In an organized sector, there are five specific sources of financing to meet the long-term requirements of a firm: These are discussed in the following paragraphs: Equity shares were earlier known as ordinary shares (or common stock). (iii) Free from Restrictive Covenants Lease financing is free from restrictive covenants whereas the financial institutions often put a number of restrictions on borrowers, such as, conversion of loan into equity, appoint nominee directors, restrictions on payment of dividend, and so on. Long Term Source of Finance - This long term fund is utilized for more than five years. This residual income is either directly distributed to them in the form of dividend or indirectly in the form of bonus shares. However, for obtaining further finance in case of any existing company, the management should, as far as possible, avoid issuing equity shares. Paying dividend on equity shares is not an obligation for an organization when there is less profit or loss, ii. Depending on various factors, the period can stretch for more than 5 to 20 years. Generally, the financial institutions charge an interest rate that is related to the credit risk of the proposal, subject usually to a certain minimum prime lending rate (PLR) or floor rate. SBA loans offer competitive rates and repayment periods of up to 25 years. Equity financing is the process of the sale of an ownership interest to various investors to raise funds for business objectives. Trade credit 2. (v) Safety from the Risk of Obsolescence In a lease contract, the lessor being the owner of the leased asset bears the risk of obsolescence. The lessee pays a fixed rental to the lessor at the beginning or at the end of a month, quarter, half year, or year. The holders of convertible preference shares have to pay conversion price at a given date for converting their shares into equity shares. Long term finance are capital requirements for a period of more than 1 year. Hence, a group of shareholders may control the company by purchasing shares and they may use such control for their personal advantage at the cost of companys interests. (iii) Creation of Monopolies Continuous ploughing back of profits over a long time may lead a company to grow into a monopoly. The characteristics of term loans are as follows: i. Their features, types, advantages and limitations are discussed in the following paragraphs: In some markets the two terms, debentures and bonds are used synonymously, but in the US they refer to two separate kinds of debt-based securities. (iii) Increase in Market Value Usually a portion of the profits is ploughed back into the business which results in enhanced earning power of the company and increase in the market value of its shares. Limiting the liability of equity shareholders to the amount of shares they hold, iv. Foreign Capital. Trade Credit Bearer Debentures Refer to the debentures that are not registered in the books of the organization. Prohibited Content 3. There are a number of sources of short-term finance which are listed below: 1. His position is akin to that of a person who uses the asset with borrowed money. Cumulative Preference Shares Refer to the shares for which dividends get accumulated over a period of time. (i) Costly Source of Finance Lease financing is a costly source of finance for the lessee because lease rentals include a profit margin for the lessor as also the cost of risk of obsolescence. The dividend policy of the company is determined by the directors. You can calculate this by, ROR = {(Current Investment Value Original Investment Value)/Original Investment Value} * 100, Invested Capital is the total money that a firm raises by issuing debt to bond holders and securities to equity shareholders. Long term 2; Basics Long term finance - Funding obtained exceeding three years in duration. Covenants may also include the appointment of nominee director by financial institutions to safeguard their interests. (d) Sometimes internal accruals as a source of finance are preferred over the other sources due to the financial and taxation position of the companys shareholders. It is computed by dividing the amount of the original loan by the number of payments. (b) It is obligatory on the part of the borrower to pay the interest and repayment of principal irrespective of its financial position. (c) Sometimes, a conservative dividend policy leads to huge accumulation of retained earnings leading to over-capitalization. (vii) No Effect on Debt-Equity Ratio Lease is considered a hidden form of debt because neither the leased asset nor the lease liability is depicted on the balance sheet. Copyright 2023 . 4 Sources of Long Term Financing 4.1 External sources of finance 4.2 Equity Shares 4.3 Preference Shares 4.4 Debentures and Bonds 4.5 Venture capital 4.6 Term Loans 4.7 Lease financing 5 Internal Sources of finance 5.1 Retained earnings 5.1.1 Advantages of Retained Earnings 5.2 Sale of assets Long Term Financing Needs of a Business iv. (v) Loss on Liquidation In case of liquidation, equity shareholders have to bear the maximum risk. Some of the new financial instruments are discussed below: Zero-coupon bonds are purchased at a high discount, known as deep discount, on the face value of the bond. When the organization has sufficient profit, the accumulated dividend of these preference shares is paid. (a) The terms and conditions of term loans are negotiable between borrowers and lenders and as a result, it may sometimes affect the interest of lenders. (iv) Flexibility in Fixing the Rentals Lease rentals are fixed in such a way that the lessee is able to pay them from the cash flows generated from his business operations. Raising funds through equity shares for long-term investment as these shares are repaid during the lifetime of the organization, iii. Disclaimer 8. Lenders normally lend in proportion to the amount of shareholders funds. But, in case of companies Also, the use of retained earnings does not require compliance of any legal formalities. From Managements (Borrowers) Point of View: (a) Yearly interest payment and repayment of principal is obligatory on the part of borrower. As stated earlier, in case of sole proprietary concerns and partnership firms, long-term funds are generally provided by the owners themselves and by the retained profits. (c) In addition to collateral security, restrictive covenants are also imposed by the lenders which lead to unnecessary interference in the functioning of the business concern. Loans from co-operatives 1. These various sources are described below. (iii) Not Bound to Pay Dividend A company is not legally bound to pay dividend to its equity shareholders. Some of the long-term sources of finance are:- 1. The borrower may be asked to maintain a minimum asset base, not to raise additional loans or to repay existing loans, restricting the company to sell its key assets without prior approval of the lender, inclusion of the representative of the financial institution in the borrowing company and so on. They are a flexible source of finance provided by the banks to meet the long-term capital needs of the organization. The advantage of having internal accruals like depreciation and retained earnings is clearly seen in their characteristics. In addition, long-term financing is required to finance long-term investment projects. These are called covenants. It is also referred to as ploughing back of profit. Ploughing Back of Profits 4. The saved taxes are allowed to accumulate as reserves. It is obtained from Capital market. However, they rank behind the companys creditors. Term loans differ from short-term loans which are employed to finance short-term working capital need and tend to be self-liquidating over a period of time usually less than a year. 4) Paytm to raise funds via selling a significant controlling stake in the company to Warren Buffet for $10-$12 billion. (c) They do not dilute the ownership of the company. Bonds are generally issued by government agencies, financial institutions and large corporations, and debentures are issued by companies. (iii) High Profitability Leasing business is highly profitable to the lessor because the rate of return is more than what the lessor pays on his borrowings. There are different vehicles through which long-term and short-term financing is made available. The terms loans represent a source of debt capital that is normally obtained by companies from term lending institutions. For this reason, they are also called hybrid financing instruments. Later, they may increase the rate of dividend out of past profits and may sell their shares at a profit. ii. Depending upon the intrinsic value of shares, the market value fluctuates. ii. SBA 7 (a) loans, for example, range from $25,000 . Since, both debenture and term loan are a type of debt financing, they share basic characteristics of a debt and hence their pros and cons are also similar. The warrant gives a right to the debenture holder to obtain equity shares specified in the warrant after the expiry of a certain period at a price not exceeding the cap price specified in the warrant. What is long-term finance. You have learnt about short term finance in the previous lesson. Sources of Long Term Financing. But an amendment in the Companies Act, 2000 permitted companies to issue equity shares with differential voting rights. But in case of Companies whose financial . The SPN holder has an option to sell back the SPN to the company at par value after the lock-in period. The organization has to pay dividends on these preference shares at the end of financial year. IPO is a means of raising capital for companies by allowing them to trade their shares on the stock exchange.read more or opt for a private investor to take a substantial stake in the company. Make it difficult to repay funds raised by issuing equity shares during the lifetime of an organization, even if these funds are not in use. After the maturity of the financed the borrower needs to return the financier the real amount with some profit and interest. Share capital or Equity shares Do not allow an organization to show the dividend paid on these shares on the debit side of profit and loss account. Shares are a part of stocks that consist of fixed assets and current assets, which may change at different situations. iii. These shares are a kind of award for employees for the work rendered by them to organization. Content Filtration 6. Stringent provisions under the IBC Code for non-repayment of the debt obligations may lead to. The fund is arranged through preference and equity shares and debentures etc. Interest is computed on the amount of the unpaid balance of the loan at each payment period. Help in collecting funds at the right time, iv. The capital procured by issue of equity shares is a permanent source of funds to the company as it need not be redeemed during the lifetime of the company. This is one of the important sources of internal financing used for fixed as well as working capital. Do not bind an organization to offer any asset as security to preference shareholders, v. Carry less risk for investors as compared to equity shares. It is faster than the companys equity or preference shares issue as there are fewer regulations to abide by and less complexity. The total value of retained profits in a company can be seen in the equity section of the balance sheet. and is accumulated from the capital market. Equity warrant is generally attached to non-convertible debentures as a sweetener to improve their marketability. Advantages and Disadvantages of Loans from Financial Institutions: Such loans offer all the advantages and disadvantages of debenture financing. In case of any default in debenture interest payment, the debenture holders can sell the companys assets and recover their dues. Term loans carry a fixed interest rate and the payment is made in installments which consist of both principal and interest. Involve less cost in raising funds than equity shares, ii. The government of India made several changes in the economic policy of the country in the early 1990s. Market value is the value at which the shares are traded on the stock exchange. Sources of Long-term Finance. They can be redeemable, irredeemable, convertible, and non-convertible. This article shall discuss major sources of long-term debt financing for most corporations. However, there is a notified period after which fully paid FCDs will be automatically and compulsorily converted into shares. Higher amount of shareholders funds provides higher safety to the lenders. (b) They are very flexible as the management has complete control over how they are reinvested and what proportion is kept rather than paid as dividends. (B) Disadvantages or Dangers of Excessive Ploughing Back: (i) Misuse of Retained Earnings It is not necessary that the management may always use the retained earnings to the advantage of shareholders. The lender is usually a commercial bank. Debenture holders of an organization arc known as creditors. According to Section 2 (30) of the Companies Act, 2013, the term debenture includes debenture stock, bonds and any other securities of a company whether constituting a charge on the assets of the company or not.. Thus the scarce financial resources of the business may be preserved for other purposes. In other words, a debenture is an agreement between a debenture holder and an organization, which acknowledges that the organization would repay the debt at a specified date to debenture holders. The basic characteristics of term loan have been discussed below: The term loans are secured loans. At the time of liquidation, these shares are paid after paying all the liabilities. Funds raised through these can be paid back over many years. Lease is a contract between the owner of an asset and the user of such asset. It may come from different sources such as equity, debt, hybrid instruments, or internally generated retained earnings. Long term sources of finance are those, which remains with the business for a longer duration of time. The control of the company may change to new shareholders who may reap the benefits of the companys prosperity and progress. Serve as a source of long-term capital and are repaid during the lifetime of the organization. The volatility of markets is a major factor that should be considered to determine the price of a share in the market at a particular point of time. The amount of long term capital depends upon the scale of business and nature of business. Each share has a certain face value which is also called its nominal value. Definition: Long term, either debt or equity, refers to the time period of more than five years. Allow debenture holders to receive payment before equity and preference shareholders even at the time of liquidation of an organization. Long-term finance Personal savings Personal savings is money that has been saved up by an entrepreneur. A debenture is a certificate issued by a company under its seal acknowledging a debt due by it to its holders. An initial public offering (IPO) occurs when a private company makes its shares available to the general public for the first time. This makes employees feel that they are owners of the organization and motivate them to demonstrate dedication in their work. These funds may be used to finance the cost of acquisition of fixed assets that are needed for expansion, modernization and diversification programmes of the company. The right of lenders to appoint nominee directors on the board of the borrowing company may further restrict the managerial freedom. Save an organization from unnecessary interference of preference shareholders as they do not enjoy any voting right, v. Prevent preference shareholders from claiming f or the assets of the organization. It represents the interest-free perpetual capital of the company raised by public or private routes. Facilitate debenture holders to be paid back during the lifetime of an organization, iv. Equity and Loans from Government 2. Hence they are unable to exercise effective and real control over the company. (iii) No Real Control over the Company There are a number of shareholders and most of them are scattered and unorganised. A portion of debenture can be converted into equity shares, the second portion may be redeemed after some period, and third portion may be non- convertible and continue to provide interest at the option of the holder. (i) Economical Method It is very economical method of financing. The less the firm relies on external sources of funding, more is the retention of the ownership of the firm. These are very similar to ZCBs and there are no interest payments. A financial plan is typically considered long-term when its goals span more than a year into the future. (b) If the purpose for utilization of retained earnings is not clearly stated, it may lead to careless spending of funds. Increase cost of capital when an organization raises fund from equity shares. Companies can also raise internal finance by selling off assets for cash. Sources of Long-Term Finance for a Company, Firm or Business, The main characteristics of retained profits are that there is no compulsory maturity like term loans and debentures and they are not characterized by fixed burden of interest or installment p, Essays, Research Papers and Articles on Business Management, Raising of Finance for a Company: 12 Methods, Sources of Industrial Finance in India | Financial Management, Essay on the Sources of Business Finance | Finance | Financial Management, Human Resource Planning: Meaning, Objectives, Purpose, Importance and Process, Long-Term Sources of Finance Equity Shares, Preference Shares, Ploughing Back of Profits, Debentures, Financial Institutions and Lease Financing, Long-Term Sources of Finance Shares, Debentures and Term Loans, Long-Term Sources of Finance Equity Capital, Preference Capital, Debt Capital, Internal Sources and Foreign Capital. (ii) Simplicity Borrowing from banks and financial institutions involve time consuming and complicated procedures whereas a leasing contract is simple to negotiate and free from cumbersome procedures. In addition, long-term financing is required to finance long-term investment projects. Non-Convertible Preference Shares Refer to the shares that cannot be converted into equity shares. (iii) Manipulation by a Group of Shareholders Shares of a company can be purchased and sold in the stock market. Finance is required for a long period also. (iv) Bonus Shares Equity shareholders have a claim on the residual income of the company. Lease Financing 7. Assets which are financed through term loans serve as primary security and the other assets of the company serve as collateral security. Funds required for a business may be classified as long term and short term. vi. Internal Sources 10. (iv) Excessive Penalties Sometimes, lessee has to pay excessive penalties if he terminates the lease before the expiry of lease period.
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