It is of vital significance for modern business which requires huge capital. 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. Similarly, when the company is wound up, they can exercise their claim on those assets which are left after the payment of all other claims including that of preference shareholders. This is known as retained earnings. Depending on various factors, the period can stretch for more than 5 to 20 years. The internal accruals, like depreciation and retained earnings, have been discussed below: Depreciation means the decline in the value of fixed assets due to use and wear and tear. 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. By using our website, you agree to our use of cookies (. Lease is a contract between the owner of an asset and the user of such asset. Later, they may increase the rate of dividend out of past profits and may sell their shares at a profit. (v) Increase in the Credit Worthiness of the Company Since the company need not depend upon outside sources for its financial needs; it increases the credit worthiness of the company. It is recorded as expenditure in the accounting system of a firm. Lower debt improves a companys debt capacity and creditworthiness, as well. (ii) No Advantage of Trading on Equity If a Company issues only equity shares, it will be deprived of the benefits of trading on equity. Customers' advances 4. However, there are certain disadvantages of using internal accruals as a source of finance. Also, the use of retained earnings does not require compliance of any legal formalities. These funds are normally used for investing in projects that will generate synergies for the company in the future years. iii. Allow debenture holders to receive fixed rate of interest, iii. Issue of debentures. In addition, these shares help in motivating employees and increase their productivity. The advantages of term loans are as follows: ii. Allow debenture holders to receive payment before equity and preference shareholders even at the time of liquidation of an organization. Image Guidelines 4. Leasing is, thus, a device of long term source of finance. Short-Term Sources of Finance Short-term sources of funds: Money acquired must be paid back within one year. It is usually done for big projects, financing, and company expansion. Public Deposits 4. However, they may be rescheduled to enable corporate borrowers to tide over temporary financial exigencies. Internal Sources 5. Long term 2; Basics Long term finance - Funding obtained exceeding three years in duration. Funds required for a business may be classified as long term and short term. Term Loans 8. Market value is the value at which the shares are traded on the stock exchange. Serve as a source of long-term capital and are repaid during the lifetime of the organization. Interest is paid every year and principal is paid on the date of maturity. The common practice in India is the repayment of principal in equal instalments and payment of interest on the outstanding loan. A term sheet is an agreement facilitating a fundraising process whereby two parties mutually agree to abide by the mentioned clauses concerning the investment. The sources of long-term finance refer to the institutions or agencies from, or through which finance for a long period can be procured. They have control over the working of the company. (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. A debenture is a marketable legal contract whereby the company promises to pay, whosoever owns it, a specified rate of interest for a defined period of time and to repay the principal on the specific date of maturity. These preference shares are issued for a fixed time-period and are paid during existence of the organization. Result in overcapitalization if more than required equity shares are issued. Depending on various factors, the period can stretch for more than 5 to 20 years. 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. When companies are considering new investments, they may compare available sources of finance to determine which would be most appropriate for a new endeavor. If a company wants to raise money privately, it may approach the major debt investors in the market and borrow from them at higher interest rates. Firstly, as compared to interest, dividends cannot be deducted from the income of the company while calculating taxes. (iv) Excessive Penalties Sometimes, lessee has to pay excessive penalties if he terminates the lease before the expiry of lease period. In this lesson, you will learn about various sources of long term finance and the advantages and disadvantages of each source. It is obtained from Capital market. The payment of a portion of the unpaid balance of the loan is called a payment of principal. Such debentures provide many options to debenture holders. (ii) Increase in Rate of Dividends In case of higher profits in the company, these shareholders are handsomely rewarded in the form of higher dividends. At the time of liquidation, these shares are paid after paying all the liabilities. Long Term Source of Finance - This long term fund is utilized for more than five years. (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. Preference shares are a long-term source of finance for a company. 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. Lenders normally lend in proportion to the amount of shareholders funds. 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. (Nickels, McHugh, McHugh, N.D.) Long-Term Finance The disadvantages of preference shares are as follows: i. They carry a fixed interest rate and give the borrower the flexibility to structure the repayment schedule over the tenure of the loan based on the companys. Let us have a look at the following disadvantages of equity shares: i. Rate of Return (ROR) refers to the expected return on investment (gain or loss) & it is expressed as a percentage. 3.6 Efficiency ratio analysis. Long-term finance can be defined as any financial instrument with maturity exceeding one year (such as bank loans, bonds, leasing and other forms of debt finance), and public and private equity instruments. For example, if an expansion or acquisition is allowed with venture capital, the investor might demand part ownership of the firm, rather than simply a share in the profits, including a say in management. The characteristics of preference shares are as follows: i. ii. Trade Credit Here are the other recommended articles on Corporate Finance -. For example, a ZCB offered by a financial institution has a face value of Rs.20,000 but will be issued to the subscribers as part of this offer at Rs.11,980. Companies can also raise internal finance by selling off assets for cash. The amount of capital decided to be raised from members of the public is divided into units of equal value. Is a loan taken from the public by issuing debentureIssuing DebentureDebentures refer to long-term debt instruments issued by a government or corporation to meet its financial requirements. Out of the realised value of assets, first the claims of creditors and then preference shareholders are satisfied, and the remaining balance, if any, is paid to equity shareholders. Loans from co-operatives 1. (b) If the purpose for utilization of retained earnings is not clearly stated, it may lead to careless spending of funds. For new company recourse to equity share financing is most desirable because the management is under no legal obligation to pay dividends to shareholders and the management can retain its earnings entirely for their investment in the enterprise. Financial institutions impose a penalty for defaults on the payment of installment of principal and/or interest. Non-Convertible Debentures Refer to the debentures that have no right to get converted into the equity shares during their maturity period. Banks or financial institutions generally give them for more than one year. Medium term finance One to three years. However, there is a notified period after which fully paid FCDs will be automatically and compulsorily converted into shares. (c) They do not dilute the ownership of the company. Further, this provision has been incorporated in the corporate laws by section 43(a) (ii) of Companies Act, 2013. Secondly, equity shares have high floatation cost in terms of underwriting, brokerage and other issue expenses in comparison to other securities. Examples of Long-term Sources of finance Equity Share Capital Following points discuss the types of equity shares in brief: Refer to shares that are issued in place of dividends. In case of any default in debenture interest payment, the debenture holders can sell the companys assets and recover their dues. Long term finance can be said as an investment or financing that is bound to be kept continue for a period exceeding one year. Internal finance can be appealing for certain types of investments, while in other cases, it may be advantageous to tap external financing. Hence they are unable to exercise effective and real control over the company. Some of the long-term sources of finance are:- 1. Despite the above disadvantages, the ploughing back of profits is a popular source of long-term finance and is widely used by most of the companies. Provide no voting rights to debenture holders, ii. Debentures are offered to the public for subscription in the same way as for issue of equity shares. Make organizations more focused on profitable projects, as they have to pay interests on quarterly, half yearly, and annual basis, vi. The borrowing company needs to follow a repayment schedule for paying back the term loan to the financial institution. At the end of the period of lease contract, the asset reverts back to the lessor, who is the legal owner of the asset. 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. iii. 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. (e) Debt financing by term loan has fixed installments till the maturity of the loan. 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 (b) Like any other form of debt financing, term loans also increase the financial risk of the company. Equity shareholders control the business. But an amendment in the Companies Act, 2000 permitted companies to issue equity shares with differential voting rights. What is long-term finance. It is allowed to be deducted while arriving at the net profits of the firm subject to adherence of the percentages of allowable depreciation fixed under the tax laws. The holders of convertible preference shares have to pay conversion price at a given date for converting their shares into equity shares. Here we discuss the two types of external sources of finance: long-term financing (equity, debentures, term loans, preferred stocks, venture capital) and short-term financing (bank overdraft and short-term loans). As a result, the lender has a regular and steady income. When a company does not distribute whole of its profits as dividend but reinvests a part of it in the business, it is known as ploughing back of profits or retention of earnings. (f) The less debt the company has, the more attractive it is to potential investors and buyers. Preference shares give preferential rights to their holders in comparison to equity shares. Bonds are generally issued by government agencies, financial institutions and large corporations, and debentures are issued by companies. iv. Disclaimer 8. These shares carry a fixed percent of dividend, which is lower than equity shareholders. the detail sources of long term financing are shown in the following diagram: long term financing external sources internal sources owners capital retained earnings institutional sources non-institutional sources depreciation provision provident funds sales of fixed asset commercial bank common stock over use of fixed asset (ii) Over-Capitalisation Retained earnings are used for the issue of bonus shares which may result to over-capitalisation without any corresponding increase in its earnings. Help in maintaining good relation with financial institutions, iii. The organization has to pay dividends on these preference shares at the end of financial year. Registered Debentures Refer to the debentures that are registered in the books of the organization. Restrictive covenants are binding legal obligations written in the loan agreement to safeguard the interest of the lender. Equity and Loans from Government 2. Lease Financing 7. However, prime basis on which a share is valued is the price at which it is expected to be sold. The right of lenders to appoint nominee directors on the board of the borrowing company may further restrict the managerial freedom. Depending upon the intrinsic value of shares, the market value fluctuates. (v) Dissatisfaction among the Shareholders Excessive ploughing back of profits may create dissatisfaction among the shareholders since the rate of dividend is quite low in relation to the earnings of the company. On the other hand, the holder of a conventional bond not only receives the face value of the bond at maturity but is also paid regular interests at the coupon rate over the life of the bond. It just requires a resolution to be passed in the annual general meeting of the company. Internal sources of finance come from inside the business, meanwhile, external sources of finance come from outside the business. (iii) Not Bound to Pay Dividend A company is not legally bound to pay dividend to its equity shareholders. Account Disable 12. Internal sources of finance examples This method of financing is also known as self-financing or internal financing. (b) Like other sources of debt financing, the lenders of term loans do not have any right to have direct control over the affairs of the company. A long-term target for many Premier League clubs, Koulibaly joined Chelsea on a four-year contract and was seen as a ready-made solution after centre-backs Antonio Rudiger and Andreas Christensen . (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. Even during the winding up of the organization, the investment of preference shareholders is paid before equity shareholders. 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