Entrepreneurship Development

Long and Short Term Sources of Finance

Finance is one of the important pre-requisites to start a project of an enterprise. In fact, it is availability of finance that facilitates an entrepreneur to combine together the other factors of production like land, labour, machinery and raw material to produce goods. Financing an enterprise is a critical element for success in business. Every entrepreneur should chalk out its future financial requirements in the beginning.

Sources of Finance

1Long Term Source of Finance
2Short Term Sources of Finance

Long Term Source of Finance

(1) Equity shares capital – Shares which are not preference shares are called equity shares. In other words, equity shareholders are entitled for dividend and capital after the payment of dividend and capital to preference shares. The holders of these shares are the legal owners of the company. They have unrestricted claim on profits and assets of a company and possessed all voting rights in the company. In fact, the foremost objective of a company is to maximize the value of its equity shares. But, being the owners of the company, they bear the risk of ownership also.

(2) Preference shares capital – Preference shares are the shares which carry preferential rights over equity shares both regarding the payment of dividend and the return of capital at the time of winding up. These shares may be of various types like cumulative and non- cumulative, redeemable and irredeemable, participating and non-participating, and convertible and non-convertible. However, a company limited by shares cannot issue irredeemable shares as per latest regulations of the Companies Act. It has also been provided in the Act that a company limited by shares can issue preference shares which are liable to be redeemed within a period of maximum twenty years.

(3) Internal accruals – Internal accruals of an enterprise consist of depreciation fund and retained earnings. Depreciation represents the allocation of capital expenditure to various period over which the capital expenditure is expected to benefit the enterprise. Each year a depreciation cost is shown in the profit and loss account. In other words, certain amount is charged as depreciation fund which can be utilized to replace the asset when the life of the asset is over. Hence, it is considered as an internal source of finance. Retained earnings are that portion of equity earnings which are ploughed back in the enterprise. Out of profits earned, certain amount is transferred to various reserves that can be utilized later on as and when the requirement arises. It is also an important source of long-term finance.

(4) Term loans – Enterprises obtain long-term debt mainly by raising term loans. Term loan represents a source of debt finance which is generally repayable in less than ten years. Financial institutions provide rupee term loans as well as foreign currency term loans. Rupee term loans are provided directly to industrial concerns for setting up new projects as well as for expansion, renovation and modernization of projects. These funds are given for incurring expenditure on land, building, plant and machinery, preliminary expenses, margin money for working capital, etc. Foreign currency term loans are provided by financial institutions for meeting the foreign currency expenditure on import of machinery, equipments and technical know-how fees. Term loans typically represent secured borrowings. Usually, assets which are financed with the term loan, provide the prime security. Other assets of the enterprise may serve as collateral security. The interest on term loan and principal repayment are definite obligations that are payable irrespective of the financial situation of the enterprise.

(5) Debentures – Debentures are one of the frequently used methods by which a company raises long-term funds. A debenture is an instrument issued by a company acknowledging a debt due by it to its holders. A fixed rate of interest is paid by the company on these debentures. A company can issue various types of debentures like redeemable and irredeemable, secured and unsecured, convertible and non-convertible, etc. A debenture trustee must be appointed by a company issuing debentures. The trustee protects the interests of debenture-holders and redresses their grievances. In addition, the company has to create a debenture redemption reserve account out of its profits and the amount credited to such account can only be used for the redemption of debentures. No company can issue any debentures carrying any voting rights. Debentures and bonds are used as synonymous in India and there is no distinction between the two terms in our country.

(6) Miscellaneous sources – Apart from the above mentioned sources of finance, there are several other sources from which long-term finance may be obtained. These sources include:

  • Deferred Credit
  • Lease Finance
  • Hire Purchase
  • Public Deposits
  • Venture Capital
  • Export Finance
  • Government Incentives

Short Term Source of Finance

This finance is needed to meet the day-to-day business requirements. In other words, short- term finance is obtained to meet the working capital requirements of the enterprise. Therefore, these sources of finance are called working capital advances. The main short-term sources have been explained as below:

(1) Bank sources – Commercial banks are the most important source of providing short-term finance. The different forms of providing short-term finance by the banks are as follows:

  • Cash credits – Cash credit is an arrangement under which the borrower is allowed to withdraw money from the bank up to a certain limit. The limit is determined by the bank on the basis of borrower’s financial position and credit worthiness or security deposited by the borrower. The borrower can repay the amount, partially or fully, as and when he desires. Interest is charged only on the amount actually withdrawn by the borrower. However, a minimum charge may be payable to the bank for availing this facility. 
  • Overdrafts – It is a temporary arrangement in which a customer operating current account with a bank is allowed by the bank to overdraw money upto a certain limit. Generally, this overdraft facility is provided for very short-term like one week or fortnight. Overdraft limit is determined by the bank and the borrower can overdraw upto the limit without completing any formality. Interest is charged by the bank on the actual amount overdrawn by the customer and rate of interest charged is little higher as compared to term loans. It is the simplest and convenient source of finance to meet the working capital requirements.
  • Discounting of bills – It is a form of advance provided by the bank to the holder of the bill before its maturity date after deducting discount. The bank presents the bill to the acceptor of the bill on the maturity date and gets its payment. If the bill is dishonoured on the maturity date, the total amount is recovered from the customer who had availed this facility of discounting the bill.
  • Letters of credit – A letter of credit is an arrangement where a bank helps its customers to obtain credit from its suppliers. When a bank issues a letter of credit in favour of its customers for some specific purchases, the bank undertakes the responsibility to honour the obligation of its customer in case of default.

(2) Non-bank Sources – These sources of finance include the following:

  • Trade credit – Trade credit represents the credit usually allowed by suppliers to their customers according to trade customs. If the payment for purchasing goods is not made immediately, it becomes a short-term finance. Amount of trade credit depends upon the credit worthiness of an enterprise. 
  • Commercial papers – Commercial paper is an unsecured money market instrument issued in the form of a promissory note. Corporate having tangible net worth minimum of 4 crore can issue commercial papers (CPs). CPs can be issued in denominations of 5 lakh or multiples thereof for a period ranging between 7 days to one year.
  • Advances from customers – Some businessmen demand advance money from their customers at the time of accepting their orders. Such an advance may be fixed percentage of amount of the order. Such advances are adjusted at the time of payment of full price of the goods. No interest is paid on such advance by the businessman.
  • Accrued expenses – Expenses which have been incurred but have not become due for payment, are called accrued expenses. Wages and salaries are usually paid in the month next to the month in which the services were rendered. Similarly, interest is paid periodically whereas the principal amount is used continuously. Likewise, the tax is paid periodically much after earning of profits. Therefore, the time-lag in the payment of accrued expenses is considered as a short-term source of finance.
  • Factoring – Factoring is a business activity in which a financial intermediary takes over the responsibility of collecting a firm’s receivables. In other words, a factor is a financial institution which offers services relating to management and financing of debts arising from credit sales. The factor advances 70 to 80 percent money to the entrepreneur against receivables and charges interest at rate higher than the lending rate of commercial banks. The balance amount is paid by the factor to the entrepreneur on due date after deducting cost of factoring. Thus, factoring is considered as a short- bow term source of finance.
  • Short-term loans from Financial institutions – It is an advance of a fixed amount from a financial institution and sanctioned for a fixed term. Interest is charged on the total amount of loan and rate of interest is usually lower as compared to cash credit and overdraft. The total loan amount with interest is paid by the businessman on due date.

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