Company—
(i) Because of the high stamp duty, the cost of raising capital in the form of
debentures becomes very high,
(ii) Companies hesitate to issue debentures which may dry up the bank credit
for their inability to offer clean and unencumbered security to bankers.
Difficulties of the Investors—
(i) Debentures are usually issued in denominations of Rs. 500 each and as such
common investors cannot purchase debentures
(ii) Debentures are not issued with attractive terms; service of trustees for
debenture-holders are not generally available, and the securities market
cannot ensure a prompt liquidity of debentures, and
(iii) As debentures are purchased by conservative investors, the Government
securities are more preferred than debentures by those investors. Besides the
safety of investment, the Government securities are being offered at present
with an attractive yield factor. As a result there is a general diversion of funds
towards saving certificates, plan certificates etc.
In order to make debentures attractive now the companies have introduced
convertible clause. These convertible debentures have become very popular
with investors.
3. Public Deposits
Under this method, the company invites the public to deposit their money
with the company for a specific period at a specified rate of interest. In India,
on account of certain historical reasons, this method was very popular till the
first quarter of the present century. At that time, the public themselves used
to run to good companies to deposit their surplus funds. This was the most
important source for the cotton mills in Bombay and Ahmedabad. The system
however, had its own drawbacks and weaknesses. In times of real need of
money it was difficult to obtain deposits through this source. The tendency of
the depositors to withdraw their advances on the slightest rumours made the
position still worst. This system therefore is highly inelastic, volatile and very
undependable.
At present no facility is available of ‘insurance cover’ as it is available for
bank deposits. The interest received by investors is not free from income tax.
The funds thus collected from public may be used in non-priority sectors and
the indiscrimate borrowings may distort interest rate pattern in the country.
The maximum rate of interest payable is now 8% and on debentures it is 7.5%.
The slugishness in the capital market after 1962 and the increasing
difficulties experienced by the company in raising finance again attracted
the investors for making public deposits. The difference was that the
company now invites the public to deposit their funds with the company.
During the last two decades or so there has been a substantial growth in
public deposits. But unfortunately several cases of malpractices were
noticed. Hence, the Reserve Bank of India issued several rules
and regulations for the acceptance of the deposits by the Non-Banking and
Non-Financial Companies. The purpose is to curb the undesirable and
unhealthy practices of the companies and thus to protect the interests of
the innocent investors.
4. Retained Earnings
Ploughing back of profits is a method of financing, commonly used by the
established companies. It is an internal source of finance. It is a part of
profit which has not been distributed to shareholders in the form of
dividends. This method avoids any long-term commitment and does not
dilute the ownership by sale of voting shares. As far as expansion
programmes are concerned, the retained earnings provide a better method
as there is no immediate pressure on the company to pay back the amount.
The method of ploughing back of profits is cheaper.
The method of ploughing back or self-financing has its shortcomings and if
carried too far, might prove dangerous. In the hands of over zealous
directors it might lead to overinvestment in the industry causing over
expansion. Again the shareholders who have little individual interest in the
company and who are ever-changing, want as high a dividend as possible. If
in pursuit of a policy of building up reserves, the directors, though
unwillingly, lead the shareholders to believe that they are inconsiderate to
the interests of the latter, there is a great danger of the available capital
being distributed in an ill-balanced manner, so far as the industry is
concerned. But one thing should be noted that if such a policy is pursued
cautiously, this method can help, to a great extent, to grow.
5. Loans from Specialised Financing Institutions
Today, perhaps there will be no company of worth naming which has not
received financial assistance in one form or the other from the special
financial institutions operating in India. It is only after independence that
the Indian government took special steps to promote, establish and help the
creation of those special financing institutions. The Industrial Finance
Corporation of India (IFCI) was established in 1948 and since then dozens of
large and or small financing corporations have been created. The Industrial
Development Bank of India (IDBI), started in 1964, is the appex body to co-
ordinate the activities of all the financial institutions operating in the
country. These institutions with minor variations provide financial assistance
in the following forms :
(a) Provision of loans (long-term);
(b) Underwriting of shares and debentures issued by the companies;
(c) Guaranteeing loans and deferred payments etc. on behalf of the
companies; (d) Direct subscriptions to shares and debentures of the
companies; and
(e) Re-financing of loans, (this is specially done by the IDBI).
Since the details of their working etc., has been discussed in the subsequent
chapter it is enough to note here that these institutions which were created
initially to supplement the existing channels in a way to help the main sources
have now become so essential that they have become the part of the financial
system of the country.
The borrowing company has to submit a detailed application form for
obtaining loans and other financial assistance from these corporations. They
have also to submit a copy of the project report to the financial institutions
so that the later can make a thorough appraisal of the borrowers’ financial
position as well as the profitability of the proposed plan.
However, with the entry of commercial banks in the long-tern financing of
business, these financial institutions are disappearing one after the other.
Some of these have even converted or started as Banking Companies. IFCI has
disapproved, IDBI, ICICI, HDFC have started and merged with banking units.
UTI has also started a UTI Bank.
6. Other Financial Institutions
In this category, we can include the commercial banks, the Unit Trust of India
and the Life Insurance Corporation of India. Commercial Banks are
conventionally regarded as the main source for short term finance but
recently they have been participating in medium term loans also. The
borrowing companies procure finance from commercial banks in a number of
ways.
Unit Trust of India and the Life Insurance Corporation of India fall under a
different category. Unlike commercial banks, they do not give direct financial
assistance to the companies but provide help in indirect manner by
underwriting shares and debentures of the company and directly subscribing
to their securities. In most of the States in India, the State governments have
also sponsored development corporations to provide financial and other help
to the companies.
The above sources of finance are for long term and medium term. Long term
funds are raised for a minimum period of ten years & medium term funds are
raised for a period ranging from more than one year to less than ten years.
Finance can be raised for short term also. Its period is twelve months or less
than this. Short term finance can be raised from the following sources :
1. Trade Credit :—Trade credit facilitates the purchase of supplies without
immediate payment. It is a very simple method of raising short term finance.
No interest is payable on trade credits. The actual cost is the loss of cash
discounts. Moreover, no charge is created against the assets of the buyer of
goods. Trade credit is given to reputed customers only. The period of credit
depends upon the nature of the product, location of the customer, customs
of trade, degree of competition, etc.
2. Instalment Credit :—This type of credit is given by the equipment
suppliers to business firms. Some portion of the cost price of the asset is paid
at the time of delivery and the balance is paid in a number of instalments.
Interest is also included in the amount of instalment.
3. Accounts Receivables :—Under this source, the accounts receivables
of a business concern are purchased by a financing company. The finance
companies usually make advances upto sixty percent of the value of the
accounts receivable pledged. Bad debts, if any, are to be borne by the
business concern itself.
4. Customer advance :—The customer advance represents a part of the
price of the products that have been ordered by the customer and which will
be delivered at a later date. Generally, this advance is only in case of big
orders & customers insist that the goods are supplied as per their
requirements.
5. Bank Credit :—Commercial banks provide finance for short term by any
of the following methods :
1. Loans : Under this scheme customers are given full amount of loan in cash
and its repayment is also done in one instalment. The borrower is required to
pay the interest on the whole amount.
2. Cash Credit : This is a running account from and to which withdrawals
and deposits can be made frequently. The customer has to pay interest only
on the amount actually utilised. Here, a borrower is allowed to borrow upto
a certain limit against the security of assets, guarantees or promisary notes
signed by two or more sureties.
3. Overdraft : Here, the bank allows its customer to overdraw his current
account. The customer is charged on the amount actually overdrawn.
 4. Discounting of Bills : Here, Banks finance the firm by discounting their
credit instruments like bills of exchange, promissory notes and hundies at a
price lower than their face value.

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TABLE OF CONTENTS

 1 Contents

 2 Unit-1 Lesson-1 THE BUSINESS SYSTEM

 3 Unit-1 Lesson-2 ENTREPRENEURIAL PROCESS

 4 Unit-2 Lesson-1 THE PROCESS OF MANAGEMENT

 5 Unit-2 Lesson-2 MANAGERIAL PLANNING

 6 Unit-2 Lesson-3 NATURE AND PROCESS OF ORGANISING

 7 Unit-3 Lesson-1 DIRECTION—COMMUNICATION, LEADERSHIP AND MOTIVATION

 8 Unit-3 Lesson-2 CONTROL : CONCEPT AND PROCESS

 9 Unit-4 Lesson-1 MARKETING MANAGEMENT—NATURE, IMPORTANCE AND CONCEPT

 10 Unit-4 LESSON 2 MARKET SEGMENTATION

 11 Unit-4 Lesson-3 FINANCIAL MANAGEMENT

 12 Unit-4 Lesson-4 HUMAN RESOURCE MANAGEMENT

 13 Unit-5 LESSON 1 CHANGE MANAGEMENT

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