Premlal C R
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.
