Unit-14 FINANCE

UNIT-14

FINANCE

Finance

Each and every business organization needs money for its future activities. So the finance can be considered as the life blood of each and every business.

Meaning

            Finance means the money which is invested or required in the business for its smooth running.

TYPES OF FINANCE

Finance is available through different ways. According to the source, the finance is classified into two,

            1. Internal Source of Finance

            2. External source of Finance

1. INTERNAL SOURCES OF FINANCE (SELF FINANCE)

Which means the finance is raised within the organization and not from outside sources. Following are the types of internal source of finance,

            a. Owner’s contribution – Which means whenever the business needs finance, the owners may contribute money themselves to the business.

            Advantages

1. No need of interest payment.

2. No need of collateral security and more formalities.

            Disadvantages

1. It is not practicable always because the owners may have the shortage of money.

2. Limited amount is available

            b. Retained Profit – Which means the part of profit is kept in the business for future purposes without distributing to the owners.

            Advantages

1. It does not have to be paid back.

2. No need of interest payment.

3. No need of collateral security.

4. No more formalities required

            Disadvantages

1. It is depend on the availability of profit in the business.

2. Limited amount is available.

            c. Selling and Lease back of Assets -  In this method, if a business needs money, it may sell their assets such as machinery, vehicles, properties, etc to the finance houses and take back the possession of the same assets by paying a charge (rent) called lease premium.

            Advantages

1. It is suitable for raising large amount of money.

2. By paying a nominal charge the business gets the possession of valuable assets.

3. No need of servicing and repairing of assets to the user.

            Disadvantages

1. Transfer of the ownership of assets

2. Liability of the payment of lease premium for the agreed period.

2. EXTERNAL SOURCES OF FINANCE

Which means the finance is raised in the business from outside parties such as bank, creditors, etc. External sources of Finance are of two types namely,

            -Long term sources

            -Short term sources

LONG TERM SOURCES OF FINANCE

These are the sources of finance aimed for long term purposes of the business and handles large amounts. Following are the examples of long term sources of finance,

1. SHARES – The capital of the company will be divided into a number of equal units called shares. Only the Public ltd company can issue shares to the public for raising capital. Shares are of two types-

            -Preference share- It is a type of share having the preferential right of getting fixed rate of dividend before it goes to the ordinary share holders.

            -Ordinary share- It is a type of share except preference shares which does not have any preferential right to get dividend or capital. It will be paid after satisfying the debenture interest and preference dividend.

Advantages of shares

1. Large amount of capital can be raised.

2. No need of repayment of capital

3. No need of interest payment

4. Share holders have the voting right in the company.

5. Share holders get dividend out of profit.

6. Easy to transfer

            Disadvantages of shares.

1. Dividend is paid out of profit, if there is no profit, no dividend at all.

2. It is not suitable for small amount of capital

3. More formalities required for issuing shares to the public.

            2. DEBENTURES – debentures are the instruments issued by the company inorder to borrow money from the public. It is a loan to the company and the debenture holders are creditors to the company and get fixed rate of interest whether there is profit or loss in the company.

            Advantages of debentures.

1. Debenture holders get fixed rate of interest if profit or loss in the business.

2. They will be paid first of all if the company winds up.

3. The company can repay the debenture when it no longer requires the money.

            Disadvantages of debentures.

1. It is a liability to the company

2. Debenture holders cannot vote for the company

3. Debenture holders cannot participate in the company’s administration.

            3. LONG TERM BANK LOANS- Under this method, the business can borrow money from the bank for a long term purposes by giving collateral securities.

            Advantages of long term loans

1. Large amount can be arranged.

2. Can be repayable in many years.

3. Lower rate of interest comparing to overdraft.

            Disadvantages of long term loans

1. It brings long term liabilities.

2. Collateral securities are required; if any default to repay the loan, the bank will attach the securities.

3. Burden of interest payment.

4. More formalities are required -separate loan account.

SHORT TERM SOURCES OF FINANCE

1. OVER DRAFT- It is an informal method of borrowing by which business can borrow a fixed amount through the current account for a short period of time. Variable rate of interest is charged on overdraft.

Advantages of overdraft.

1. Variable rate of interest.

2. No need of more formalities such as collateral securities.

3. It brings good relationship between the bank and the customers.

4. Overdraft is based on credit worthiness of the customer.

5. Interest will be charged only for the amount overdrawn.

Disadvantages of overdraft

1. It is not suitable for large amount of finance.

2. Comparing to bank loan, the rate of interest is high for overdraft, and in long run, it will be very expensive.        

3. Overdraft is allowed only for limited period of time.

4. Limited amount is allowed.

5. High chance of bad debt to the banks

2. TRADE CREDIT

            Trade credit is an informal form of finance by which the regular customers are allowed to purchase goods without paying immediately. Normally, within one month, the entire amount is settled by the customers.

Advantages of Trade credit.

 1. No more formalities required.

2. No need of interest payment.

3. It saves money without immediate payment.

4. It allows cash discount if settle in time.

5. It brings good relationship between the seller and the buyer.

Disadvantages of Trade credit.

1. High chance of bad debt to the sellers.

2. Less turnover to the sellers.

3. Allowed only for short period of time.

4. Limited amount is allowed.

5. Allowed only for regular customers.

3. HIRE PURCHASE AGREEMENT

In this system the customer can hire goods and can buy them at the end of the hire period. Consumer durable goods like freezers, washing machines, etc. are sold in this way. The goods remain the property of the seller till the last payment is made.

Features of Hire purchase

The hire purchase agreement is an agreement to hire the goods with an option to purchase.

Ownership lies in the hands of the seller till the buyer pays the full amount.

If the buyer fails to pay the installment, the goods can be repossessed by the seller.

Advantages of hire purchase to the buyer

1. It enables the lower income people to obtain high valued capital goods.

2. Goods can be bought immediately and the payments can be made in installment.

3. Good quality goods can be bought when they are needed the most.

4. It saves the payment of purchase price as lump-sum payment.

Advantages of hire purchase to the seller

1. It helps to increase the sales.

2. If the payment is not made the seller can repossess the goods.

3. Lower turnover to the sellers.

4. Chance of depreciation.

Disadvantages of hire purchase to the buyer

1. Goods once bought cannot be sold until the last installment has been paid up.

2. Goods can be bought only from those sellers who offer hire purchase credit.

3. High price of goods.

4. Hire purchase system motivates the people to buy unnecessary luxury items.

Disadvantages of hire purchase to the seller

1. Risk of bad debts.

2. Goods repossessed may not be in a good condition and may have little resale value.

3. Requires more clerical work to maintain the record of payment.

4. LEASING

            Leasing is a type of finance by which fixed assets are rented to the users. The finance houses rent the assets to the users by charging a less amount called lease premium. Here the user never owns the asset.

Advantages of leasing

1. Business can get the usage of assets by spending less premium.

2. It saves the immediate lump sum payment.

3. It ensures the short term of money to the business.

Disadvantages of leasing

1. Users cannot be the owner of the asset.

2. Owner has to suffer the cost of repair if any.

3. Chance of depreciation and loss of resale value.

5. FACTORING

             In this method the factoring house (factor) will pay the business up to the 80% of their accounts receivables (invoices) each month immediately. There are three parties in this method first one who gives money to the business is called the factor and the second one who has to pay money to the factor on behalf of the company called debtors and the third one the business.

Advantages of factoring

1. Easy to raise money

2. It ensures the immediate cash inflow

3. There is no risk of bad debt to the business

4. Better relationship between the business and the factor

Disadvantages of factoring

1. High commission to the factors (20% of account receivables)

2. Risk of bad debt to the factors

3. According to the chance of bad debt, commission may increase.

6. SHORT TERM LOANS

            In this method the banks give advances to the business less than one year. Business has to provide collateral securities to the bank in order to get the loan.

BUSINESS FINANCE

Business finance means the finance invested in the business in the form of capital and other assets.

Calculation of Business Finance

1. Capital

             The money invested by the owners in the business is called capital. According to the accounting equation the capital is equal to

Capital = Assets – Liabilities.

Capital is of two types,

            -Fixed capital

            -Working capital. 

2. Fixed capital.

            Fixed capital is the amount of money which is invested in the fixed assets of the business. Fixed capital is employed in the business on a permanent basis to run the business for long term.

            Eg- Land, building, machinery, vehicles, furniture, goodwill, premises, etc.

3. Working capital.

            Working capital is the amount of money which is available in the business for the day to day operations. It is also known as circulating capital. Working capital is the excess of current assets over the current liabilities.

Working capital= Total current assets – Total current liabilities.

a. Current Assets.

            Current assets are those which can be converted into cash immediately.

            Eg- Stock of goods, cash in hand, cash at bank, prepaid expenses, debtors, etc.

b. Current Liabilities.

            Current liabilities are those which are payable in a short period of time.

Eg- Bank Overdraft, Sundry creditors, short term loans, declared dividends, etc.

Advantages of sufficient working capital.

1. It helps to pay to the creditors in time and enable them to get cash discounts.

2. It helps to buy seasonal goods bulkily.

3. It helps to maintain the creditworthiness of the business.

4. It helps to meet the daily expenses like wages, salaries, interest, rent, etc.

5. It ensures the continuity of production and the smooth running of business.

Disadvantages of shortage of working capital

1. It affects the smooth running of the business.

2. It may lose the creditworthiness of the business.

3. It may lead to the refusal of the overdraft and loan from the banks.

4. It may lose the cash discounts.

Reasons for the decrease in working capital.

1. Fewer turnovers to the goods.

2. The company making loss on its trading.

3. Increased credit sale.

4. Less cash inflows due to delay in payment from debtors.

5. Purchase of fixed assets for ready cash.

6. The company declaring dividend, which increases the current liabilities

Measures to increase working capital

1. Take short term advances like overdraft and loans.

2. Reduce price of the goods that would increase sales.

3. Increase advertisements and sales promotions.

4. Postpone the immediate payments and purchases.

5. Offer more cash discounts to the debtors for immediate payment.

6. Selling and lease back of assets.

4. Working Capital Ratio

             Working capital ratio shows the percentage of the current assets over the current liabilities.

            Working Capital Ratio =     Total Current Assets

                                                           Total Current Liabilities

5. Mark-up.

            The profit as the percentage of cost of goods sold is known as mark-up.

            Mark-up    =       Gross Profit

                                   Cost of goods sold

6. Margin

            The profit as the percentage of sales price of the goods is known as margin

            Margin     =        Gross Profit

                                         Selling Price

7. Net profit ratio.

            The net profit as the percentage of net sales (turnover) is known as net profit ratio.

            Net Profit Ratio  =        Net Profit

                                             Turnover (Net sales)

8. Gross profit ratio

             The GP as the percentage of net sales is known as GP Ratio.

            Gross Profit Ratio  =        Gross Profit

                                                    Turnover (Net sales)

9. Stock turnover ratio

             This ratio reveals the number of times finished goods are turned over a particular period. It measures the speed at which stocks are cleared off.

            Stock Turnover Ratio  =    Cost of goods sold

                                                                Average stock

NB:- Cost of goods sold =  Opening stock + Purchases + Carriage Inwards – Closing Stock.

         Average stock  = Opening Stock + Closing Stock

                                                                     2

Reasons for the decrease in stock turnover.

1. High capital is tied up in the stocks.

2. Inefficiency of the firm.

3. Inefficient sales promotions and advertisements

4. Lack of credit facilities to the customers.

5. High price of the goods

Measures to increase stock turnover

1. Place small order with the suppliers.

2. Reduce prices of the goods

3. Increase advertisements and sales promotions

4. Increase credit facilities.