Role and Kinds of Finance Bcom Notes

Role and Kinds of Finance Bcom Notes:- In this post, you will get the notes of B.com 3rd year money and financial system, by reading this post you can score well in the exam, hope that this post has helped you with this post to all your friends and all groups right now I must share it so that every student can read this post and it can also be helped in this post. Role Kinds of Finance

ROLE AND KINDS OF FINANCE

Meaning Of Finance

The finance deals with income and expenditure of an individual, i.e., household, business (both industry and trade), agriculture, service and government. In other words, finance is concerned with timely and economical use of one’s monetary resources in consumption and investments and procure required amount of funds of different duration from the most economical and profitable source and its effective and profitable utilization so that there may not be surplus for productive funds nor there should be shortage of funds.

Finance is the study how individuals, institutions and business firms acquire, spend and manage money and other financial resources. The finance can also be defined both in terms of the macro as well as micro level that is at individual, business firms and government level. The finance at macro level is the study of how financial intermediaries, financial markets and policy -markers interact and operate within a country and in the global financial system.

Role Kinds of Finance

Role of Finance

Since finances are required for all economic activities it is called life blood of the economy. It is not possible to make payments for purchase of consumption goods and capital goods without finance or it is possible to run an enterprise without finance, nor to carry on work of panchayats, local bodies, state government or central government or other organizations. Therefore finance plays a pivotal role in any economic activity whether to meet day-to-day expenditure or developmental expenditure. Hence finance deals with income or revenue from all sources and its use for all payments whether for consumption or interment.

Role Kinds of Finance

Sources of Business Finance.

The term ‘source’ implies the agencies from which finance is procured in the business. A business firm can raise funds from two main sources:

I. Owned Funds;

II. Borrowed Funds.

I. Owned Funds

These funds are contributed by the owners of the business, i.e.. proprietors, partners or shareholders as the case may be. In a sole proprietorship, the proprietor himself provides the funds (capital). In a partnership firm, the funds are contributed by the partners thereof. In a joint stock company funds are raised by the issue of shares. Owners funds are generally used as permanent capital or long term capital as they remain invested in the business as long as the business continues to exist.

Owned funds can be raised through issue of shares and retained profits. ‘Share’ is a part in the share capital of a company. A share may be defined as one of the units into which share capital of a company has been divided. The person holding the share is known as shareholder. He receives dividend from the company as a consideration for investing his money into the company.” According to the Indian companies Act, 1956 a company can issue two types of shares (1) Equity shares; (II) Preference shares.

Role Kinds of Finance

1. EQUITY SHARES

Equity shares were earlier known as ordinary shares. All the shares, other than preference shares, are called equity shares. Equity shares do not carry any preferential rights in the payment of dividend and repayment of capital. The rate of dividend on these shares is not fixed. It depends on the availability of divisible profits and the discretion of directors. Equity shares rank after the preference shares as divident is paid out of the residual profits left after paying dividend on preference shares. Equity Capital is paid after meeting all other claims including that of preference shareholders. So equity shareholders are the real risk bearer as they take risk both regarding dividend and return of capital.

The holders of equity shares are the virtual owners of the company. They have a control over the working of the company as they enjoy full voting rights in the management and control of the company. The voting rights are proportionate to the amount paid upon equity shares. Equity share capital cannot be redeemed during the life-time of the company.

Advantages of Equity Shares: Both the company and the investors are benefitted by equity shares:

(i) Permanent Capital: It is a source of permanent capital without any commitment of a fixed return to the shareholders.

(ii) No Fixed Burden: There is no fixed burden on the company by way of return on equity share since payment of dividend on these shares depends on the availability of profits and the discretion of the directors.

(iii) No Charge on Assets: Equity shares are issued without any charge on assets. Since issue of equity shares does not require mortgaging or pledging, the assets remain free of charge for borrowing money in future.

(iv) Increase in Credit Worthiness: Equity provides the credibility to the company and confidence to the prospective loan providers.

(v) Small Denomination: The nominal or face value of an equity share is generally quite low, such as Rs.10. Therefore, even persons with limited means can buy equity shares.

(vi) Voting Rights: Equity shareholders have voting rights which can be used by them in matters relating to management and administration. They appoint directors who represent them.

(vii) Suitable for Enterprising Investors: Equity shares are the ideal investment for bold and enterprising investors. They get handsome dividend and the value of their holdings appreciate during boom periods.

Disadvantages of Equity Shares: Following are the disadvantages of equity shares:

(i) Higher Floatation Costs: Floatation cost of new issue of equity shares is higher than of other kind of securities.

(ii) No Trading on Equity: If a company issues only equity shares, it cannot obtain the benefits of trading on equity.

(iii) Takeover Bids: Persons who seek to gain control over a company may indulge in undesirable practices. The control of the company can be easily manipulated through cornering of shares by a group of shareholders for their personal advantage at the cost of company’s interest.

(iv) Concentration of Control: Any new issue of equity shares must be offered first to the existing shareholders. As a result, there is a concentration of control in a few hands.

(v) Uncertainty of Income: Since the rate of dividend paid on equity shares is not fixed, income of the equity shareholders remains uncertain.

(vi) High Risks: Equity reholders bear high degree of risk associated with the fluctuation in the market prices in their shares.

(vii) Loss Due to Liquidation: Equity shareholders may get loss or nothing at the time of liquidation of the company because they are paid last of all.

Role Kinds of Finance

2. PREFERENCE SHARES

Preference shares are those shares which have got preferential right, i.e., priority over the equity shares in payment of dividend at a fixed rate and also in the return of capital in the event of winding up of the company. So whenever the company has distributable profits, dividend at a fixed rate is payable on preference shares before any dividend is paid on equity shares.

Secondly, at the time of winding up of the company, capital is repaid (returned) to preference shareholders prior to the return of equity capital.

Preferential shares have no voting rights, therefore they have no say in the management.

Advantages of Preference Shares: Both the company and the investors are benefitted by preference shares:

(i) No Obligation to Pay Dividend: These is no legal compulsion for a company to pay dividend on preference shares, if its profits in a particular year are insufficient. In case of cumulative preference shares, however, dividend not paid for any year will have to be paid in subsequent year(s) when dividend is declared.

(ii) No Interference in Management: Generally, preference shares do not carry voting rights, so it does not affect the equity shareholders control over management.

(iii) No Charge on Assets: Issue of preference shares does not create any sort of mortgage or charge on the assets of the company. Thus, the assets are freely available for raising loans in future.

(iv) Flexibility in Capital Structure: By issuing preference shares, a company can make its capital structure flexible. The capital can be repaid (by making payment to redeemable preference shares) when it is no longer required in business.

(v) Enlargement of Resources: Issue of preference shares enlarge the resources of funds as some financial institutions and individuals prefer to invest in preference shares due to the assurance of fixed return.

(vi) Preferential Right as to Dividend: The holders of preference shares enjoy preferential right as to the payment of dividend as the payment of preference dividend is made before the payment of equity dividend.

(vii) Preferential Right as to Repayment of Capital: The holders of preference shares also enjoy preferential right as to repayment of capital as the repayment of preference shares capital is made before the repayment of equity share capital.

(viii) Regular Fixed Income: Preference shares are particularly useful for those investors who want fixed regular income with comparatively lower risk. Disadvantages of Preference Shares: Company and investors suffer the following disadvantages on issue of such shares:

(i) Fixed Burden on Company: Preference shares are entitled to dividend at a fixed rate. The burden is greater in case of cumulative preference shares because whether the company has made profits or not, the liability for payment of dividend will come into existence.

(ii) No Tax Advantage: Dividend paid on preference shares is treated as a part of divisible profit and not an expense. Therefore, the company has to pay income tax on this dividend also.

(iii) Limited Appeal: Issue of preference shares does not attract many investors because of risk of no dividend in case of losses or inadequate profits.

(iv) No Participation in Management: Preference shareholders do not have any voting rights except at their class meetings. Thus, they cannot participate in the management of the company.

(v) No Participation in Extra Profits: Except participating preference shares, other preference shareholders are not entitled to any share out of extra profits. By extra profits is meant the profit left over after making payment of dividend at a given rate to equity shareholders.

(vi) No Participation in Surplus: At the time of liquidation of the company, preference shareholders get only that amount they had invested whereas equity shareholders get the surplus too.

Role Kinds of Finance

3. RETAINED PROFITS OR PLOUGHING BACK OF PROFITS

Retained profits refer to the profits which have not been distributed as dividends but have been kept for use in business. Instead of distributing the entire amount of profits amongst the shareholders as dividends, the companies generally retain a part of their profits in the form of reserves every year. After a few years, it becomes a large amount which is then employed for modernisation and growth of business. Besides, the reserves built up during the prosperous period can be utilised to save the company from difficult situations arising during depression. Retained profits are also known as ploughing back of profits, self-financing or internal financing. Advantages of Retained Profits: The main advantages of retained profits are as follows:

Additional Capital: Retained profits are the most convenient source of raising additional capital. It does not involve any floatation costs.
No Obligations: Ploughing back of profits neither imposes fixed commitment to pay dividend nor the obligation of repayment of capital after some time.
Freedom from Financial Worries: The company is freed from financial worries and it can undertake its plans for growth and expansion without bothering about the money market conditions.
No Effect on Control: Control over the management of the company remains unaffected as there is no addition to the number of shareholders.
Enhancement of Reputation: Retained profits add to the financial strength and improved credibility of the company. The company’s borrowing capacity is increased and it can face unforeseen contingencies, trade cycles and other crises.
Lower Tax Liability: To encourage self-financing, the government allows tax relief on ploughed back profits. Thus, the income tax liability of the company is considerably reduced.

Disadvantages of Retained Profits: Retained profits may result in the following drawbacks:

Low Dividends: Ploughing back of profits reduce the current rate of dividends and deprives the present shareholders of what their investment has earned. This may cause dissatisfaction among the shareholders.
Misuse of Funds: The profits retained by a company under the pretext of strengthening its financial position, are likely to be misused by the directors. They may invest them in unprofitable or undesirable channels.
Danger of Over-capitalisation: There is always a danger of over-capitalization if the company retains profits on continuous basis year after year without requirement of funds for profitable investments.
Obstruction in Balanced Growth: Retained profits may obstruct in the balanced growth of industries. The profits which might have been invested in other industries are reinvested in the same industry. Thus, it deprives other industries of the necessary capital.

Role Kinds of Finance

II. BORROWED FUNDS

Business may borrow funds from external sources such as individuals, banks and financial institutions, etc. These borrowings may include debentures, public deposits, commercial loans, discounting of bills, and long-term loans from the financial institutions. The availability of borrowed funds usually depends upon the financial strength of the business or the reputation of its owners. Borrowed funds involve periodical payments of interest at a specified rate and repayment of the principal sum either in instalments or after the expiry of the fixed period for which the loan was granted,

DEBENTURES: When a company wants to take a loan on a long-term basis so that the loan becomes the company’s capital, it issues debentures. By debenture is meant a ‘document that contains acknowledgment of indebtedness. It is issued by the company under its common seal and gives an undertaking to repay the debt at a specified date and specifies the conditions related to the loan taken by the company.

Advantages of Debentures: Debentures are an important source of raising long-term finance. The main advantages of debentures are as follows:

(i) No Interference in Management: Debenture holders do not have any voting rights, therefore, they do not interfere in the management and control of the company.

(ii) Flexibility in Financial Structure: Issue of debentures creates flexibility in the financial structure of the company. When a company wants to reduce the debt, the redeemable debentures can be refunded. Similarly, when the company needs funds, additional debentures can be issued.

(iii) Economical Means: Debentures are the most economical means of raising loans for the company. Underwriting commission, brokerage and other expenses of issue are lesser. (iv) Tax Relief: Interest in respect of debentures is allowed as deduction in computation of taxable income. This results in tax relief for the company.

(v) Trading on Equity: After payment of interest at a fixed rate to debenture holders, the remaining profits are available to shareholders. When the earnings of the company increase, the rate of dividend on equity shares can be increased. this is known as trading on equity.

(vi) Appeal to Cautious Investors: Debentures attract those investors who are cautious and conservative and who particularly prefer a stable rate of return with little or no risk. (vii) Safety of Investment : Debentures are generally secured by a charge on the company’s assets. Therefore, their repayment is assured.

Disadvantages of Debentures: The raising of funds through debentures is subject to the following limitations:

(i) Permanent Burden of Interest: Interest on debentures is always cumulative and it is to be paid irrespective of the profits or otherwise of the company. During the period of depression, it becomes a heavy burden.

(ii) Reduction in Credit-worthiness: The Credit-worthiness of a company which has issued a large amount of debentures falls.

(iii) Risky Affair: Raising funds through debentures is more risky. since in the event of failure of the company to pay interest or the principal instalment in time, the debenture holders may resort to the extreme remedy of filing a petition for winding up of the company.

(iv) No Voting Rights: Debenture holders do not have any voting rights. Therefore, they cannot interfere in the policies and management of the company.

SPECIAL FINANCIAL INSTITUTIONS: Companies raise large quantity of finance by issuing shares and debentures but due to rise in the costs of projects, they have to depend upon other long-term and medium term loans. In the post-independence period, special financial institutions were set up with the objective of providing large amount of long-term and medium term capital to the industries. Demand for medium and long-term funds which had arisen beyond the traditional sources of supply of funds has been met to a large extent by these institutions. Following are the main financial institutions functioning in the country:

(i) Industrial Finance Corporation of India (IFCI).

(ii) State Financial Corporations (SFCs).

(iii) Industrial Credit and Investment Corporation of India (ICICI).

(iv) National Industrial Development Corporation (NIDC).

(v) State Industrial Development Corporations (SIDCs).

(vi) Unit Trust of India (UTI).

(vii) Industrial Development Bank of India (IDBI).

All these institutions help in promoting new companies, expansion and development of existing companies and meeting the financial requirements of companies during economic depression.

PUBLIC DEPOSITS: Public deposits refer to the deposits received by a company from the public as loan or debt. These are the unsecured deposits invited by the companies from the public, as per rules; public deposits can be invited by companies for a period of 6 months to 3 years. However, they can be renewed from time to time. The rate of interest on public deposits depends on the period of deposit and reputation of the company but it is generally higher than on bank deposits. Interest is paid either monthly or at the end of specified period.

Public deposits are raised by companies to meet their short-term and medium-term financial needs. It is a simple method of raising finance for which the company has only to advertise in the newspapers giving particulars about its financial position as prescribed by the Companies Act. Any person can fill up the prescribed form and deposit the money with the company. The company in return issues a deposit receipt which is an acknowledgment of debt by the company. The terms and conditions of the deposit are printed on the back of the receipt. Depositors can withdraw their money on the expiry of the specified period or earlier after giving notice to the company. Companies

are not permitted to raise unlimited amounts of fund through public deposits, The aggregate of all outstanding deposits cannot exceed 25% of the paid up capital and free reserves of the company.

Advantages of Public Deposits: The advantages of public deposits are following:

(i) Simple and Easy Procedure: The procedure for obtaining public deposits is much simpler than equity and debenture issue. It saves the company from the lengthy and complicated formalities that have to be complied with for raising funds through other sources.

(ii) No Charge on Assets: Public deposits do not create any charge on assets. They are mostly unsecured.

(iii) Flexibility in Financial Structure: Public deposits introduce flexibility in the financial structure of the company. The deposits can be returned whenever they are not required.

(iv) Benefit of Trading on Equity: Company gets benefit of trading on equity. If the company is earning large amount of profit then after paying limited amount as interest, the remaining profit is distributed among the shareholders.

(v) No Interference in Management: Depositors cannot interfere in management since they do not have any voting rights.

(vi) Low Tax Liability: Interest paid on public deposits is a charge against the profits, here it helps in bringing down the tax liability of the company.

Disadvantages of Public Deposits: Main disadvantages of public deposits are as under:

(i) Uncertain and Unreliable Source: Public deposits are an uncertain and unreliable source of finance. These deposits are rightly said as “fair weather friends’ as the public is willing to give deposits during good times only.

(ii) Maximum Limit: The amount of fund that can be raised by way of public deposits is limited because of legal restrictions.

(iii) Unsuitable for New Companies: Finances through the public deposits are raised on the strength of reputation, standing and credit worthiness. Hence, the new concerns which are yet to built their reputation, cannot rely on this source.

(iv) Limited Appeal: Public deposits do not appeal as a mode of investment to bold investors who want capital gains. Conservation investors may also not like these deposits in the absence of proper security.

COMMERCIAL BANKS: Commercial banks are an important source of raising short-term and medium-term finance. Different forms in which commercial banks normally provide finance are as follows:

(i) Overdraft: Customers who have current account in the bank are allowed to withdraw more than the balance to their credit upto a certain limit. This is a short-term arrangement.

(ii) Short-term Loans: Commercial banks generally provide short-term loans upto one year but now a days, term loans exceeding one year are also provided by banks.

(iii) Cash Credit: Under this facility, bank lends money upto a specified limit against security. The bank places a certain amount to the credit of the customer. Out of the sanctioned amount the customer withdraws the amount as and when he needs.

(vi) Discounting of Bills Receivable: Under this facility, bank discounts bills receivables of its customers. It charges some commission on it. This method is widely used in business world for raising short-term finance.

Role Kinds of Finance