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OMBC 203
FINANCIAL MANAGEMENT (FM)

Unit 5:
Long-Term Sources of Finance

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Introduction

• As we are aware, finance is the life blood of

business and is of vital significance for
modern business which requires huge
capital. Funds required for a business maybe
classified as long term and short term. Long
term finance is required for purchasing fixed
assets like land and building, machinery etc.
The amount of long term capital depends
upon the scale of business and nature of
business.

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Long Term Finance – Its meaning and purpose

• A business requires funds to purchase fixed assets like land and

building, plant and machinery, furniture etc. These assets may be
regarded as the foundation of business. The capital required for these
assets is called: fixed capital
• A part of the working capital is also of a permanent nature. Funds
required for this part of the working capital and for fixed capital is
called long term finance.

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 Purpose of long term finance:

Finance •Business requires fixed assets like

•machines, Building, furniture etc. Finance required to buy
these assets is for a long period, because such assets can be
fixed assets: used for a long period and are not for resale.

To finance the •Business is a continuing activity. It must have a certain amount

of working capital which would be needed again and again.
permanent part of This part of working capital is of a fixed or permanent nature.
working capital: This requirement is also met from long term funds.

To finance growth •Expansion of business requires investment

and expansion of of a huge amount of capital permanently or
business: for a long period.

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 Factors determining long-term financial
requirements

The amount required to meet the long term capital needs of a company depend
upon many factors. These are :

1. Nature of Business:
The nature and character of a business determines the amount of
fixed capital. A manufacturing company requires land, building,
machines etc. So it has to invest a large amount of capital for a
long period. But abrading concern dealing in, say, washing
machines will require a smaller amount of long term fund because
it does not have to buy building or machines.

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 Factors determining long-term financial
requirements

2. Nature of goods produced:

If a business is engaged in manufacturing small and simple articles
it will require a smaller amount of fixed capital as compared tone
manufacturing heavy machines or heavy consumer items like cars,
refrigerators etc. which will require more fixed capital.
3. Technology used:
In heavy industries like steel the fixed capital investment is larger
than in the case of a business producing plastic jars using simple
technology or producing goods using labour intensive technique.

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 Sources of long term finance
The main sources of long term finance are as follows:
• These are issued to the general public. These
may be of two types: (i)Equity & (ii)Preference.
1. Shares:
The holders of shares are the owners of the
business.

• These are also issued to the general public. The

2. Debentures: holders of debentures are the creditors of the
company.

• General public also like to deposit their savings

with popular and well established company
3. Public Deposits : which can pay interest periodically and pay-
back the deposit when due.

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 Sources of long term finance

• The company may not distribute the whole of its

4. Retained earnings: profits among its shareholders. It may retain a part
of the profits and utilize it as capital

• Many industrial development banks, cooperative

5. Term loans banks and commercial banks grant medium term
from banks: loans for a period of three to five years.

• There are many specialized financial institutions

established by the Central and State governments
which give long term loans at reasonable rate of
6. Loan from
interest.
financial • Some of these institutions are:
institutions: • Industrial Finance Corporation of India (IFCI), Industrial
Development Bank of India (IDBI),Industrial Credit and
Investment Corporation of India (ICICI), Unit Trust of
India (UTI), State Finance Corporations etc.

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 Shares

Issue of shares is the main source of long term finance. Shares are issued by
joint stock companies to the public. A company divides its capital into units
of a definite face value, say of Rs. 10 each or Rs. 100 each. Each unit is called
a share. A person holding shares is called a shareholder.
Investors are of different habits and temperaments. Some want to take lesser
risk and are interested in a regular income. There are others who may take
greater risking anticipation of huge profits in future. In order to tap the
savings of different types of people, a company may issue different types of
shares. These are:
1.Preference shares, and
2. Equity Shares.

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 Preference Shares

• Preference Shares are the shares which carry preferential rights over
the equity shares. These rights are
o receiving dividends at a fixed rate,
o getting back the capital in case the company is wound-up.
• Investment in these shares are safe, and a preference shareholder
also gets dividend regularly.

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 Equity Shares

• Equity shares are shares which do not enjoy any preferential right in
the matter of payment of dividend or repayment of capital. The
equity shareholder gets dividend only after the payment of dividends
to the preference shares. There is no fixed rate of dividend for equity
shareholders. The rate of dividend depends upon the surplus profits.
In case of winding up of a company, the equity share capital is
refunded only after refunding the preference share capital. Equity
shareholders have the right to take part in the management of the
company. However, equity shares also carry more risk.

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MERITS :To the shareholders

1. 2.
In case there are The value of equity
good profits, the shares goes up in
company pays the stock market
dividend to the with the increase
equity shareholders in profits of the
at a higher rate. concern.

4.
Equity shareholders
3. have greater say in
Equity shares can the management of a
be easily sold in company as they are
conferred voting
the stock market
rights by the Articles
of Association.

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 To the Management

A company can raise fixed capital by issuing equity

shares without creating any charge on its fixed
assets.

The capital raised by issuing equity shares is not

required to be paid back during the life time of the
company. It will be paid back only if the company is
wound up.
There is no liability on the company regarding
payment of dividend on equity shares. The
company may declare dividend only if there are
enough profits.

If a company raises more capital by issuing equity

shares, it leads to greater confidence among the
investors and creditors.

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 Characteristics of shares

The main characteristics of shares are following:

 It is a unit of capital of the company.

 Each share is of a definite face value.
 A share certificate is issued to a shareholder
indicating the number of shares and the
amount.
 Each share has a distinct number.
 The face value of a share indicates the
interest of a person in the company and the
extent of his liability.
 Shares are transferable units.

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 Debentures

• Whenever a company wants to borrow a large amount of fund for a

long but fixed period, it can borrow from the general public by
issuing loan certificates called Debentures. The total amount to be
borrowed is divided into units of fixed amount say of Rs.100 each.
• These units are called Debentures. These are offered to the public
to subscribe in the same manner as is done in the case of shares. A
debenture is issued under the common seal of the company. It is a
written acknowledgement of money borrowed. It specifies the
terms and conditions, such as rate of interest, time repayment,
security offered, etc.

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 Characteristics of Debenture

Following are the characteristics of Debentures

• Debenture holders are the creditors of the company. They are entitled to periodic
payment of interest at a fixed rate.
• Debentures are repayable after a fixed period of time, say five years or seven years
as per agreed terms.
• Debenture holders do not carry voting rights.
• Ordinarily, debentures are secured. In case the company fails to pay interest on
debentures or repay the principal amount, the debenture holders can recover it
from the sale of the assets of the company.

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 Types of Debentures

• Debentures may be classified as:

o Redeemable Debentures and Irredeemable Debentures
o Convertible Debentures and Non-convertible Debentures.
• Redeemable Debentures :
These are debentures repayable on a pre-determined date or at any time prior to
their maturity, provided the company so desires and gives a notice to that effect.
• Irredeemable Debentures :
These are also called perpetual debentures. Accompany is not bound to repay the
amount during its life time. If the issuing company fails to pay the interest, it has to
redeem such debentures.

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 Types of Debentures

• Convertible Debentures :
The holders of these debentures are given the option to convert their debentures
into equity shares at a time and in a ratio as decided by the company.
• Non-convertible Debentures:
These debentures cannot be converted into shares.

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 Retained Earnings

• Like an individual, companies also set aside a part of their profits to meet future
requirements of capital. Companies keep these savings in various accounts such as
General Reserve, Debenture Redemption Reserve and Dividend Equalization
Reserve etc. These reserves can be used to meet long term financial requirements.
The portion of the profits which is not distributed among the shareholders but is
retained and is used in business is called retained earnings or ploughing back of
profits. As per Indian Companies Act., companies are required to transfer a part of
their profits in reserves. The amount so kept in reserve may be used to buy fixed
assets. This is called internal financing.

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 MERITS :

Following are the benefits of retained earnings:

• Cheap Source of Capital :
No expenses are incurred when capital is available from this source. There is no
obligation on the part of the company either to pay interest or pay back the
money. It can safely be used for expansion and modernization of business.
• Financial stability :
A company which has enough reserves can face ups and downs in business. Such
companies can continue with their business even in depression, thus building up
its goodwill.
• Benefits to the shareholders:
Shareholders may get dividend out of reserves even if the company does not earn
enough profit. Due to reserves, there is capital appreciation, i.e. the value of
shares go up in the share market .

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 Limitation

Following are the limitations of Retained Earnings:

• Huge Profit :
This method of financing is possible only when there are huge profits and
that too for many years.
• Dissatisfaction among shareholders :
When funds accumulate in reserves, bonus shares are issued to the
shareholders to capitalize such funds. Hence the company has to pay more
dividends. By retained earnings the real capital does not increase while
the liability increases. In case bonus shares are not issued, it may create a
situation of under–capitalisation because the rate of dividend will be
much higher as compared to other companies.

Cont…
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 Limitation

• Fear of monopoly :
Through ploughing back of profits, companies increase their financial
strength. Companies may throw out their competitors from the market
and monopolize their position.
• Mis-management of funds :
Capital accumulated through retained earnings encourages management
to spend carelessly.

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 Deferred Credit

• A deferred credit could mean money received in advance of it being

earned, such as deferred revenue, unearned revenue, or customer
advances. A deferred credit could also result from complicated
transactions where a credit amount arises, but the amount is not revenue.
• A deferred credit is reported as a liability on the balance sheet. Depending
on the specifics, the deferred credit might be a current liability or a
noncurrent liability. In the past, it was common to see a noncurrent
liability section with the heading Deferred Credits.

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THANK YOU
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