Long-Term Sources of Finance
The long-term sources of finance fulfil the financial requirements of a business entity for the time periods exceeding five years and can be in the form of shares, debentures, loans from financial institutions and long-term borrowings. In general, these sources of finance are used for investing in long-term projects that are going to generate returns for the company in the future years. Long-term funds are paid back during the lifetime of the organisation.
Table of Content
- 1 Long-Term Sources of Finance
- 2 Equity Shares – Meaning, Advantages and Limitations
- 3 Preference Shares – Meaning, Advantages and Limitations
- 4 Debentures–meaning, Advantages and Limitations
- 5 Retained Earnings – Meaning, Advantages and Limitations
- 6 Loan From Banks and Financial Institutions – Meaning, Advantages and Limitations
- 7 Venture Funding – Meaning, Advantages and Limitations
- 8 Asset Securitisation – Meaning, Advantages and Limitations
- 9 International Financing (Euro Issue, Foreign Currency Loans, ADR, FCCB, GDR) – Meaning, Advantages and Limitations
There are a number of different sources available with a business concern to meet its long-term financial needs. These sources of long-term finance broadly include share capital (equity shares and preference shares) and debt capital (i.e., bonds and debentures, long-term borrowings or other debt instruments).
Long-term financing has various merits as stated below:
- Helps in growth and expansion
- Provides stability as the organisation need not search for funding sources too often
- Supports the long-term capital objectives of the organisation
- Helps in managing the use of assets and cash flows to manage the asset-liability position of the organisation efficiently
- Provides ownership and control opportunities to equity investors
- Enables diversification of the debt portfolio
Despite the merits stated above, long-term financing has the following drawbacks:
- Regulations for payment of interest and repayment of principal amount are rigid
- The valuations and future fundraising of the organisation may be impacted
- Non-repayment of the debt obligations may lead to liquidation due to strict provisions under the IBC Code
- Long-term agreements are typically rigid and are hard to opt-out of
Equity shares, also known as common shares, represent the ownership capital in a company. Equity shareholders are the legal owners of the company and they have an unlimited claim on the income and assets of the company and enjoy complete voting power in the company. Ownership benefits come with their share of risks, and as such equity shareholders bear the risk of ownership; equity dividend is paid after preference dividend has been paid.
Also, the rate of dividend on equity shares is not fixed and depends on the availability of divisible profits and the intent of the board of directors. Equity shares may receive a higher rate of dividend when the company performance is good and a low rate when performance is poor. By the issue of ordinary equity shares, a public limited company can raise capital/funds from its promoters or from the general investing public. Such capital is known as the owner’s capital or equity capital. Equity shares also includes bonus shares and sweat equity shares.
Let us discuss each of these types in brief.
- Bonus shares: Bonus shares are those that are issued to existing shareholders in place of dividends when an organisation has accumulated sufficient profit but prefers to have more working capital at its disposal.
- Sweat equity shares: Sweat equity shares refer to those shares that are issued to the employees of an organisation as a reward and recognition for their services. Sweat equity shares are always issued at a discount and are a means of making share-based payments to employees of the company. They act as an incentive and help to motivate employees and increase productivity.
- Permanent source: Equity shares serve as a source of permanent capital that is available for use during the lifetime of the organisation. The obligation to refund it comes up only at the time of winding up of the business.
- No need for security: Mortgaging of assets is not needed to secure equity capital. Hence, assets are available to use as mortgage to raise further finance from other sources.
- Increase in borrowing capacity: Lenders generally lend in proportion to the amount of shareholder’s funds. Equity capital raises the latter which affords more security to the lenders and thus increases the borrowing capacity of a business.
- No obligation to pay dividend: There is no legal obligation on the company to pay dividend on equity shares. In case, the company wishes to reinvest all of its income, it is free to do so.
- Increase in market value: The market value of equity shares increases with the earning capacity of the business.
- Voting rights: Equity shareholders have voting rights in the company.
- Higher dividends in case of profits: Equity shares provide higher dividends when the company performs well.
- Bonus shares: Equity shareholders can receive bonus shares in lieu of dividend if the company has ample profit but wants to retain working capital.
- Liquidity: Equity shares are a much more liquid investment for investors as compared with other investments because selling shares is easier if the need arises.
- Higher cost: Equity shares are costlier for the company because dividends are paid out of post-tax profits. Moreover, equity shares have a higher floatation cost regarding underwriting, brokerage, etc., as compared with other securities.
- Does not facilitate trading on equity: A company issuing only equity shares is unable to reap the benefits of trading on equity.
- Dividend is not fixed: Equity shareholders are not entitled to a fixed rate of dividend. In fact, equity shareholders receive dividend only after each and every stakeholder has been paid. If the company performs poorly, it may lower the rate of dividend or suspend it completely. Even if it does well, the company may plough back a portion of the profits.
- Fall in the market value: Just as the shareholder can gain with a rise in the market value of equity shares, there is a risk of a fall in the market value of shares if the company does not accumulate sufficient profits.
- No real control: Equity shareholders are numerous and most of them are scattered and unorganised due to which they have no real control over the company.
- Risk of total loss: Equity shareholders bear the brunt in case of liquidation as they are last in the line of claim to the company’s assets. In a lot of cases, they do not get anything at all as the company is not liable to them.
Preference shares also commonly known as preferred stock, is a special type of share where dividends are paid to shareholders prior to the issuance of common stock dividends. Preference shares are suitable for investors who want a steady source of income without taking on the risks of volatility in the common shares. Preference shareholders also give up the upside potential of common shares as preference shares do not change their value substantially in any given holding period.
For preference shareholders, the dividend is fixed however, they do not hold voting rights as opposed to common shareholders. Preference shares are a special kind of shares. Preference shareholders enjoy priority, both with respect to the fixed payment of dividend and also towards the repayment of capital invested in the company in case of winding up or liquidation. Preference share capital is also a source of long-term finance. As explained in the previous chapter, these shares carry preferential rights over equity shares with respect to payment of dividend and return of capital.
There are different types of preference shares issued by a company as described below:
- Convertible preference shares: This type can be converted into equity shares after a specified time-period.
- Non-convertible preference shares: This type cannot be converted into equity shares.
- Participating preference shares: This type of shares offers the right to a share in surplus profit after the company has paid its other shareholders. Hence, participating preference shareholders are entitled to a fixed rate of dividend plus a share in the company’s extra earnings.
- Non-participating preference shares: These shares offer a fixed rate of dividend but no right to partake in the extra earnings or surplus assets during the liquidation of a company.
- Redeemable preference shares: These shares are issued for a specified time-period and the company has the right to repurchase the shares at its discretion. These shares are useful for shielding against the impact of inflation and the decline of the monetary rate. It is possible to trade these shares on stock exchanges.
- Irredeemable preference shares: These preference shares can only be repaid at the time of liquidation of the company after it has repaid all the liabilities.
- Cumulative preference shares: For these shares, dividends get accumulated over a period of time and the shareholders receive dividend in arrears when the company has sufficient profit.
- Non-cumulative preference shares: For these shares, the dividend does not get accumulated over a period of time and the company has to pay dividend from the net profits at the end of the financial year. The shareholders have no claim to outstanding dividend from any future profit.
- No legal obligation for dividend payment: There is no compulsion of payment of preference dividend because non-payment of dividend does not amount to bankruptcy. This dividend is not a fixed liability such as the interest on the debt which has to be paid in all circumstances.
- Improves borrowing capacity: Preference shares become a part of net worth and therefore reduces debt to equity ratio. This is how the overall borrowing capacity of the company increases.
- No dilution in control: Issue of preference share does not lead to dilution in control of existing equity shareholders because the voting rights are not attached to the issue of preference share capital. The preference shareholders invest their capital with fixed dividend percentage but they do not get control rights with them.
- No charge on assets: While taking a term loan security needs to be given to the financial institution in the form of primary security and collateral security. There are no such requirements and therefore, the company gets the required money and the assets also remain free of any kind of charge on them.
- Heavy dividend: Usually, preference shares carry a higher rate of dividend than the rate of interest on debentures.
- Accumulation of dividend: The arrears of preference dividend accumulate in case of cumulative preference shares. It is a permanent burden for the company.
- Costly: Comparing to debentures, financing of preference shares is more costly.
- No voting rights: Since preference shares have no voting rights, the interest of the preference shareholders may be damaged by the equity shareholders.
- Way to liquidation: Sometimes, instead of using the available limited cash for productive purpose, the Board may give it to the preference shareholders as dividend. In the long run, this may lead to insolvency.
Debentures–meaning, Advantages and Limitations
Debentures are a widely used source of long-term capital for a company. Capital acquired through the issue of debentures represents debt taken by the company and is also known as debt capital. A debenture is a certificate issued under the common seal of the company acknowledging a receipt of money. Debentures carry a fixed interest rate and a specified date of maturity. On the date of maturity, the principal has to be repaid.
Various Merits to Use Debentures
- Cheaper source: The interest cost incurred on debentures enjoys a tax shield which indirectly lowers the cost. Therefore, the effective interest cost of debentures is lower when taking the current tax rate into account. Moreover, debt financiers face relatively lower risk, so the returns offered to them are also lower.
- No dilution of control: The issue of debentures does not dilute the control of the existing shareholders or the owners of the company.
- No dilution in share of profits: Using debentures as a source of finance does not affect the profit-sharing percentage of existing shareholders unlike equity as debenture holders have no share in profits. The company is legally bound to only pay the agreed amount of interest.
- Financial leverage: If the rate of return on investment on debentures is greater than the percentage of interest, a profit-making company can maximise the wealth due to financial leverage.
- Low issue cost: The cost of the issuing debentures is lower than that of equity shares.
- Flexibility: Debentures with callable feature provide flexibility in the capital structure as the company can redeem them if there is a decrease in the rate of interest in the market (to issue new debentures with lower interest rates) or at its discretion (when it has surplus funds).
- Stable income for investor: Debentures provides the investor a fixed and stable return on his investment plus a preferential right of payment at the time of liquidation.
Disadvantages of Debentures
- Obligation to pay: The company is legally bound to pay interest even if there is no profit or even if there is loss.
- Security: It is difficult for a company with insufficient fixed assets to provide security against debentures.
- Increase risk: Financing through debentures increase the financial risk associated with the business firm.
- No voting rights to debenture holders: As investors, debenture holders have no right to vote in the official meetings of the organisation and influence the decision.
- No profit sharing: The returns on debentures are fixed, even if the earnings of the company increase.
Retained Earnings – Meaning, Advantages and Limitations
Retained earnings are a feasible option as a source of long-term finance for a company that has been operating for some time. An existing company can plough back its profits by not distributing all of it as dividend but reinvesting a part in the business known as retained earnings. This is an internal or self-financing method.
Advantages of Using Retained Earnings
- Economical method: It is one of the most economical methods of financing, apart from the opportunity cost, i.e., the return they could have obtained elsewhere.
- Shields from uncertainty of market: A company with sufficient retained earnings can easily absorb the uncertainty of the market.
- Balanced dividend policy: Retained earnings can be used for paying dividends in the years when there are inadequate profits.
- Self-dependence: The company has self-dependence with retained earnings as it need not rely upon external funding sources such as loans or debentures.
- No dilution of ownership: Retained earnings do not dilute the ownership of the company.
- Increase in creditworthiness: The company does not depend upon external sources for its funding which increases its creditworthiness. Less debt also makes the business more attractive to potential investors.
- Strengthen the financial position: The financial position of a company is strengthened and its capital is appreciated through retained earnings which, in turn, raises the market value of shares and wealth.
- Repayment of long-term liabilities: The company is able to repay its long-term loans and is eased from the burden of fixed interest payments.
Disadvantages of Using Retained Earnings
- High opportunity cost: Retained earnings are associated with a high opportunity cost because equity shareholders have sacrificed the returns they could have earned elsewhere.
- Overcapitalisation: A conservative dividend policy can result in a build-up of retained earnings leading to over capitalisation with no corresponding increase in earnings.
- Risk of unethical practice: The management can misuse retained earnings as an opportunity to manipulate the market value of the company’s shares. They may declare lower dividends for the sake of retained earnings and when the market value of the share falls, purchase them at reduced prices. Afterwards, they may increase the rate of dividend and sell these shares for a profit.
- Shareholder discontent: Excessive ploughing back of profits may create discontent amongst the shareholders if the dividend rate is low in comparison with the earnings of the company.
Loan From Banks and Financial Institutions – Meaning, Advantages and Limitations
Many specialised institutions and banks offer long-term financial assistance to industries. Long-term loans can be obtained from national financial institutions such as Industrial Finance Corporation of India (IFCI), State Financial Corporations (SFCs), Industrial Development Bank of India (IDBI), National Industrial Development Corporation (NIDC), Life Insurance Corporation of India (LIC), Unit Trust of India (UTI), Industrial Reconstruction Bank of India (IRBI), and more.
State Financial Corporations and State Industrial Development Corporations have been established at the state level to provide loans to businesses. The maturity period of long-term loans provided by banks and financial institutions ranges between 5 to 10 years. The lending institution and borrower negotiate the terms and conditions of these loans at the time of loan disbursal.
Advantages of Term Loans
- Easy: The raising of funds through this source is relatively easier as compared with issuing shares or raising venture capital.
- No loss of control: This source of finance does not allow the interference of the lending institution in the internal affairs of the company.
- Fixed instalments: Term loans have fixed instalments for payment until the maturity of the loan. In times of inflation, the borrower will benefit because the effective cost of future instalments will go down due to a fall in the value of the currency.
- Security: The lending institution has a low risk when dispensing these loans because they are always secured. The assets financed by loans act as primary security, while all the other assets of the borrower act as secondary security for the loan.
Disadvantages of Term Loans
- Restrictive covenants: The lending institutions impose several restrictive terms and conditions on the borrower to protect their interests. These are called covenants and may include terms such as maintaining a minimum current ratio, prohibiting sale of fixed assets without the lender’s approval, kerbs on taking additional loans, usage of assets, the creation of liabilities or cash flows. Covenants may also control the payment of dividend and salaries by the borrower.
- Obligation to pay: The borrowing company is legally bound to pay the interest and repay the principal of the term loan. New businesses or those facing loss may find this rigidity very difficult to comply with.
- Convertibility: Financial institutions usually insist on the option of converting their loans into equity shares of the company.
- Repayment schedule: The repayment schedule of these loans is predetermined and the borrower has to stick to this schedule to avoid penalties.
- High risk: Because these loans are always secured, they carry a high risk for the borrower.
Venture Funding – Meaning, Advantages and Limitations
Venture capital is a form of long-term finance that is especially suited to projects that carry high risk and high rewards. It provides young business entities much-needed capital and managerial assistance in the early stages of their start-ups or projects. The funds are provided in exchange for equity participation through the direct purchase of the shares and debentures of the start-up.
Under the concept of venture capital financing, venture capitalists invest their money in acquisition of equity shares or debt securities issued by new and inexperienced business entities who expect to potentially attain success out of their highly risky projects undertaken.
Venture capital financing is seen from the point of view of long-term investments made in small and medium enterprises which have the potential of growth orientation. Besides providing an assistance of funds, venture capitalists also offer support to new business entities in the form of business networking, sales strategy and management expertise so as to ensure growth and success of their ventures.
Advantages to Using Venture Capital
- Opportunity for expansion: Venture capital provides a start-up in nascent stages with an opportunity to expand. This is because venture capital source does not require collateral and there is no obligation to repay the loan. Banks and other financial institutions are unwilling to back start-ups because of the high risks, high initial cost and limited operating history.
- No obligation for repayment: One major benefit of using venture capital as a source is that there is no obligation to repay investors in case of loss or failure.
- Counselling and support: Venture capitalists also provide valuable guidance, expertise, technical assistance, and counselling to the start-up with their experience in building and expanding startups. Typically, a member of the venture capitalist firm is appointed to the board of the start-up and is actively involved in the company’s decision-making process.
- Builds networks and connections: Venture capitalists have a huge network of connections in the business community that can be very useful for the start-up.
- Strict regulations: Venture capitalists are reliable as they have to comply with anti-money laundering and other such regulations by regulatory bodies.
- Easy to locate: Venture capitalists are listed in various directories and are fairly easy to search for.
Limitations of Using Venture Capital
- Dilution of ownership and control: Venture capitalists take huge risk to invest huge capital in the start-ups in exchange for a stake in the equity. In case the start-up is successful, they not only earn huge profits but also become a part of the Board of Directors of the company. They actively participate in the decision-making process of the start-up, diluting the ownership and control of the entrepreneur.
- Early redemption: Venture capitalists may decide on early redemption of the investment as their main focus is to earn capital gains. For business entities whose business plan will take a longer time to provide liquidity, this might not work.
- Complicated and lengthy process: Since venture capital finance involves a lot of risk and uncertainty, the process of availing of these funds is not easy. The start-up has to provide a detailed business plan to the venture capitalist which the latter reviews. There might be one or more meetings to discuss the business plan in detail. The venture capitalist then verifies these details and offers a term sheet only if he finds everything satisfactory.
- Hard to capture the attention of a venture capitalist: It is usually hard for a start-up to get the attention of venture capitalists, who get proposals from many business entities.
- Funds might be released slowly: Even though the start-up would like to get all the requested finance at once, it is a huge risk for the venture capitalist who may decide to release funds in instalments only when the start-up reaches certain milestones.
- Under-valuation of start-up company: If a venture capitalist wants to sell off their equity stake, they may force the owner of the company to list the company. An untimely listing may lead to an undervaluation of the company’s shares.
Asset Securitisation – Meaning, Advantages and Limitations
Asset securitisation is the process of converting the receivables of an organisation into debt securities and then trading these securities in the same way as stocks, bonds and futures contracts. In other words, asset securitisation is a process where a company consolidates several of its assets into securities and then issues these securities to the investors, who earn interest.
It is a means of converting the illiquid assets into liquid assets to free up the blocked capital. These small assets would not sell individually so they are consolidated into a special purpose vehicle (SPV). Through asset securitisation companies are able to raise finance by selling assets or income streams into the SPV.
Asset securitisation has the following merits:
- Frees capital: Asset securitisation’s biggest advantage is that it frees up blocked capital. Therefore, it reduces the need for financial leverage in case of any immediate requirement.
- Provides liquidity: Another equally great advantage is that it converts illiquid assets, such as the receivables on loans, into liquid assets.
- Lowers funding cost: Securitisation enables companies possessing financial assets to have quick access to low-cost sources of finance and lower their dependence on financial intermediaries.
- Improved monitoring: A high level of data transparency and a robust system is needed for securitisation which streamlines the system and improves overall monitoring and control of asset portfolios.
- Risk management: The company’s risk of bad debts can be transferred by securitising its receivables.
- Off-balance-sheet funding: For accounting purposes, securitisation is treated as a sale of assets instead of financing. Hence, the transaction is not recorded as a liability on its balance sheet. This allows a business to raise funds without increasing the debt/equity ratio.
- Better financial ratios: Securitisation improves financial ratios as it enables larger transaction volumes with the same capital which leads to higher profitability and returns.
- Flexibility: Securitisation offers flexibility as the instrument can be customised in terms of duration, repayment schedule, and interest rate, to meet the demands of the company and the risk-taking of the investor.
- Lower credit risk: The securitised assets have less credit risk for the investor as these are treated as a separate entity from the originating business.
- Safe investment: Investors can diversify their portfolios with securitisation as the exposure is to a pool of assets.
- Better returns: Securitisation has a proven track record of consistently good performance with no downgrades or defaults.
Disadvantages of Securitisation
- Complexity: Securitisation is generally a complicated and expensive way of raising long-term finance as compared with some other methods.
- Restrictive: Securitisation may inhibit the ability of a firm to raise funding in the future.
- Loss of control on assets: It may cause an organisation to lose direct control of some of its assets which may lead to lowering of the organisation’s value in the event of flotation.
- Expensive to revert: If a business wants to close the SPV and take back its assets, it may cost it a considerable amount of money.
- Inaccurate risk assessment: At times, even the originator might identify the value of underlying assets or the associated credit risk inaccurately.
International Financing (Euro Issue, Foreign Currency Loans, ADR, FCCB, GDR) – Meaning, Advantages and Limitations
Sometimes, business entities may find it hard to find funding in their home country or they may find that international funding may be more advantageous to them, and they can avail finance from various international sources. International financing includes all the sources of finance or capital used to raise funds in a foreign currency outside the home country. There are various factors to consider when choosing the international source of finance.
Firstly, businesses need to choose the source according to the purpose for which the funds are required. The cost of acquiring the funds and the cost of utilising the funds both need to be taken into account. Foreign currency loans are speculative and if exchange rates and interest rates are not favourable, it may be harder to repay these loans. Hence, businesses should also analyse their financial position and make sure they will be able to repay the principal and interest on the borrowed amount.
The most widely used source of international financing is the euro issue which includes various sources such as American Depository Receipts (ADR), Global Depository Receipts (GDR), and Foreign Currency Convertible Bonds. Euro issue refers to the issue listed on the European or American Stock Exchange by either non-American or non-European companies (in our case, Indian companies). To list these issues in foreign stock exchanges, Indian companies have to comply with their regulations. Let us try and understand GDR and ADR in turn.
GDR option allows a company to issue equity shares and keep them in the custody of an intermediary called a domestic custodian. The domestic custodian bank acts as an agent of the issuer and instructs the overseas depository bank to issue fresh securities in the form of GDR against shares kept under the local custodian bank.
In other words, GDR is a process of issuing securities in a foreign country by an overseas depository bank that are authorised by the issuing company in the home country. GDRs are listed on European or American stock exchanges and are denominated in foreign currency, usually in U.S. dollars. The issuer collects the proceeds in foreign currency.
A foreign currency convertible bond (FCCB) is a type of convertible bond issued in a currency different than the issuer’s domestic currency. In other words, the money being raised by the issuing company is in the form of foreign currency. A convertible bond is a mix between a debt and equity instrument. It acts as a bond by making regular coupon and principal payments, but these bonds also give the bondholder the option to convert the bond into stock.
American Depository Receipts
The ADR is very similar to GDR except for the fact that the former is more likely to be listed and traded on US Stock Exchange while the latter is generally listed on European stock exchanges.
Let us have a look at some of the major advantages of euro issues as given below:
- Cheaper source for foreign currency: Raising capital through euro issues allows businesses to have a cheap source of foreign currency funds without exchange risks, particularly for those businesses that have foreign currency receivables.
- Wider access: Euro issues offer a company access to a wider market and international sources of funds. Hence, larger volume funding may be easier to obtain relative to domestic sources.
- More opportunity: This source of funding opens up various opportunities for organisations in new markets.
- Enhanced exposure and liquidity: Euro issues provide greater international exposure to organisations and can improve liquidity for their shares.
While the euro issue offers many advantages and is an attractive source of finance for companies, there are few limitations of the euro issue which need to be taken into account and are given below:
- High exchange risk: While euro issues are generally available at lower costs, companies without sufficient receivables face currency exchange risk and may have to sustain hedging costs due to which savings will be offset.
- Not available to all companies: Due to money laundering concerns and capital flow out of the country, the government has strict guidelines for availing international finance. To avail finance via euro issues, companies have to follow the guidelines and meet the criteria issued by the Reserve Bank of India. Only companies that can do so are able to avail of such funds.
- Takes time: Funding through the euro issue does not occur immediately.
Foreign Currency Loans
Foreign currency loans are another source of international financing. When a company borrows money in a foreign currency and has to repay the loan in this currency too, it is known as a foreign currency loan. When a company takes a foreign currency loan, it anticipates interest and exchange rate advantages (though these might not always happen). In practice, when a borrower applies for a foreign currency loan, the domestic bank obtains the loan sum in the foreign currency from the overseas bank, converts it into the domestic currency and pays it out to the borrower.
At the time of payment of interest and repayment of principal, the borrower gives the bank the domestic currency, which it converts into the foreign currency and transfers it to the overseas bank. This type of loan involves high processing fees but may eventually cost less than the same loan in domestic currency because interest rates differ between different currencies.
Hence, if the credit interest rates are currently lower in the foreign currency than in domestic currency, and the borrower predicts they will remain low for the duration of the loan, the foreign currency loan will be a great idea. Moreover, if the exchange rate favours the home currency, the borrower has to repay less. The disadvantage is that the risks are high because if the interest and exchange rate advantages do not work, then the amount of debt to repay will be quite high.