This article throws light upon the top four sources of finance. The sources are: 1. Sale and Lease Back 2. Hire-Purchase 3. Retained Earnings 4. Depreciation Provisions.
National Financial Institutions: Source # 1. Sale and Lease Back:
Under this method, the companies who have substantial fixed assets at low book values may dispose-off those assets at the prevailing market price on condition that the buyer would lease the assets back to the vendor for long period, e.g., 50 years’ or 99 years’ lease etc.
The advantages of this source are:
(a) The fixed assets are realised at current market price without actually parting with their physical possession;
(b) Fund is available immediately after this transaction which can be utilised by the company;
(c) In computing taxable income, the rent so paid for such lease is an admissible deduction against the revenues, i.e., it is a charge against profit.
National Financial Institutions: Source # 2. Hire-Purchase:
Under this system, the buyer pays a stipulated amount at the time of taking delivery of the assets, the balance being payable by a number of specified/fixed instalments of the end of a certain specific period together with a certain rate of interest. In the circumstances, ownership is transferred from the seller to the buyer only when the last instalment is paid.
No doubt, it is an extreme form of finance, i.e., fixed assets is purchased but immediate payment is not made. In short, a hire-purchase agreement is one under which a firm takes delivery of fixed assets promising to pay the price by a certain number of instalments and, until full payment is made, to pay hire charge for using the goods.
It has the following advantages:
(i) It assumes that fixed assets may be used immediately after acquisition rather than owned.
(ii) Since the entire amount is not paid by the firm, raising of funds for large initial sum is not required.
(iii) Interest paid on outstanding balance of such transactions is an admissible deduction while computing taxable income of a firm.
But this method is not free from snags. Because, the cost of financing under this source is higher in comparison with any other sources of debt finance. For instance, the interest which is paid on unpaid balance is comparatively higher than other sources, viz., bank borrowings.
National Financial Institutions: Source # 3. Retained Earnings:
There are many firms who prefer to adopt a sound dividend policy and set aside a certain sum of money against their earnings for the purpose of re-investing in the business. They, however, prefer to grow gradually and normally from the inside, i.e., through self-financing which, in other words, is considered as the best method in company finance.
Needless to mention that when a company retains a part of undistributed profits in the form of free resources and the same is utilised for further expansion, it is known as ploughing-in of profit or retained earnings. Therefore, retention in the garb of free or general reserve and/or credit balance of Profit and Loss Account may also become a source of finance for an established firm.
Although it is essentially a means of financing for extension and development of a firm and its availability depends upon a host of factors, such as the rate of taxation, the dividend policy of the firm, Government policy on the payment of dividends by the corporate sector, extent of available surplus and upon the firm’s appropriation policy, it is very often used to finance the working capital requirements of a firm.
Need for retained earnings are noted below:
(i) Most of the firms use it in order to expand both fixed capital as well as working capital for further expansion and development and/or improvements within the firm itself.
(ii) It can be used to improve the efficiency of the plant and equipment.
(iii) Unreliability on the statement of accounts compels management to retain a part of substantial profit. Because, profits on paper may be overstated while actual profit may be less than that.
(i) The most significant feature of retained earnings is that it is a cost-free source of finance, since there is no direct cost on it, there is 110 dilution of earnings per share, there is also no cost of raising capital. At the same time, no compulsory periodic payment in the form of interest or dividend.
(ii) There will be no change in control since equity capital is not increased and, as such, owners/shareholders are absolutely free from outside control.
(iii) It is a source of permanent finance as there is perpetual use of funds.
(iv) There are 110 restrictions on managerial freedom like debentures and preference shares.
(v) Retained earnings do not require any pledge, mortgage etc., like other loans.
(vi) Large accumulated profits ensure stable dividend policy and enhance the credit standing of the firm. Assured credit position helps the firm in a number of ways, viz., to get cheaper working capital, stable dividends make broad-based market which increases the market value of shares etc. For accelerated economic development and rapid capital formation this practice is socially desirable.
(i) Tendency towards monopoly may grow due to over-investment;
(ii) Danger of misuse of funds may be noticed;
(iii) Danger of manipulation about the value of share may be made by the management;
(iv) Overcapitalization due to frequent issue of bonus shares may happen;
(v) Shareholders may not be interested as they receive a low rate of dividend since a part of the profit is being retained.
Retained Earnings in India:
Till, 1970, there was a declining trend in retained earnings in India industry due to the following:
(i) As there was over-increasing reliance on borrowed capital, Indian companies were required to pay ever-growing interest charges in order to claim a greater part of gross profits.
(ii) Since there was a substantial increase in the rate of corporate taxation.
(iii) Till 1970, management was required to maintain expected rate of dividend although there were no substantial earnings. As such, in order to maintain that rate, retained earnings were adjusted against profit and, as a result, there was a constant decline in retained earnings in our country.
National Financial Institutions: Source # 4. Depreciation Provisions:
Short-term financing is less expensive than long-term one. But at the same time, short-term financing involves greater degree of risk. In the circumstances, the choice of sources between short-term and long-term for financing working capital of a firm has to be decided with reference to the risk-return trade off.
Generally, however, in view of lower cost and flexibility, management usually finds it more convenient to finance their working capital requirements by relying more on short-term sources than on long-term sources.
In India, recently, the role of Bank in relation to working capital finance to industries, among others, was reviewed at the instance of Reserve Bank of India by a study group under the chairmanship of Mr. P L. Tandon, as an imbalance was noticed between the growth of Bank credit and industrial production within the country.
The study group in its report, not only suggested three distinct methods of working out the working capital gap of firms, but also mentioned that borrowers must provide 25% of total current assets out of long-term funds, i.e., owned funds plus long- term borrowings. The said 25% being calculated differently at the aforesaid three distinct stages.