Industrial Economics and Management, Schemes and Mind Maps of Industrial economy

Download Industrial Economics and Management and more Schemes and Mind Maps Industrial economy in PDF only on Docsity! UNIT – III: FINANCIAL MANAGEMENT Business implies a commercial activity of producing and distributing goods and services to final consumers for a profit. To undertake various business activities, an entity requires money and thus, finance is said to be the spine of business that keeps it going. The capital brought in, to the business by the proprietor is not sufficient to fulfil the financial needs and so he/she looks for new ways to fulfil fixed capital and working capital needs. Fixed capital requirements Funds are required to purchase fixed assets like land and building, plant and machinery, and furniture and fixtures. This is known as fixed capital requirements of the enterprise. The funds required in fixed assets remain invested in the business for a long period of time. Different business units need varying amount of fixed capital depending on various factors such as the nature of business, etc. For example, a trading concern may require small amount of fixed capital as compared to a manufacturing concern. Likewise, the need for fixed capital investment would be greater for a large enterprise, as compared to that of a small enterprise. Working capital requirements: Funds required for day-to-day operations of an enterprise are known as working capital.It is used for holding current assets such as stock of material, bills receivables and for meeting current expenses like salaries, wages, taxes, and rent. The amount of working capital required varies from one business concern to another depending on various factors. For example, A business unit selling goods on credit, or having a slow sales turnover, would require more working capital as compared to a concern selling its goods and services on cash basis or having a speedier turnover. The requirement for fixed and working capital increases with the growth and expansion of business. Based on the source of generation, it is classified as internal and external sources, wherein former covers those means which are generated within the business.Conversely, the latter implies the sources of funds that are generated outside the business like finance provided by the investors, lending institutions etc. Definition of Internal Sources of Finance In business, internal sources of finance delineate the funds raised from existing assets and day to day operations of the concern. It aims at increasing the cash generated from regular business activities. For this purpose, evaluation and control of costs are made, along with reviewing the budget. Moreover, the credit terms with customers are verified, so as to effectively manage the collection of receivables. Internal sources of finance include selling of assets, ploughing back of profit (retained earnings), and reduction in working capital. Definition of External Sources of Finance External sources of finance refer to the cash flows generated from outside sources of the organization, whether from private means or from the financial market. In external financing, the funds are arranged from the sources outside the business. There are two types of external sources of finance, i.e. long term source of finance and short term sources of finance. Further on the basis of nature, they can be classified as: Equity Financing: Equity is the major source of finance for most of the companies which indicate the share in the ownership of the firm and the interest of the shareholders. The firms raise capital by selling its shares to the investors. It includes:  Ordinary shares  Preference shares Debt financing: The source of finance wherein fixed payment has to be made to the lenders is debt financing. It includes: Another internal source of finance is the sale of assets. Whenever business sells off its assets and the cash generated is used internally for financing the capital needs, we call it an internal source of finance by the sale of assets. Reduction of Working capital: It is interesting to know how a reduction in working capital can work as an internal source of finance. Working capital has broadly two components. One, Current Assets, which include Stock / Inventory, Account Receivables – Debtors and Cash / Bank Balances. Second, Current Liabilities, which include Account Payables – Creditors and Bank Overdraft. Normally, a business requires two types of finance viz. long-term finance for capital expenditure and working capital finance for day to day needs. Reduction in working capital can be achieved either by speeding up the cycle of account receivables and stock or by lengthening the cycle of account payables. In essence, both will reduce the working capital requirement and therefore the funds invested for working capital can be utilized for the other finance or capital requirements. This source has a little different analytics. This source is generated out of the efficient management of working capital and appropriate usage of working capital management techniques. Trade Credit: Trade credit is the credit extended by one trader to another for the purchase of goods and services. Trade credit facilitates the purchase of supplies without immediate payment. Such credit appears in the records of the buyer of goods as ‘sundry creditors’ or ‘accounts payable’. Trade credit is commonly used by business organisations as a source of short-term financing. It is granted to those customers who have reasonable amount of financial standing and goodwill. The volume and period of credit extended depends on factors such as reputation of the purchasing firm, financial position of the seller, volume of purchases, past record of payment and degree of competition in the market. Terms of trade credit may vary from one industry to another and from one person to another. A firm may also offer different credit terms to different customers. Lease Financing: A lease is a contractual agreement whereby one party i.e., the owner of an asset grants the other party the right to use the asset in return for a periodic payment. In other words, it is a renting of an asset for some specified period. The owner of the assets is called the ‘lessor’ while the party that uses the assets is known as the ‘lessee’. The lessee pays a fixed periodic amount called lease rental to the lessor for the use of the asset. The terms and conditions regulating the lease arrangements are given in the lease contract. At the end of the lease period, the asset goes back to the lessor. Lease finance provides an important means of modernisation and diversification to the firm. Such type of financing is more prevalent in the acquisition of such assets as computers and electronic equipment which become obsolete quicker because of the fast changing technological developments. While making the leasing decision, the cost of leasing an asset must be compared with the cost of owning the same. Public Deposits: The deposits that are raised by organisations directly from the public are known as public deposits. Rates of interest offered on public deposits are usually higher than that offered on bank deposits. Any person who is interested in depositing money in an organisation can do so by filling up a prescribed form. The organisation in return issues a deposit receipt as acknowledgment of the debt. Public deposits can take care of both medium and short-term financial requirements of a business. The deposits are beneficial to both the depositor as well as to the organisation. While the depositors get higher interest rate than that offered by banks, the cost of deposits to the company is less than the cost of borrowings from banks. Companies generally invite public deposits for a period upto three years. The acceptance of public deposits is regulated by the Reserve Bank of India. Commercial Paper (CP): Commercial Paper emerged as a source of short term finance in our country in the early nineties. Commercial paper is an unsecured promissory note issued by a firm to raise funds for a short period, varying from 90 days to 364 days. It is issued by one firm to other business firms, insurance companies, pension funds and banks. The amount raised by CP is generally very large. As the debt is totally unsecured, the firms having good credit rating can issue the CP. Its regulation comes under the purview of the Reserve Bank of India. Issue of Shares: The capital obtained by issue of shares is known as share capital. The capital of a company is divided into small units called shares. Each share has its nominal value. For example, a company can issue 1,00,000 shares of Rs. 10 each for a total value of Rs. 10,00,000. The person holding the share is known as shareholder. There are two types of shares normally issued by a company. These are equity shares and preference shares. The money raised by issue of equity shares is called equity share capital, while the money raised by issue of preference shares is called preference share capital. Equity Shares:Equity shares is the most important source of raising long term capital by a company. Equity shares represent the ownership of a company and thus the capital raised by issue of such shares is known as ownership capital or owner’s funds. Equity share capital is a prerequisite to the creation of a company. Equity shareholders do not get a fixed dividend but are paid on the basis of earnings by the company. They are referred to as ‘residual owners’ since they receive what is left after all other claims on the company’s income and assets have been settled. They enjoy the reward as well as bear the risk of ownership. Their liability, however, is limited to the extent of capital contributed by them in the company. Further, through their right to vote, these shareholders have a right to participate in the management of the company. Preference Shares: The capital raised by issue of preference shares is called preference share capital. The preference shareholders enjoy a preferential position over equity shareholders in two ways: (i) receiving a fixed rate of dividend, out of the net profits of the company, before any dividend is declared for equity shareholders; and (ii) receiving their capital after the claims of the company’s creditors have been settled, at the time of liquidation. In other words, as compared to the equity shareholders, the preference shareholders have a preferential claim over dividend and repayment of capital. Preference shares resemble debentures as they bear fixed rate of return. Also as the dividend is payable only at the discretion of the directors and only out of profit after tax, to that extent, these resemble equity shares. Thus, preference shares have some characteristics of both equity shares and debentures. Preference shareholders generally do not enjoy any voting rights. A company can issue different types of preference shares Debentures: Debentures are an important instrument for raising long term debt capital. A company can raise funds through issue of debentures, which bear a fixed rate of interest. The debenture issued by a company is an acknowledgment that the company has borrowed a certain amount of money, which it promises to repay at a future date. Debenture holders are, therefore, termed as creditors of the company.