SOURCES OF FINANCE The Sources of business finance may be grouped under two heads i.e. Owners’ Funds I. Preference Shares II. Equity Shares Borrowed Funds • • • • III. Debentures Public deposits Loans and Credits from banks Financial Institutions Reinvestment of profit OWNERS’ FUNDS: Owners fund may consist of money raised from issue of shares and reinvestment of profits. Owners fund also called ownership securities is the raising of capital stock. The capital may consist of equity shares and retained profits. The company may also retain its profits for further investment. These funds are raised for a longer period and remain with the company permanently for longer period of time. The following are the features of owners’ funds: • • • • • The funds remain with the business on a permanent basis. The owners of these funds have controlling rights over working of the business. If the company has surplus profits then these may be distributed as dividend to shareholders. The reinvested profits belong to the owners of business. No security is required for raising owners’ funds. SHARE: The capital of a company is divided into a number of equal parts known as shares. According to section 2(46) of Companies Act, 1956, defines it as “a share in the share capital of a company, and includes stock except, where a distinction between stock and share is expressed or implied.” I.PREFERENCE SHARES: As the name suggests, these shares have two preferences as compared to other types of shares.
1. The first preference is Payment of dividend. Whenever company has distributable profits, the dividend is first paid on preference share capital and other shareholders are paid dividend out of the remaining profit, if any. 2. The second preference is repayment of capital at the time of liquidation of the company. After payment made to outside creditors, preference share capital is returned. Equity shareholders will be only when preference share capital is paid in full. Features of preference shares 1. Preference shares have priority over payment of dividend & repayment of capital. 2. The rate of dividend on preference shares is fixed. But in case participating preference shares, additional dividend may be paid if profit remains after paying equity dividend. 3. The preference share capital remains permanently with the company except in case of redeemable preference shares. 4. Preference shares do not create any charge over the assets of the company. 5. Preference shares do not have voting rights. 6. Redeemable preference shares can be paid off if the company has surplus funds. 7. If the company does not have sufficient profits in the current year then dividend on cumulative preference shares is carried forward to the next year. Types of preference shares 1. Cumulative Preference shares: It is a type of share where dividend not paid in any year is carried forward to the next year. These shares have a right to claim arrears of dividend for the year for which there is no profit. The dividend on preference shares goes on cumulating unless it is paid. 2. Non-Cumulative preference Shares: The holders of these shares have no claim for arrears of dividend. If there are sufficient profits then they are paid dividend but they cannot claim arrears of dividend in subsequent years. 3. Redeemable Preference Shares: It denotes a type of preference share which is redeemed after the expiry of a certain period. Normally, redeemable preference shares are redeemed after 10 or 12 years. 4. Irredeemable Preference Shares: These types of preference shares are not redeemed during the life of the company. These are just like equity shares but enjoy a fixed rate of dividend. 5. Convertible Preference Share: The holders of these shares may be given a right to convert their holdings into equity shares after a specified period. These are called convertible preference shares. 6. Non-Convertible Preference Shares: The shares which cannot be converted into equity shares are known as non-convertible preference shares. 7. Participating Preference Shares: The holders of these shares participate in the surplus profits of the company. They are firstly paid a fixed rate of dividend and then a reasonable rate of
dividend is paid on equity shares. If some profits remain after paying both these dividends, then preference shareholders participate in the surplus profits. 8. Non-Participating Preference Shares: The shares on which only a fixed rate of dividend is paid are known as non-participating preference shares. The shares do not carry the additional right of sharing of profits of the company. Advantages of preference shares: 1. The holders of preference shares get guaranteed rate of dividend. 2. Issue of preference shares is useful for the company to raise long-term funds for the company. 3. There is no need to mortgage property on these shares. 4. Preference shares do not have a voting power and right to participate in the management. Therefore, their issue does not affect the control and management of the company. 5. Redeemable preference shares have advantage of repayment of capital whenever there is surplus profit in the company. 6. As a fixed rate of dividend is payable on preference shares, these enable a company to adopt trading on equity. (Trading on Equity- Use of long term sources of funds i.e. equity share capital, preference share capital and debentures in order to increase the value of firm, earning per share is called Trading on equity.) Disadvantages of preference shares: • Permanent burden on the company to pay fixed rate of dividend even though there is no profit. • Preference shareholders do not have voting rights and right to participate in the management of the company. • The cost of raising the preference share capital is higher than other fixed interest bearing securities. II.EQUITY SHARES All shares which are not preference shares are called Equity shares. In other words, these shares do not have preferential right for dividend or repayment of capital. Equity shares are also known as ordinary shares and the holders of these shares are the real owners of the company. The equity shareholders are paid dividend after paying it to preference shareholders. The rate of dividend on these shares depends on the profits of the company. They may get fixed rate of dividend or they may not get anything. They have a voting right in the meetings of shareholders and have a control over working of the company. They take risk of both regarding dividend and return of capital. Equity share capital cannot be redeemed during the life time of the company. Features of equity shares:
• Equity shares are ordinary shares with no preferential rights. • Equity share capital remains permanently with the company as it is returned only when the company is wound up. • Equity shareholders have voting rights and elect the management of the company. • Equity shareholders are paid fluctuating rate of dividend depending on the availability of profit. Advantages of Equity shares: • Equity shares do not create any obligations to pay fixed rate of dividend. • Equity shares can be issued without creating any charge over the assets of the company. • It is a permanent source of long term capital of the company. • The company is not required to redeem the equity shares before the liquidation. • Equity shareholders are the real owners of the company who have voting rights and enjoy control over the management of the company. • In case of profit, equity shareholders are the real gainers by way of increased dividends and appreciation in the value of shares. Disadvantages of equity shares: • Equity shareholders do not get preferential right over profits and capital. • If only equity shares are issued, company cannot take the advantage of trading on equity. • Equity shareholders can put obstacles for management by manipulation and organizing themselves. • Investment in equity shares is risky for the investors. • Equity shareholders do not get guaranteed dividend. DISTINCTION BETWEEN PREFERENCE SHARES AND EQUITY SHARES PREFERENCE SHARES EQUITY SHARES Dividend at fixed rate is paid on preference shares. Preference shares have preferential right to get fixed rate of dividend over equity shares. Preference shares have preferential right to return of capital in the event of winding up of the company. Preference shareholders are not the real owners of the company. No voting right is given to preference shareholders. The rate of payment of dividend varies depending upon the profit of the company. Dividend is paid on equity shares only after paying dividend on preference shares. Equity shares have no such preference. The capital is returned only after satisfying claims of preference shares. Equity shareholders are the real owners of the company. They have full voting rights and participate in electing management.