Internal sources of finance can be classified into three categories-

• Owners Capital
• Depreciation funds
• Retained earnings

Owners Capital

It refers to the amount of funds invested by the owner of the business. The owner may choose to use his/her personal savings to meet the business expenditures.

Depreciation Fund

Depreciation funds are an important source of internal finance.

Depreciation means a decrease in the value of assets due to wear and tear, obsolescence, accident, etc. generally depreciation is charged against fixed assets of a company at a fixed rate every year.

A depreciation fund is created to meet the working capital requirements of the business and account for depreciation on the company’s assets. It is one kind of provision of the fund, which helps to reduce the tax burden and increase the overall profitability of the company.

Retained Earnings

It represents the earnings not distributed to shareholders. A firm may retain a portion or whole of its profits and utilize it for financing its projects.

Retained earnings are another method of internal sources of finance. Under this, a particular part of the company’s profit are reserved as retained earnings for meeting its short-term financial needs. According to the companies act 1956 certain percentage, as prescribed by the central government (not exceeding 10%) of the net profit after tax of a financial year have to be compulsorily transferred to reserve by a company before declaring its dividends.

• Retained earnings are useful for the expansion and diversification of the company.
• A company does not need to raise loans for further requirements if they have retained earnings.
• Retained earnings are one of the cheapest sources of finance.
• Sometimes excessive use of retained earnings leads to a monopolistic attitude of the company.
• The management by manipulating the value of the share in the stock can misuse the retained earnings.

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Deferred Shares are normally issued to the founders of a company.

A deferred share is a share that does not have any right to the assets of the company which is undergoing bankruptcy until all common and preference shareholders are paid.

According to the Companies Act, no public company or subsidiary to the public company can issue deferred shares.

Deferred shares are issued to the founders at a small denomination to have control over the management by the virtue of their voting rights. Deferred shares are mostly used as a method of compensation to executives and founders of a company and as a means to induce an investor in a company.

NO PAR SHARES

Those shares which have no face value are called No Par Shares. The company issues No Par Shares which are divided into a number of specific shares without any specific denomination.

No par value stock (No Par Shares) prices are determined by the amount that investors are willing to pay for the No Par Shares in an open market. The benefit of no-par value shares is that companies can issue stock at a higher price in its future offering.

The value of no par shares can be measured by dividing the net worth of the company with a total no. of shares:

Value of no par share = Real Net Worth/Total Number of Shares

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A Mutual fund is a trust that attracts savings which are then invested in capital markets. A Mutual fund is an investment vehicle for investors who pool their savings for investing in diversified portfolio securities with the aim of attractive yields and appreciation in their value.

According to SEBI, a mutual fund defined as a fund, established in the form of a trust to raise money through the sale units of the public under one or more schemes for investing in securities, including money and market instruments.

Advantages of Mutual Fund

• Mutual funds promote savings among the lower and middle-income groups of investors because mutual funds units are available with a single unit of ₹ 10 and multiplies of the same value
• Mutual funds reduce the risks as they diversify the investment into shares, debentures, bonds, etc.
• Mutual funds can be recapitalized at any time i.e. one can sell their mutual fund units at any time
• Investors get an attractive return because mutual funds are linked with the stock market
• Mutual funds are convenient and easy to invest
• Mutual funds are flexible which means it can be transferred from one scheme to another easily
• Mutual funds contribute to the economy

Types of Mutual fund

Following are the types of mutual funds:

1. Public sector Mutual funds – State bank of India, Canara Bank, Punjab national bank, general insurance, corporation are some of the public sector mutual funds.
2. Private sector Mutual funds – Kothari pioneer fund, twentieth-century fund, ICCI fund, Morgan Stanly fund, Taurus fund and CRB fund are examples of the private sector of mutual funds.
3. Open-ended mutual funds – When the mutual fund units are sold and redeemed at any time on the basis of the price determined by the fund’s net asset value, it is called an open-ended mutual fund. There is no maturity period in these mutual funds and investors can sell the units back whenever they wish.
4. Closed-ended Mutual funds – These types of mutual funds have a fixed maturity period from 2-15 years. The units of these funds can’t be redeemed.
5. Growth generated Mutual funds – These types of mutual funds are reinvested in highly growth-oriented equity shares. It consists of securities that offer high returns and growth potential.
6. Income generated mutual funds – When the investors need regular income for their investment then they can select income generated mutual funds. These funds offer a regular dividend to its investors.
7. Balanced Mutual funds – The balanced mutual funds are characterized by investment in a combination of various securities as well as government bonds. It consists of both equity and debt instruments.
8.  Domestic Mutual funds – When the mutual funds mobilize savings from a particular country or region it is called domestic mutual funds.
9. Global Mutual funds – When the mutual fund investment stocks are traded in the market throughout the world, it is called global mutual funds.
10. Regional mutual funds – When the mutual funds consist of investment from a particular region of a country then it is called a regional mutual fund.
11. Sector mutual funds- Sector mutual funds are specialized in a particular industry which consists of aggressive funds from a particular sector/industry.

Mutual funds in India

There are various mutual funds companies in India that invest in equity or stocks and manage the fund to achieve a range of goals.

Many equity mutual funds are structured to generate long term capital gains through growth or value investing strategies like Birla SL Frontline Equity fund, while others focus on generating income for its shareholders. Indian mutual funds may also invest in bonds and other securities with the goal of generating regular interest income. Funds can also take a balanced approach i.e. invest in both equity and debt instruments to create diverse portfolios that offer stability and also offer the potential for huge gains in the stock market.

Mutual funds in India are regulated by the securities and exchange board of India (SEBI). The SEBI regulations include a minimum of ₹ 500 million for open-ended debt funds and ₹ 200 million for closed-ended funds. Indian mutual funds are only allowed to borrow up to 20% of their value for a term not to exceed six months to meet short term requirements.

Mutual Fund Sponsor

The mutual fund sponsor can be either an individual, a group of individuals, or a corporate body. The Sponsor is responsible for registration with SEBI. Once approved, the sponsor must form a trust to hold the assets of the fund, appoint a board of trustees, and choose an asset management company.

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Preference shares are those shares which give preferential rights to its holders to receive dividend and get back the initial investment at the time of winding up of the company.

Preference shareholders as the name suggest enjoy preference over the payment of dividend. The dividend paid on these shares is generally at a fixed rate. They don’t have voting rights but they are eligible to get a fixed rate of dividend.

 Features of Preference Shares

• Maturity period – It has no fixed maturity period except in the case of redeemable preference shares. It can be redeemable at the time of liquidation of the company.
• Claim on Income – Preference shareholders have a residual claim on income. They are paid a fixed rate of dividend.
• Claim on Assets – Preference shareholders have a residual claim on company assets too. Preference is given to the preference shareholders at the time of liquidation.
• Control – Preference shareholders have no control over the management as they have no voting rights.

Advantages of Preference Shares

• Fixed Dividend – Dividend rate is fixed in case of these shares, it provides a fixed rate of income to its holders.
• Redemption – They are redeemable in nature as they can be redeemed after a specific period.
• Convertibility – They are convertible in nature. They can be converted into equity shares whenever the need arises.
• Cumulative Dividend – One more advantage of these shares is they can have a cumulative dividend. If the company does not earn any profit in any year, the dividend for that year can be cumulated with future dividends.
• Raising capital – It is one of the most common source for long term finance. It helps in raising long term capital for the company.

Disadvantages of Preference Shares

• No voting rights – Preference shareholders have no voting rights which means they have no control over the management.
• Permanent burden – Cumulative preference become the permanent burden for the management because the company has to pay the dividend even for the unprofitable period.
• Taxation – They are not a deductible expense while calculating tax.
• Expensive – They are an expensive source of finance compared to equity shares.

Types of Preference Shares

Cumulative Preference Shares – Cumulative preference shares are those which have the right to claim dividend even for those years in which the company has no profit. If the company does not earn any profit, they are unable to get any dividend but they have the right to get the cumulative dividend for the previous year if the company earns a profit.

Non-Cumulative Preference Shares – Non-cumulative preference shares have no right to claim dividends when there is no profit. They don’t enjoy these benefits.

Redeemable Preference Shares – Redeemable Preference shares become redeemable when they have a fixed maturity period. It can be redeemable during the lifetime of the company.

Irredeemable Preference Shares – Irredeemable preference shares are those which can only be redeemed after the company`s liquidation.

Participating Preference Shares – Participative shareholders are those which participate in the extra profit of the company. If some profit remains after paying dividends then they can claim for the remaining extra profit.

Non-Participating Preference Shares – Only a fixed rate of dividend is paid on these shares. Shareholders of these shares do not have the right to claim for extra remaining profit.

Convertible Preference Shares – The holders of these shares are given the right to convert their shares into equity shares after a specific period.

Non-Convertible Preference Shares – Those preference shares which cannot be converted into equity shares are called non-convertible preference shares.

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Equity Shares Capital represents the investment made by the owners of the business. They enjoy the rewards and bear the risks of ownership of the business. Equity Shareholders are paid dividends only after paying the dividend to preference shareholders and after meeting the future investment needs of the organization.

An equity share, also known as ordinary share represents ownership in a company, where each holder is a fractional owner and undertakes the maximum liability regarding the business. 

• Equity shares are issued to the public for long term financing.
• They are irredeemable in nature.
• Equity shareholders are the owners of the company.
• They have control over the management and they receive a dividend if the company is making profits.

Features of Equity Shares

• No Maturity Period – Equity shares are irredeemable in nature, which means they have no maturity period. They cannot be redeemed during the lifetime of the business.
• Right to Control – Since equity shareholders are the real owner of the company they have control over management and have a right to make decisions regarding business operations.
• Voting Rights – Equity shareholders have voting rights in the meeting of the company, with the help of voting rights they can influence business decisions.
• Transferable – Equity shares are transferable in nature they can be transferred from one person to another person with or without consideration.
• Claim on Assets – In case of winding up of a company, equity shareholders have the right to claim on assets. This right is only available to equity shareholders.
• Claim on Income – After paying a fixed rate of dividend to preference shareholders, equity shareholders have the right over company profits.
• Limited liability – Equity shareholders have only limited liability which is the value of shares they have purchased.  If the shareholders have fully paid up shares, they have no liability.

Advantages of Equity Shares

• Permanent Source of Finance – Equity shares are a permanent source of finance. It can be used for long term financial needs such as procurement of fixed assets.
• Less Cost of Capital – Equity shares are a very good source of finance for the company as they consist of less cost of capital compared to other sources of finance.
• Voting rights – Equity shareholders have voting rights which means they can change or remove any decision in a meeting. This type of right is only available to equity shareholders.
• No Fixed Dividend – A business does not have any obligation to pay a dividend to equity shareholders. If the company earns profit then equity shareholders are eligible to get dividend otherwise they cannot claim any dividend from the company.
• Liquidity – Equity shares are liquid in nature which means they can be sold easily in the capital market.

Disadvantages of Equity Shares

• Irredeemable – Equity shares cannot be redeemed during the lifetime of the business.
• No Trading on Equity – When the company raises capital through equity, they can’t take advantage of trading on equity.
• An obstacle in Management – Since equity shareholders are the real owner of management they can create obstacles and influence business decisions as they have the power to change any management decision.
• Speculation – Equity shares trading in the share market can lead to speculation during a fortunate period.

Types of Equity Shares

Equity shares are written on the liability side of a balance sheet. They are of following types –

 Authorized share capital

Authorized share capital is the maximum amount that a company can raise by issuing the shares and on which the registration fee is paid. This limit is mentioned in their Memorandum cannot be exceeded unless the Memorandum of Association is altered.

Issued share capital

Issued share capital is a part of authorized share capital. This is that part of authorized share capital which the company offers for subscription to investors and includes shares allotted to members for any consideration.

Subscribed share capital

It is a part of issued share capital which has been subscribed or purchased by an investor at a mutually-agreed value and has been legally allotted.

Called-up Capital

It means the total amount of called up capital on the shares issued and subscribed by the shareholders. It refers to the number of shares that were initially sold but were later not required by the company.

Paid-up share capital

Paid-up share capital is a part of called-up capital. It is the amount that the investors have paid to the company.

Right shares

These shares are issued after the original issue of shares to existing shareholders in the proportion of their holdings in the company. Such shares are being offered to the existing equity shareholders on a pro-rata basis. It is issued to protect the ownership of the existing investors.

Bonus shares

Bonus shares are additional shares provided to the existing shareholders without any additional cost, depending upon their holdings in the company. It is a part of the company’s retained earnings which are not given out in the form of dividends but are converted into free shares.

Sweat equity shares

Sweat equity shares are those shares which are issued at a discount to its directors or employees as a mode of payment for their contribution. It may be provided in lieu of some intellectual property, valuable additions, or reward for services. 

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Funds are required continuously in business and companies raise funds through various sources of finance. These sources of finance can be classified on the basis of time, ownership and control, and their sources of generation.

Deciding the correct sources of finance is one of the most difficult task for those who are deciding to start a new business or already have an established business. So every organization should consider all aspects regarding different sources of finance before deciding from which source they want to raise funds.   

Classification of Sources of Finance or Sources of Funds

Sources of Finance on the Basis of Time Period

1. Long-Term Sources

These are the sources of finance that fulfill the financial requirements of the business for a longer period which is more than 5 years. It includes debenture, equity shares, preference shares, loans, etc. This finance is generally used for the procurement of fixed assets like plant, equipment, machinery, etc.

Also Read: Long Term Sources of Finance

2. Medium-Term Sources

These are the sources that are required for a period of more than one year but less than five years. Examples of these sources are a loan from banks, public deposits, a loan from a financial institution, etc.

3. Short-Term Sources

These are the funds that are required for less than a year. Few examples of these sources are trade credit, banks, commercial paper, etc.

Sources of Finance on the Basis of Ownership

1. Owner’s fund

These are those funds that are raised by the owner of the business. It can be raised by the sole person or the partners or by the shareholders. This capital remains invested in the business for a longer period of time. Equity shares and retained earnings are two main sources of the owner’s fund.

2. Borrowed fund

This is the most commonly used source of funds. Borrowed funds provide funds for a specific period, on certain terms and conditions. It has to be repaid after the expiry of the period with interest. These funds are raised from loans and borrowings. It includes loans from commercial banks, issue of debentures, loans from financial institutions, public deposits, and trade credit.

Sources of Finance on the Basis of Sources of Generation

1. Internal Sources

Internal sources of finance are those funds that are within an organization. Basically, these sources fulfill the short and limited needs of a business. Examples of these sources are equity share capital and retained earnings.

Also Read: Internal Sources of Finance

2. External Sources

These refer to those sources which involve raising funds outside of an organization. It is useful when a large amount of money is needed. Some examples of it are banks, financial institutions, debentures, public deposits, preference shares, etc.

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According to I.C.W.A, “A budget is a financial and/or quantitative statement prepared prior to a defined period of time, of the policy to be pursued during that period for the purpose of attaining a given objective.”

Features of a Budget

• It is a financial and quantitative statement of a plan of action
• It is always expressed in terms of money and/or quantity
• It is prepared prior to the implementation of the operational plan
• It is based on pre-determined management policy
• It is prepared to achieve specific financial objectives
• It indicates the costs and revenues, capital to be employed, incremental effects on former budgets etc.

Budgeting

Budgeting refers to the process of preparation, implementation and operation of budgets. It involves formulation of operational plans for a given future period and expressing it in monetary terms.

Types of Budget

On the Basis of Time

• Long Term Budget – Budget prepared for a period of 5 to 10 years.
• Short Term Budget – Budget prepared for a period of 1 to 2 years.
• Current Budget – Budget prepared for a period of less than 6 months.

On the Basis of Activity

• Fixed Budget – Budget that is fixed for a given level of activity or time period and does not change with changing business situations.
• Flexible Budget – Budget that is flexible and can be revised from time to time according to the changing business needs and situations.

On the Basis of Nature of transaction

• Capital Budget– Budget prepared for the capital expenditures of a business.
• Operating Budget – Budget prepared to meet the day to day expenses of a business.

On the Basis of Functions

Master Budget – Various functional budgets are integrated together to form a master budget.

Financial Budgets – Budgets related to various costs and revenues of the organization.

• Cash Budget
• Working Capital Budget
• Capital Expenditure Budget
• Income Statement
• Budgeted Balance Sheet
• Retained Earnings

Operational Budgets – Budgets prepared for different activities or operations of the organization.

• Sales Budget
• Production Budget
• Purchase Budget
• Materials Budget
• Personnel Budget
• Plant Utilization Budget
• Marketing Budget
• Administrative & Selling expenses budget
• Manufacturing Expenses budget

Budgetary Control 

Budgetary Control is the process of determining various budgeted figures for an organization for the future period and then comparing the budgeted figures with actual figures for calculating deviations and taking remedial measures to minimize deviations. It is a continuous process that helps in planning and controlling costs.

According to Howard and Brown, “Budgetary control is a system of controlling costs which includes preparation of budgets, coordination of departments, comparison of actual performance with budgeted performance and acting upon the results to achieve maximum profitability.”

Requirements of a Good Budgetary System

• Budgeting process must be backed by the Chief Executive of an organization
• Organizational goals must be clearly stated and quantified and further divided into functional goals
• People responsible for execution of budget must be involved in its preparation
• Budgets must be realistic, continuous and must cover all relevant aspects
• Budgeting system must be based on information, communication and participation
• Clear responsibilities for effective budget implementation must be established

Essentials of Budgetary Control

(1)Organization Structure

(2) Budget Centers – It may be a department or a group of people in a department, who are responsible for preparation of a budget.

(3) Budget Manual – It is a written document containing rules, regulation, policies and guidelines for preparing budgets.

(4) Budget Officer (Coordinator) – The person responsible for scrutinizing, evaluating and finalizing the budgets prepared by different functional heads.

(5) Budget period – Time period for which budget is prepared.

(6) Budget Committee – Group of people responsible for preparation and execution of budgets

(7) Determining Key Factor – Principle factor that influences all budgets

Steps in Budgetary Control System

Advantages of Budgetary control

• Effective budgetary control leads to maximization of profit
• It facilitates coordination between different functional departments
• It acts as a tool for measuring (financial and operational) performance
• It helps in eliminating wastages and taking corrective actions
• It helps in reducing costs
• It helps to take decisions regarding performance appraisal of employees

Also Read:

• Zero Based Budgeting
• Performance Budgeting
• Responsibility Accounting

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Features of Performance Budgeting 

Performance Budgeting provides

• The purpose and objectives for which funds are required
• Costs of programs and related activities proposed to accomplish those objectives
• The output that will be produced under each activity.

Performance Budgeting implies that the budget must clearly indicate the actual achievement or output, expected by spending a particular amount on a particular activity. Hence, It is an output oriented budget that focuses more on achievement rather than means of achievements.

The costs and benefits of each activity are analysed for making decisions regarding allocation of funds.

It involves use of management tools such as – work measurement, bench marking and unit costing etc. to prepare a budget.

This system has been designed to plan for long term.

Process of Performance Budgeting

• Formulation of objectives
• Identifying various programmes and project which will accomplish these objectives
• Evaluation & selection of programmes & projects on the basis of cost benefit analysis
• Development of performance criteria for various programmes
• Preparing financial plans for each program and the final annual budget
• Assessing the performance of each programme an comparing the same with budgeted performance
• Correcting deviations

Advantages of Performance Budgeting

• It states clearly the purpose & objectives for which funds are needed.
• It improves performance of units in a continuous manner
• It brings transparency in the budget formulation process
• It helps in decision making regarding allocation of funds
• It acts as a tool for reviewing efficiency of programs
• It integrates the process of planning, programming & budgeting

Limitations of Performance Budgeting 

• It focuses on quantitative evaluation rather than qualitative evaluation.
• It is ineffective without a proper and systematic accounting and reporting system.
• It is difficult to quantify social benefits.
• It is difficult to accurate estimate benefits arising out of each activity.

Also Read:  Zero-Based Budgeting

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Causes of Risk

• Wrong decision or Wrong timing
• Term of Investment – Long term investments are more risky than short-term investments as future is uncertain.
• Level of Investment – Higher the quantum of investment the higher is the risk.
• Nature of Industry – Risk is higher in speculative and cyclical industries while less in defensive and growth industries.
• Political and Legal factors – Risk may arise due to changes in government policy and legislative regulations in a country.

Types of Risk

Systematic Risk

It refers to the risk caused by factors external to a business which affects the entire industry and not any specific business. They are uncontrollable and unavoidable by a business and are associated with economic, social, legal and political aspects of all securities in an economy.

• Market Risk – It is the risk caused by the alternating forces of demand and supply (bear and bull market) i.e. the value of investment increases or decreases due to the movements in the market factors. These factors may be tangible or intangible. In Bull Market, when the economy is booming the Security Index takes an upward swing and increases for a significant period of time while the opposite happens in a Bear Market.
• Interest Risk – It is the risk that adversely affects the investment due to unexpected changes in market interest rates. A change in monetary policy by the central bank will directly affect the debt instruments like bonds and debentures due to changes in interest rates.
• Purchasing Power Risk – It refers to the risk of reduction in purchasing power of expected returns due to high rate of inflation.

Unsystematic Risk

It refers to risk caused by the factors internal to a business and unlike systematic risk it is specific to a business and hence can be controlled by the business. It arises due to lack of operating efficiency in a business or due to its inability to grow or maintain competitive edge or achieve stable profits.

• Business Risk – It arises due to: Internal risk – It is associated with the operational efficiency of the business, and External risk – It is associated with the economic, social, political and legal factors external to the business which can affect it adversely.
• Financial Risk – It is the risk related to the capital structure of a business. An inefficient capital structure results in financial instability and leads to unstable earnings. Hence there must be an optimum mix of debt and equity to ensure financial stability and reduce financial risk. Types  of Financial Risk – Credit risk, Currency risk, Country risk, Liquidity risk

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Presentation/Project/Slides Transcript

Topic: Dupont Analysis

Dupont analysis also Dupont model is a financial ratio based on return on equity ratio that is used to analyze a company’s ability to increase its return on equity.

It breaks down the return on equity ratio to explain how companies can increase their return for investors.

The Dupont analysis looks at three main components of the ROE ratio.

• Profit Margin
• Total Asset Turnover
• Financial Leverage

A company can increase its return on equity by maintaining a high profit margin, increasing asset turnover, or leveraging assets more effectively.

The Dupont Model equates ROE to profit margin, asset turnover, and financial leverage.

DuPont Analysis

ROE = Profit Margin X Total Asset Turnover X Financial Leverage

Analysis

Dupont Analysis was developed to analyze the ROE and the effects that different business performance measures have on this ratio. The objective is to analyze the variable causing the current ROE. For instance, if investors are unsatisfied with a low ROE, the management can use this formula to pinpoint the problem area whether it is a lower profit margin, asset turnover, or poor financial leveraging.

Once the problem is determined, management can attempt to correct deviations.

Example

• We have two companies Bob Retailers and Joey Retailers
• Both of these companies operate in the same industry and have the same return on equity ratio of 45 percent.
• This model can be used to show the strengths and weaknesses of each company.
• Each company has the following ratios:

BOB 45% = .30 x .50 x .30

JOEY 45% = .15 x 6.0 x .50

Both companies have the same overall ROE, but the companies’ operations may be completely different from each other.

Bob Retailers is generating sales while maintaining a lower cost of goods as evidenced by its higher profit margin. But, the company is having a difficult time turning over large amounts of sales.

Joey Retailers business is selling products at a smaller margin, but it is turning over a lot of products. This is evident from its low profit margin and extremely high asset turnover.

This model helps investors to compare similar companies like these with similar ratios. Investors can then evaluate perceived risks with each company’s business model.

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