7 Different Source of Finance with its Merits and Limitations

Every business needs finance for running the operations. It needs to raise finance for it. There are many different sources available for raising finance for a business. Some of which are listed below:

#1 Equity shares

Equity shares are hold by the real owners of the company. They have the full control over the working of the company. These shares have right to vote and right to participate in the management.

Merits

  • Permanent capital: Equity share capital is very important source of finance because these are for long term and remained till the winding up of the company.
  • No charge on the assets: For raising funds by issue of equity shares, a company does not need to mortgage it’s any of the assets or any security against it.
  • Higher returns: Equity shareholders higher rate of return and extra normal profit in the year if the company earns high profit as the profit which is left in the hands of company after fulfilling its liabilities is of owners only.
  • Control: The shareholders have full control over the company like right to vote and right to take decisions or participate in the management.
  • No burden on the company: Payment of equity dividend is not compulsion for the company to be paid. It is paid only if company earns adequate profit, so that is why this source do not put burden on the company.
  • Pre-emptive right: Equity shareholders get pre-emptive right as if company wants to issue more shares then older shareholders will get first chance to accept or reject the shares, then only these shares will be issued further.

Limitations

  • Risk: Equity shareholders bear higher risk because payment of equity dividend is not compulsion for the company. So, when the company do not have adequate profit the equity dividend is not distributed.
  • Higher Cost: Cost of equity shares is greater than the cost of preference shares because many formalities like issue of prospectus, appointing the brokers or underwriters are only involved in issue of equity shares.
  • Share market conditions: Equity shareholders are the primary risk bearers therefore the demand of equity share is more in the boom period. So, the issue of shares totally depends upon the share market conditions.
  • Delay: Issue of equity shares is very lengthy process which results in the more time consumption. So, it always leads to the delay in the issue.

#2 Preference shares

Preference shares are considered safer in the investment as compared to equity shares because they receive dividend at a fixed rate. They are like the creditors and do not have voting rights. These are of 6 types:

  • Cumulative preference shares
  • Non-cumulative preference shares
  • Participating preference shares
  • Non-participating preference shares
  • Convertible preference shares
  • Non-Convertible shares

Merits

  • Safe Investment: Preference shareholder’s investment is safe and they have preferential right to claim dividend and capital over the equity shares.
  • No charge on the assets: The company does not need to mortgage its assets for the issue of preference shares.
  • Control: It does not affect the control of equity shareholders because they do not have voting rights.
  • Fixed dividend: Shareholders get fixed dividend so they are useful for those investors who want fixed rate of return and after fixed period of time.

Limitations

  • Costly source of funds: Rate of preference dividend is greater than the rate of interest on debentures that is why it is a costly source of finance than debentures for a company to raise funds through it.
  • Not suitable for risk takers: Preference shares are not suitable for those investors who are ready and motivated to take risks and get higher profit.
  • No tax saving: Preference dividend is not deductible from profits before paying income tax therefore there is no tax saving. So, company prefer least to issue preference shares.

#3 Retained Earnings

A portion of company’s net profit after paying tax and dividend which is kept aside and not distributed that profit is called retained profit. The main purpose of this profit is reinvestment during the recession or depression period and to meet the daily needs of the business. This is also called source of self-financing.

Merits

  • No cost: No cost in the form of interest or dividend, advertisement or prospectus to be incurred by the company to get it.
  • No charge on assets: The company does not have to mortgage its any of the assets or securities against the funds.
  • Growth and Expansion: By reinvesting the retained earnings there is a greater growth and larger expansion of the company because no owners do not have to incur any additional cost as it is a free money of the company.

Limitations

  • Uncertain Source: It is an uncertain source of funds as it is not available all the time, it is possible only during the high time of the company.
  • Dissatisfaction among the shareholders: Retained profit cause dissatisfaction among the shareholders because they get low rate of dividend in case if company kept high amount of profits in the form of retained earnings with itself.

#4 Debentures

Debenture are the important debt source of finance through which a company can raise long term finance. Interest on debenture is fixed which is the return on the money invested by the debenture holders. The time period after which the interest is paid is generally 6 months or 1 year. The holders are like secured creditors of the company. There are 6 types of debentures:

  • Secured debentures
  • Unsecured Debentures
  • Convertible debentures
  • Non- Convertible Debentures
  • Redeemable Debentures
  • Registered Debentures

Merits

  • Safe Investment: Debentures are preferred by those investors who do not want to take bear risk and want fixed rate of return or income every year.
  • Less Costly: As there is no requirement of issuing prospectus which results that debentures are less costly as compared to the cost of preference shares and equity shares.
  • Control: Debenture holders are the creditors of the company so they do not have any the voting right or any control over the working of the company.
  • Tax saving: Interest paid on the debentures help the company in saving the tax because interest is charged as expense and deductible from the income of the company.

Limitations

  • Fixed Obligations: There is a greater risk when there is no earning because interest on debenture has to be paid whether the company suffers loss.
  • Charge on assets: The company has to mortgage its assets to raise the funds by issue of secured debentures.
  • Reduction in credibility: The company’s capability to borrow further funds gets reduces because of the new issue of debentures. The equity is the security of the debenture holders so if company wants to raise further funds through any other source debenture holders will not allow the company for the same.

#5 Commercial Banks

Commercial banks provide loans and advances in the form of cash credit, overdraft loans and discounting of bills. Rate of interest on loan is fixed. These banks may be government or private banks like SBI, ICICI bank, Axis Bank etc.

Merits

  • Timely financial assistance: The commercial banks provide timely financial assistance means ‘money whenever required’ to the business.
  • Secrecy: Secrecy is maintained about the loans which is taken by the businessmen from the commercial banks.
  • Easier source of funds: This is the easier source to raise the funds as there are no unnecessary formalities like no need to issue prospectus for raising funds.

Limitations

  • Short or medium term finance: The funds available from the commercial banks are for the medium term or short term. These funds cannot be used for the long-term finance as for the purchases of plant and machinery or for reinvesting it. It can only be used to make working capital requirements.
  • Charge on assets: It is necessary to mortgage assets or securities before the loan is sanctioned as because this is the source of borrowed fund.

#6 Public Deposits

The deposits that are raised by the companies direct from the public are known as public deposits. The rate of interest offered on bank deposits is less than the public deposits so with this public gets motivated to deposit their funds in companies rather than banks. This is regulated by the RBI and cannot exceed 25% of share capital and free reserves.

Merits

  • No charge on assets: The company does not need to mortgage any of its assets against the public deposit.
  • Tax saving: Interest paid on public deposit is tax deductible because this interest is charged as expenses from the profit so there is tax saving.
  • Control: Depositors do not have right to vote therefore the control remains in the hands of the real owners and is not diluted.
  • Simple procedure: The procedure for obtaining public deposits is very simpler than the issue of shares and the debentures.

Limitations

  • Short term finance: These deposits are for short term finance. The maturity period of this finance is very short therefore the company cannot depend on it for long term period.
  • Limited Funds: The quantum of public deposits is limited because of legal restrictions i.e. 25% of share capital and free reserves.
  • Not suitable for new companies: The depositors do not have trust on the new companies so that is why new companies generally find difficulty to raise funds through public deposits.

#7 Financial Institutions

The state and central government has established many new financial institutions to provide finance to companies.

Merits

  • Long term finance: Financial institutions provide long term finance.
  • Managerial advice: They provide financial, managerial and technical advice to the business firm.
  • Easy Installments: Loan can be repaid in easy installments therefore it does not put much burden on the businessman.

Limitations

  • More time consuming: The procedure for granting loan is time consuming due to rigid criteria and many formalities.
  • Restrictions: These institutions place restrictions on the Board of Directors of the companies. Eg- Company cannot pay dividend to equity shareholders before repayment of the loan.

About the Author

arpit goyalArpit Goyal is pursuing CA and B.com & also working as an article assistant in Gurgaon. He has an immense interest in Taxation. He loves to use technology to spread knowledge about taxation & accounts.

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1 Comment

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  1. Sheikh Mohamed Ali Saheb

    Dear Arpit,
    The periodical information you are providing to tax payers is of immense use. Your updates are coming at the right time. It is a tool educating and encouraging the tax payers to file their income tax returns on time. Great,
    God bless you.

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