Concept of Finance

Finance deals with fund management. Finance prepares plans and implements necessary activities about what amount of fund should be collected from which sources and where & how this fund is to be invested for highest profit in the project. In case of a business firm, fund flows in the business from selling of products. Different types of fund are needed to produce and buy goods for the business, like- purchasing machinery, purchasing raw materials, paying wages to the labours, etc. These are the utilization of fund. Funds need to be collected in a planned way as per the requirement of fund to maintain an uninterrupted production process. Finance means this process related to fund collection and utilization.

If you visit a tailoring shop in your locality, you will see there one or two person sewing with a machine. Again, someone may be cutting clothes or stitching the buttons. So to continue the tailoring business properly, the shop owner has to purchase machines, threads, buttons, scissors etc. of necessary amount. At the beginning of his business he bears these expenses from his own saving. If the fund appears insufficient, then he may take loan from his relatives to overcome the shortage. When the business is in operation, at the end of every month he needs to bear expenses for the payment of workers’ wages, house rent, electricity bill etc. and he pays all these with the money earned by sewing cloths. He also has to plan to pay back the loan money from this monthly collection. An owner of a tailoring shop always expects that he can earn some amount of profit even after meeting all necessary expenditures from the income of the business, by which he can save for the future or can utilize for business expansion even after meeting regular expenses of his family. So if an owner of a tailoring shop conducts business through a proper planning regarding the source of finance and its utilization, only then he can earn profit through smooth operation of the business. Otherwise it will be found that due to cash crises sewing thread cannot be bought timely and the customers are returning. Again, it may be needed to shut down the business due to lack of money to buy a new machine replacing the old one. To conduct the business properly, Business finance deals with when and for what reason how much amount of fund is needed and from which sources this fund should be collected for smooth operation of the business.

There has implication of finance in family too. Generally, every family has one or more than one sources of finance. Income may be obtained from different sources in different families, such as, from service, business, agricultural activities, self-employment etc. Beside these, regular expenditure of a family occurs for daily shopping costs, house rent, school fees, different bills payment etc. As expenditure should be matched with income, in this way, right time of expenditure should also be maintained. If money is insufficient as per demand, then as an example, it may happen that name of the student may be cut down from the register. In case of a family, pre-planned identification of the sources of finance and its utilization is the financial process. Other than daily expenditure of this type, sometimes occasional expenditure may be required in the family which may exceed the income ability of a person. If it is not possible to collect money from regular income sources for such expenditures like buying a new television or refrigerator, then the shortage may be fulfilled through long term loan. In that case, a loan repayment plan needs to be prepared. As a result, the concept of finance helps to determine the sources of fund and make proper management of it to conduct the family smoothly.

Financial process can be understood from the perspective of a school also. School is a social organization whose main objective is not profit earning, there also has a plan of income- expenditure and fund management. Educational institutions generally collects fund from sources of their students’ tuition fees, examination fees, admission fees, etc. The institution has to meet different expenditures with this fund to run the academic activities properly, like- payment of teacher-staff’s salary, house rent, electricity bill, different types of renovation expenses, purchasing computer and furniture. So, ensuring fund management for performing various working process of the institution nicely by considering different sources of fund and different sectors of utilization is financing in the perspective of the school.

Among above examples, tailoring shop is a profit making organization, but family and school are non-profit organizations. Our present topic is involved mainly in financing of profit-making- or business organizations. How is the financial process of a grocery shop? The shop owner earns profit by selling products. But for the purpose of selling, he needs to complete on regular basis purchasing products, paying rent, electricity bill, wages of the workers, etc. as current expenditures. Moreover, sometimes he has to spend a large amount of money for purposes like- expansion of business for the need of the customers, purchasing a refrigerator, etc. These are his fixed expenditure. Thus a grocer requires to invest both in fixed assets and current assets. If income from selling is not sufficient for collecting fund for investment, he has to collect fund from other sources like personal fund, friends-relatives, purchase on credit etc. Again, he may collect large amount of money which he needs to invest in fixed assets usually from commercial banks. In such financing, as there is the opportunity of repaying in long schedule of time, the risk of loan repayment is reduced a bit. In the case of a grocery shop, main activities of business finance are fund management through proper utilization of money received from sales proceeds in meeting current expenditures, some long term investments, collection of money from less risky sources, timely repayment of loan installments, etc.

Square Pharmaceuticals, Bata Company, Kohinoor Chemicals – these are large size business organizations which are called company. Financial process of such a company is not so simple like grocery shop or tailoring shop rather it is comparatively complex. In fund collection, a large company gets more benefit than a small organization. For example, a company collects capital by selling shares in the share market. Company’s goodwill, rate of profit, customer services or consumers’ satisfaction helps to increase the share price in share market. Business finance deals with and provides guidance regarding: from among different sources using which source, when and how much fund should be collected and in which sectors, how much amount and how will it be invested to increase the profit.

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Commercial Banks

Students, by studying this chapter, will be familiar with various commercial banks which play vital roles in the current world-economy. They will know about major and distinct aims and functions of commercial banks, their role in building the society, support in import and export, transfer of funds and development of agriculture and industry.

Commercial Banks

After we have studied this chapter, we will know about

    *Objectives and functions of commercial banks.

    *Sources of income and funds of commercial banks.

Introduction to Commercial Banks

We generally mean commercial banks by the word ‘bank’. Commercial banking system has come through a lot of modernization and specialization through ages. Usually commercial banks collect money from people that are surplus after meeting their essential requirements and lend it to the borrowers. A commercial bank is a profit oriented organization that makes profit by making deposit, transaction and lending of money.

So ‘The type of organizations which make transaction of money or service exchangeable through money, are called commercial bank.’

Objectives of Commercial Banks

Although commercial banks are mainly established for making profit, they have some other objectives. Objectives of commercial banks are discussed below:

1. Making Profit: Commercial banks are established with the fundamental objective of making profit.

2. Medium of Exchange: Commercial banks introduce cheques, bills of exchange etc. as mediums of exchange.

3. Capital Formation: Collecting surplus money from the people and formation of capital is one of the main objectives of commercial banks.

4. Welfare of People: Public welfare is an indirect objective of commercial banks.

5. Assisting in Regulation of Loans: Participating and assisting the central bank in formation of loan policy and loan regulation is one of the objectives of commercial banks.

6. Assisting in Planning and Implementation: Another purpose of commercial banks is to assist the central bank in proper development planning and implementation.

7. Proper Distribution of Wealth: Ensuring proper distribution of wealth by developing all sectors of economy in an equal pace through using monetary assets is another major goal of commercial banks.

8. Employment Generation: A purpose of commercial banks is to create opportunities for new employment by increasing economic activities.

9. Mitigating Gap between Rich and Poor: Through collecting deposit and offering loans, commercial banks enable participation of all class of people in economic activities, which help mitigate economic gaps between rich and poor classes of the society.

10. Forming a Saving-tendency: Another purpose of commercial banks is to create a saving tendency among people.

11. Security: Ensuring security of money, valuable ornaments of people is one of the purposes of commercial banks.

12. Economic Stability: Another purpose of commercial banks is to ensure economic stability by meeting the demand of funds in the market through providing loans and by working in line with the central bank’s loan policy.

13. Development of Trade and Industries: An important purpose of commercial banks is to develop trade and industries by providing all-out support in import and export.

14. Improving Standard of Living: Improving standard of living by ensuring overall economic development is also a goal of commercial banks.

Functions of Commercial Banks

As a monetary organization, banks provide various kinds of service in industrial, commercial, social and economic development of a country. We can divide the functions of banks into two categories:

A) Main Functions

B) Special and Other Functions.

A) Main Functions

1. Acceptance of Deposit and Advancing of interest: One of the main functions of commercial banks is to accept surplus money of the clients in various types of deposits, such as current, savings and fixed deposit. A bank pays interests to the holders of fixed and savings accounts on their deposited amounts in certain rates. No interest is allowed for the current accounts but various other facilities are offered to them.

2. Granting Loans and Charging Interests: Banks offer loans to the borrowers from the deposited money of their clients in various terms. Granting loan is an important function of a bank. Because by providing loans, a bank facilitates productive economic activities on one hand, and on the other hand, the amount of interest received from the borrowers is its main source of income. A bank charges higher rate of interest to its borrowers than the rate of interest it offers to the clients. The extra amount received from the borrowers is a bank’s operational income.

3. Creation of Loan Deposit: When a bank sanctions a loan to the customer, a deposit account is opened in his name and the amount is credited to his account. Then, the amount of money withdrawn by the borrower is debited from that account. In this way banks create deposits by sanctioning loans.

4. Creating Medium of Exchange: Banks use cheque, bill of exchange, certificate, bank draft, pay order, debit card, credit card etc. as payment mechanism and medium of financial transaction.

5. Creation of Capital: Banks create capital by accumulating all separate savings of people through different accounts.

6. Issue Notes: Notes are usually not issued by commercial banks but by central bank. But commercial banks issue notes in indirect forms. Thus, sometimes bank cheques serve as a medium of exchange as an alternative to notes issued by the government.

7. Service as Trustee: Commercial banks serve as trustee of properties of their customers and issue solvency certificates to them.

8. Assistance in Import and Export: An importer needs to convert local currency into foreign currency while an exporter needs to convert foreign to local currency, which is one of the functions of banks. Moreover, banks arrange for payment to the exporters on behalf of the importers through letter of credits (LC) in international business. Letter of Credit plays an important role in international trade by creating financial and business connections between importers and exporters. Providing operative assistance and suggestions in import and export related functions are representative jobs of commercial banks.

9. Service as a Government Treasury: Central bank or any other selected bank serves as the treasury of the government.

10. Change Bill of Exchange, Bill of Transport etc.: Banks change bills of exchange, bills of transport etc. in favor of its clients.

Special and Other Functions

1. Investment of Capital: Besides accepting loans, banks invest capital in industrial plants and commercial organizations, which help increase gross national production and capital mobilization.

2. Role in Economic Growth: Banks help a country’s overall economic growth, especially development of trade, commerce, transportation, communication, housing and education etc.

3. Money Transfer: Banks transfer money inside and outside the country through their mediums of exchange.

4. Security of Money: Banks ensure security of public money by keeping deposits. Besides, clients can also protect ornaments, documents of their properties in banks by using locker service.

5. Guidance: Offering various types of business guidance when sought by the clients and management of their properties, for example, collecting house rents are also included in the functions of banks.

6. Employment Generation: As a monetary organization, banks help in employment generation and indirectly create new employments by supplying loans in a country’s economy.

7. Loan Regulation: As the regulator, central bank regulates supply of money and loans by expanding and contracting loans given by the commercial banks. This is vital for ensuring economic stability and regulating inflation of money.

8. Agricultural Development: Banks facilitate agricultural development by offering loans and other assistance in this sector.

9. Industrial Development: Banks assist industrial plants by offering long-term loans.

10. Regional Development: Regional development is also supported by banks as they have network of branches in different areas of the country.

Sources of Funds of Commercial Banks

Commercial banks usually collect funds from the following sources, some of which are external sources and some of which are internal sources.

1. Paid Capital: First and foremost source of banks is paid capital. The capital is provided by the owners for Joint Stock Company, and in cases of joint capital company, capital is formed by issuing shares.

2. Reserve fund: At the time of declaring dividend, a certain portion of the profit is set aside every year which is called reserve fund. This is fund is used as capital in future.

3. Deposits: Public deposits are a powerful source of funds to a commercial bank. There are three types of bank deposits (i) current deposits (ii) saving deposits and (iii) time deposits, which the clients do not withdraw all at once. So, the bank can earn more capital by using this money as loans or business investment.

4. Borrowing: Commercial banks in times of emergency borrow loans from the central bank or from other commercial banks of the country. They can also raise funds by issuing security bonds, credit certificates etc.

Sources of Income of Commercial Banks

Commercial banks earn money through different businesses, which are detailed below

1. Interest on Loans: Commercial banks lend money to the industrialists, traders or consumers, and charge interest on the loans. This is their main source of their income.

2. Investment: Commercial banks earn profit by investing in profitable sectors like shares, issuing letters of credit, government security etc.

3. Bill Discount: Commercial banks also earn money by making discounted payment of bills of exchange in advance.

4. Commission Received from Bank draft, Travellers cheque etc.: Commercial banks earn a big amount of money by charging commissions on bank drafts, traveller’s cheques etc.

5. Correspondence: Commercial banks also earn money through charges received by offering various correspondence services for the clients at their request.

6. Rent of Lockers: People can use lockers of commercial banks for safekeeping of their valuable documents, ornaments etc. by paying certain charges, which is also a source of income of the commercial banks.

7. Agency Service: Commercial banks perform numerous agency services on behalf of their clients, such as collection and payment of cheques or bills etc. Commercial banks charge commission for such services which earn income for them.

8. Brokerage in Purchase or Trade of Shares: Banks also earn through brokerage in purchasing or trading shares.

9. Foreign Exchange: Commercial banks earn profit by acting as brokers in foreign exchange, too.

10. Import-Export: Commercial banks earn income through commission or service charges for the role it plays in international trade and transactions.

11. Letter of Credit: Banks charge commissions for issuing letters of credit on behalf of importers.

12. Trustee: Banks also charge commissions for performing services as trustee.

Expenditures of Commercial Banks

Commercial banks make following expenditure in operating its business:

1. Giving interest to the clients on their deposits

2. Giving interest to the central bank on the borrowed amount

3. Giving interest to commercial banks for the received loans

4. Payment of salaries and allowances to the employees

5. Allowances of directors and managers

6. Auditor’s charges

7. Charges for cases or other legal measures for collecting unrecovered loans

8. Rent for offices and warehouses

9. Tariffs and taxes

10. Insurance Premium

11. Charges for making correspondence through post office, telephone, telex, fax, swift etc.

12. Advertisement cost

13. Training charges of the employees

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Bond and Debenture

Bond

Bond is another tool of investment for the investors. You have known earlier that bond is a document or agreement through which a company gathers loan capital from the investors. In our country most of the companies gather loan capital through taking loans from banks or other financing organizations. As a result, bond is not yet so much familiar in our country.

Bond has some particular own features and characters from the perspectives of investors. Those are discussed below:

1. Mortgage: A company usually keeps its property or documents as mortgage against bonds. As a result, if the company is not able to meet the claims of the investors, they can realize their money by selling these properties.

2. Date of Maturity: A bond issued by a company has some certain date of maturity. On that date of maturity the investor gets back the written value as mentioned in the bond.

3. Creditor: Bond owners are considered as the creditors of a company. So they have no voting right.

4. Transform-ability: Many a time, a company may sell transferable bonds to the investors. In such cases, if the bond owners wish, they can transform the bonds at their possession to certain number of general shares as mentioned in the conditions of the debenture.

Advantages

1. Rate of Interest: As the rate of interest is fixed, the income of the investors in bonds is fixed. As a result, they have less uncertainty of income. However, sometimes the rate of interest may also change.

2. Less Risk: As immovable or other properties are kept as mortgage against bonds, the risk of investors in bonds decreases.

3. Rights on Profit and Properties: Bond owners are given interest on their investment at the very first from the income of the company. On the other hand, at the time of liquidation or closure of the company, claims of the bond owners are first met before meeting the claims of others. That is, the claims of bond owners get priority over the claims of the general and priority shareholders.

Disadvantages

1. Less Income Rate: As there is less risk in bonds compared to general shares and priority shares, the rate of income of the bond owners is less.

2. Control: As like that of priority shares the bond owners do not have voting right, they cannot involve themselves in the control of the company.

Debenture

Debenture is a bond without mortgage. So, most of the characteristics of bonds prevail in debentures. Like bond and priority shares, debentures are also not found so much in our country.

Compared to bond, its special feature is there is no mortgage against debenture. As there is no mortgage against debentures, investors do not buy debentures of all companies. Investors usually invest their money in debentures issued by big renowned companies.

Advantages and Disadvantages of Debenture

As a tool of investment some advantages and disadvantages of debentures are as follow:

Advantages

1. Regular Income: Like that of bonds, an investor gets a regular income at some fixed rate from debentures.

2. Fixed Term: Debenture is popular to many investors for its fixed term.

Disadvantages

1. No Security or Mortgage: Since there is no mortgage against a debenture, it is risky.

2. Control: Like that of bonds, an owner of debenture does not have any voting right. Hence, owners of debenture have no control in the operation of the company.

3. Rights in Profit and Property: An owner of debenture enjoys an equal status of general creditors. So, before paying interest to the owners of debenture, interest of the bond owners is paid from the income of the company. In this way, at the time of liquidation or closure of the company, claims of the debenture owners are met after meeting the claims of the bond owners.

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Share Investment

Share, Bond and Debenture issued by companies are taken as different tools of investment for the investors. Each of these tools of investment used as sources of investment has its individual features, advantages and disadvantages. Expected income and risks of the investors from these tools of investment are different. So, an investor should know about different sides of each of these tools of investment before taking his decision for investment. In this chapter we shall be able to know about these tools of investment from the perspectives of the investors.

After we have studied this chapter, we will be able to

* Describe the concepts of share, bond and debenture. Classify different types of shares.

* Identify the comparative differences among different types of shares. Be able to describe the differences between bond and debenture.

* Be able to explain dividend policy.

Introduction

In the previous chapters you have known about general share, priority share, bond and debenture as sources of financing in business firms. These tools of financing issued by companies are considered as sources of investment for the investors. An investor can invest his money in different sectors. Assume your father has 10 thousand dollar. He can, according to his wish, put it in a bank as fixed deposit or he can invest it in one or more tools of investment – general share, priority share, bond and debenture issued by companies. As sources of investment, each of these has its own special features. Expected income and risks of the investors from each of these tools of investment are different. Special features and advantages-disadvantages of each of these as source of investment and their comparative evaluation have been discussed in the following paragraphs.

General Share

Selling of shares is an important source of gathering fund for public limited companies. The voluminous total capital of the company is divided into small (equal) units and those are sold as shares. After gathering minimum capital with the approval of the government, applications are invited from the public through giving an advertisement in the newspaper with publishing a paper of statement with information about the company. When applications submitted are numbered compared to shares distributable, shares are distributed by lottery. As a result, small investors also can participate in investment by buying shares. They are indeed the owners of the company. If the company earns profit, it is distributed among them as dividend. The invested money of the shareholders is not refundable. However, if the liquid money is needed, the shareholders can sell these shares in the secondary market (such as: New York Stock Exchange) and if the price is increased there they get profit. Usually, in the cases of profitable companies, shareholders get dividend on regular basis. However, the rate of giving dividends is not pre-fixed. Giving dividend is also not mandatory for the company. If no profit occurs, dividend is not usually given. And even if the company makes profit, total amount of profit is not distributed as dividend. If the company wishes, it can give dividend at any rate, besides it can give no dividend also. But in that case, if the company cannot give dividend to the shareholders, the price of the shares is decreased in the secondary market, which is not good for the company.

Buying shares is a risky investment for the investors. Share issuing companies are not always bound to give dividends to the shareholders. If the company cannot make sufficient profit in any year, no dividend is given to the shareholders that year. Besides, when the company is closed, shares of the general shareholders are met after meeting the dues of the debtors and priority shareholders from the money got by selling the properties of the company. As a result, if there is no money left after paying all dues general shareholders may have the risk of getting no money back for their investment. For these reasons, investment in general shares is considered as the most risky investment. However, as it is a risky investment so there is also possibility of making more profit from such shares. If an investor decides to invest with clear knowledge and good calculations, general shares may have been a good source of investment for him. As a tool of investment, general shares have some special features. Those are described below:

1. General shares provide ownership to the share investors. As a result, as an owner he has the legal rights on its profits earned and its properties.

2. General shares give full authority to its owners to control the company. Shareholders control the company by applying their voting right in taking important decisions.

3. General shares are easily transferable. The investor according to his wish can handover the shares at his ownership at any time.

As a tool of investment general shares have some advantages and disadvantages:

Advantages

More Income: General shares can be a source of good income if an investor invests his money with clear knowledge and good calculations. The income earned by the investor from other tools of investment like priority shares, bonds and debentures is fixed. But income from general shares is not fixed. As a result, when the company earns more, the income of the investors also increases.

Limited Liability: The owners of the general shares jointly bear the risks of the company. The total risks of an investor are at no circumstances bigger than his invested money. For example, suppose an investor has bought 100 shares of a company and the face value of each share was 10 dollar, so his total liabilities may be at best 10 x 100 = 10,000 dollar.

Liquidity: General shares are well considered by the investors as liquid money. The investor according to his wish can collect money at any time by selling the shares at his possession. However, the liquidity of shares of all companies is not equal. Usually, the liquidity of shares of big and good companies is higher than that of other companies.

Disadvantages

Risk: Investment in general shares is comparatively more risky. There are many speculating investors in the share market. As a result, there is risk of doing loss if the investment is not guided by knowledge and good calculations.

Rights in Profit and Property Distribution: In distribution of profits, the company has to pay first all the liabilities payable to the owners of priority shares, bonds and debentures; and the general shareholders have rights on the remaining profits (if any). In this way, when the company is closed, after paying all the liabilities of the company with the money got by selling its properties, the shareholders will distribute among themselves the rest of the money (if any). That is, in both the cases the rights of the owners of priority shares, bonds and debentures get priority over the rights of the general shareholders.

Priority Share

Investment in priority shares is considered a good tool of investment for those investors who expect income at a certain rate from their investment in shares. Like that of general shares priority shares also have some own features and characters:

1. Ownership: Priority shareholders are not told full owners of the company. They are considered in between the owners of general shares and the owners of bonds and debentures.

2. Transformability: For many priority shares alternative options are there to transform them into general shares. So, if the investor wishes, he can change his status to an owner of general shares.

From the perspective of the investors, priority shares have some advantages and disadvantages. The advantages and disadvantages of priority shares are discussed below:

Advantages

1. Income at Certain Rate: The owners of priority shares get dividend at some certain rate. As a result, the shareholders have less uncertainty of income.

2. Priority on Profit Income: While giving dividend, owners of the priority shares get priority over the owners of the general shares.

3. Claims on the Properties: At the time of liquidation or closure of the company, claims of the owners of priority shares are first considered before meeting the claims of the owners of general shares. But of course, their claims are met after fulfilling the claims of the owners of debentures.

Disadvantages

1. Control: The priority shareholders do not have any voting right. So they have no control over the company.

2. Limited Income: Priority shareholders’ rate of income is fixed. Hence, priority shareholders do not get any share of extra profits made by the company.

System of Investment in Shares

Investors can invest in share markets in two ways:

1. Through Primary Market

2. Through Secondary Market.

Primary Market

Primary market means that market where a company announces the initial public offering (IPO) for selling its shares. When a company sells its shares in the market for the first time, that offer for selling is called IPO. If an investor buys shares by participating in the IPO offered by any company, it is considered that he has bought primary shares.

Secondary Market

After selling shares for the first time by a company to the investors, the investors can buy and sell shares among themselves. The market where investors buy and sell shares among themselves is called a secondary market.

Dividend and Dividend Policy

The gains or profit of a company is the deserving income of the shareholders. So, the gains or profit is distributed among the shareholders. Usually, a company does not distribute the full amount of gains or profit among the shareholders. It retains a portion of the gains and profit for financing in the affairs of business in future, and distributes the rest amount among the shareholders. The portion of gains or profit which is distributed among the shareholders is called dividend. A company can give dividend usually in two ways:

1. Cash Dividend

2. Stock Dividend or Bonus Share

Cash Dividend

The dividend which is paid in cash money is called cash dividend. For example: suppose, a company announces 10% cash dividend. An investor holds 500 shares of that company of each share priced 10 dollar. That investor will get 1 x 500 or 500 dollar as cash dividend.

Stock Dividend

Many a time, a company gives stock dividend instead of cash dividend or stock dividend side by side with cash dividend. The company usually gives stock dividend in proportion with shares issued at present. As a result, the number of shares of the company increases. Suppose, a company has at present 10 million shares of face value 10 dollar. The company announces 50% or 2:1 portion of stock dividend. As a result, if an investor has 500 shares at present, after getting the dividend the number of his shares will be 750. In this way, total shares issued by the company will be 15 million.

Dividend Policy

A company has to take dividend-related various decisions every year, for example, what portion of profit will be given as dividend, whether cash dividend or stock dividend will be given, etc. For taking these decisions, every company has particular policy which may give directions to give dividend. These policies are called dividend policies. Usually, three types of dividend policies are found, such as:

1. Fixed Money Dividend Policy: According to this policy, every year equal amount of money is given as dividend. For example, if a company gives 10 dollar dividend per share every year, it will be called fixed dividend policy. Whatever more amount of money a company may earn, it gives same amount of dividend as was given in previous years. However, in this system the amount of dividend usually does not decrease.

2. Dividend Payment Ratio Policy: According to this policy, a company decides what portion of its profit it will give as dividend. As per the decision, every year the company gives dividend proportionately. For example, suppose a company decides to give at 50% proportional rate. As a result, if in one year the company earns 20 million dollar, then it will give the shareholders 20 million x 50% or 10 million dollar as dividend.

3. Fixed Dividend along with Additional Dividend Policy: This is an ideal dividend policy for those companies which have no fixed or regular income. According to this policy, a company gives an additional dividend every year in addition to a minimum fixed dividend. As this dividend policy is much flexible than other dividend policies, many companies adopts this policy.

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Sources of Finance

Finance means fund collection, its management and distribution. In this chapter, we will learn about the concept of the sources of finance for doing the fund collection activity efficiently. Different sources of finance have different features. For these different features, fund should be collected from different sources suitable for different situations of the business. For example, to purchase a fixed asset fund should be collected through share selling. Again, to meet the daily needs such as, raw materials purchase, credit purchasing can be used or short term bank loan can be utilized.

After reading this chapter we shall be able to do:

·         Classification of sources of finance

·         Comparative discussion of the advantages and disadvantages of different term finances.

·         External Sources of Finance

Introduction

The fund required for the purpose of starting any business or to conduct the daily activities of business, selection of the sources of finance is one of the important decisions in financial management. Because, different sources has different costs of capital and the sources of different terms have different advantages and disadvantages. An institution collects fund by analyzing different sources to select that mixture of sources which will provide maximum benefit and minimum cost. Main objective of investment is profit earning. We can get net profit by subtracting the cost of capital and tax from total profit. So, the cost of capital should be reduced to maximize the profit of the business.

Concept of the different sources of finance

Business finance means supplying of fund required for running a business. Mr. William is the owner of a tailoring shop. He purchased some machines at the beginning of the business. Generally, a business person tries to collect fund from his own savings for the purpose of machines purchase related fixed investment. But if he sees after calculations that his own savings is not sufficient to purchase the machines, then he can collect fund through loan at a certain rate of interest from different commercial banks or other loan providing financial institutions. He usually collects this type of loan for a fixed term. Fund can also be collected from bank and other non-institutional sources against collateral of fixed property of business, like- building, factory and current property, like- raw materials, salable products etc. Besides, Mr. William may meet the needs of finance by reinvesting the profit earned by him without withdrawing this it from the business. If Mr. William feels cash crisis to meet the current needs, like- maintenance of machinery, payment of house rent, payment of labor wages, payment of electricity bill etc. during the time when the business is in operation, then he can receive advance from the buyers against future selling. Moreover, purchase on credit is another source of finance. Sometimes heavy machinery, big equipment, building, land, etc. can be rented from different organizations for a fixed period instead of purchasing and thus the business person can remain protected from the risk of huge investment at a time.

Thus, due to the differences of forms, nature and objectives of business, an organization collects fund from different sources. In every organization there are two separate sources of finance. One is the owners and the other is the creditors. Fund provided by the owners are called internal sources of finance and that provided by the creditors are called external sources of finance. Most of the organizations usually utilize both these two sources.

In the below table, classifications of these two sources of finance have been shown:

Internal Sources of Finance

Fund which the owner of a business invests through his saved profit or un-utilized profit is called the internal sources of finance. Internal sources of finance can be divided into two types: a) Ownership-based sources, b) Profit-based sources. Now we will know about the different kinds of these two sources of finance.

Classification of the sources of finance

Ownership Based Classifications of Internal Sources

Nature of internal fund is different for different kinds of business organizations. We know, based on ownership organizations may be of Sole Proprietorship, Partnership or Joint Stock Company. In sole proprietorship business, sources of internal fund are owner’s own savings or it may be any kind of factors of production measurable in money, such as: land, labor, capital and organization which are used in production. If the organization is a partnership business, fund invested by the partners is considered as the owner’s capital. On the contrary, if the organization is a company, fund collected through shares selling is considered as internal source of finance. Joint stock companies are of two types: Public Ltd. Company and Private Ltd. Company. Number of Initiators in private ltd. company is 2 to 50 and in public ltd. company it is minimum 7 and the maximum number may be any number limited to the shares. Both public and private ltd. companies collect capital through share selling. But a private ltd. company sells shares among the specified owners instead of selling them in the share market. An important source of capital collection for a public ltd. company is share selling.

Profit-oriented Classification of Internal Sources of Finance

A business institution earns money through producing goods and providing services. The money which remains left after deducting the production cost, selling expenses, etc. from this earnings is the profit of the business. The remaining portion of profit after deducting the interest of loan and the tax payable to the government can be used in various ways as a source of fund – these are discussed below. As in the case of loan, interest payment is compulsory but in the case of internal financing almost nothing is to be done as compulsory; so, the risk of repayment related inability is decreased. Now, we will be introduced with some profit oriented sources of finance.

a) Undistributed Profit and Savings Fund

The portion of profit which is invested in the business instead of distributing among the shareholders is called undistributed profit. If this undistributed profit is kept in separate fund for the purpose of business expansion in future it is called savings fund. Besides, this type of fund may also be created to overcome financial disasters in future.

b) Dividend Equitable Fund

Shareholders of a company usually get dividend from the company on a regular basis. Goodwill of the company implicated with giving this dividend. If in any year business earns less amount of profit then payment of dividend is not possible. But inability of dividend payment may deteriorate the business image in the market; so, in the year when the business earns huge profit, the company keeps aside small portion from the net profit as dividend equitable fund which can be used to pay the dividend also in the year when business earns insufficient profit. Thus, this fund gives the business ability to pay dividend on regular basis.

External Sources of Fund

External fund means external sources from which fund can be collected, such as, fund collected by taking a loan from bank. It is a popular source of finance. Bank loan has some features. First: Bank loan has a fixed term, within this term loan is to be utilized and the principal amount with interest has to be paid back to the bank. Second: Rate of interest remains the same, for the long period of its term no change is made. Third: Repayment of interest and installment of loan regularly and repaying the principal amount within the term is compulsory for the business. These dues have to be repaid even though the business is not profitable. Besides, fund can also be collected through selling debentures or bonds to the bank. Selling of preference shares is another source of external financing.

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Considerable Factors for Selecting the Sources

Organizations collect funds from different sources to meet the need for money. For selecting the sources, we need to analyze advantages and disadvantages of different sources and take into considerations the cost of fund collection, nature of the organization, type and purpose of need of the fund, etc. Making a right mix of the sources of fund is an important decision of the finance management. Things that should be taken into consideration for selecting right source of fund are mainly:

a) Type of Business

In the case of sole proprietorship and partnership businesses, fund is collected usually through own savings, profit of business, or loans taken from relatives. In the case of large scale purchase, leasing is also a good source of finance. In the case of public limited companies, instead of these most funds are collected through issuing shares and debentures. In (Picture: Selecting Sources of Finance based on the Types of Business Organizations) a structure of the sources of finance mix based on different formations and purposes of the business has been furnished. In the first line of the picture, we see, the source is fit for sole proprietorship and partnership business. Hereafter, it is found that undistributed profit, overdraft, short term loan and leasing are acceptable for all kinds of organizations. But long term loan and share issuing are applicable only for companies.

Picture: Selecting Sources of Finance based on the Types of Business Organizations

b) Insufficiency of Security Property

Usually in the case of a new business organization, getting loan against fixed asset as security is not possible. Besides, the selling of share and debenture is also a bit uncertain for the new companies. In such situation, if long term fund is needed, it is more logical to collect that through leasing.

c) Types of the Needs of Finance

If a company wants to buy expensive equipment’s, machinery, land, buildings, etc., then use of long term sources like- issuing share and debenture, taking lease, taking loan against security, etc. are effective. If there is shortage of fund to bear the expenditure of raw material purchase, paying wages, paying house rent, etc., then use of short term sources like- credit purchase, receivable bill security, bank overdraft can be accepted.

d) Cost of Sources of Fund

Fund can be collected from many sources. But an organization takes loan from that source where the expenses are the least. So, it issues shares for fund collection. But for collecting fund through shares the company has to pay dividend to the shareholders, which is a cost of this source. Besides, the company can mortgage its property for buying the new factory. If through such mortgage the company takes loan for long term, it has to pay installments with interest to the lending organization until the loan is fully realized. As a result, this source is also expensive. The company can accept that source of the two where the cost is least for it. Or, it can collect fund by making a profitable mix of the two sources. Dividend of share is taxable, but interest of debenture is non-taxable. Therefore, to reduce the load of tax, taking loan on interest from bank or other sources is better than collecting fund from internal sources. In many cases, more advantages are got and cost is also reduced by using a mix sources instead of using a single source.

e) Risk of Sources of Fund

If a company takes loan against security, then it has to keep properties as security to the lending organization. If it is not possible for the company to repay the loan within the specified period, then it is bound to repay the money by selling property kept as security. As a result, in selecting the suitable source, related risks of the concerned source also have to be considered.

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External Sources of Finance

External Sources of Finance means external sources from which fund can be collected, such as, fund collected by taking a loan from bank. External sources of finance are very popular. Two reasons of these are identifiable:

a) If business is financed externally through loan, then tax is imposed on the profit left after deducting the interest of loan. Thus less amount of tax can be paid.

b) In the case of small business, many times internal financing becomes comparatively less in amount; as a result, external sources act as the main sources of finance.

But one problem of external sources is the compulsory payment of interest. It was previously said that, whether profit is earned or not, business is bound to pay the imposed interest as per schedule. This problem doesn’t create if internal sources are used. On the basis of terms, external sources can be divided into three types: a) Short term, b) Mid-term and c) Long term. Now we will grow ideas of these three types of sources.

After reading this chapter we shall be able to do:

·         Sources of short term finance

·         Sources of mid-term finance

·         Sources of long term finance

Short Term Financing

Short term means less than one year. Most of the finances of an organization are usually collected from short term sources which are repaid within a year. In the case of short term financing, an organization enjoys some benefits, for example:

First: Cost of capital from the short term sources may be comparatively both the highest and the lowest. For example, loan collected from the commercial bank required to pay high rate of interest in short term. Again, different interest free sources like purchase on credit or wages kept due, a business organization can create fund for short term, which has no cost of capital. (We will learn in details about the cost of capital in the following chapters.)

Second: The process of short term capital exchanges is the fastest and simple process. On the other hand, the exchange of mid-term and long term financing requires to expend huge time and to follow long process.

Third: The business institutions whose products demand changes very swiftly within one year cannot make long term plan of production and financing. For example, due to the rapid change of demand for the fashion house’s products, these types of business make plan for short term production, and thus require small amount of money at a time. Short term sources of financing are suitable for these types of businesses.

Now we will discuss about the short term sources of finance. The sources of finance of this term can be divided into two types. We will discuss below first about the institutional sources of short term finance and then non-institutional sources of short term finance will be discussed.

1. Institutional Sources of Short Term Financing

a) Discounting Bills Receivable

When products are purchased on credit, the buying firm promises to the selling firm through signing a document to pay specified amount of money after expiry of the certain period (usually 3 months). This type of document is called the bill of exchange. This bill is receivable for the selling firm. So, selling firm can collect cash by exchanging or discounting this bill in a commercial bank. Let us assume, on January, buyer purchases goods of $5 on credit and agreed through signing the Bill of Exchange that he would be bound to pay $5 to the selling firm on March 30. In this condition, if the seller needs money before March 30, he can sell this bill to a bank before the expiry of the period but he has to receive less than $5, for example, with a discount rate of 3%, after discounting he will receive $4.

b) Bills Payable

In above example, bill of exchange is a bill receivable from the perspective of the seller, which is a bill payable to the buyers and is one of the sources of short term finance. When a business institution purchases raw materials, production materials, etc. on credit, then finance inflows for a short time in the business. Because, if business couldn’t get the opportunity of credit purchasing then finance would be required to buy on cash payment, hence if loan was collected from the bank then interest would have to be paid.

c) Short Term Bank Loan

In the case of short term finance, unsecured bank loan is one of the popular sources of finance. This kind of loan may be of different types. For example, in the case of short term bank loan, usually interest with principle amount has to be repaid at a time after a specified time period. Many times, bank tries to collect full portion or part of the sanctioned loan before the specified time period and for this purpose bank gives discount on the total amount receivable as an incentive of earlier payment. For example, if a creditor repays $6000 before the expiry of the credit term of 6 months, then he can give 2% less than the total amount, which means, the creditor can repay $4800.

Besides, if the creditor agrees to repay on demand instead of agreeing on a fixed term, then this type of loan is called “Demand Loan”. The institutions which have alternative sources of finance can use this source at a low cost of capital.

Bank Overdraft is another type of short term bank loan. Every institution usually realizes its receivables and repays its payables through current account. This type of bank account mainly gives to its account holders the opportunity of withdrawing more than the amount of savings in this account; however, the bank restricts the maximum amount of overdraft. Generally, finance collection from this type of source is a well-known system for those institutions where sales decrease for some time of a year. As an example it could be mentioned, an ice cream factory spends money throughout the year for production, warehousing, management etc. but maximum amount of ice cream is sold in summer season, so for the purpose of financing in other time of the year this type of source can be used. Generally, in the case of other types of loan, interest has to be paid till the full repayment of loan, but interest for such types of loan has to be paid only when this loan is being used. However, the rate of interest of this type of loan is higher than the other types of loan and it is repayable on demand.

d) Small Credit

This type of loan is generally provided to meet the demand of current asset for agriculture based and small & cottage industry, such as, management of a small industry, purchasing of agriculture based materials, management of a firm etc. Grameen Bank, Youth Development Bank, Co-operative Banks are used to provide such kind of bank. This kind of loan is given step by step on the achievement of goal.

2. Non-Institutional Source of Short Term Loan

a) Commercial Papers

A business organization sells Commercial Paper through promising to pay back the principal amount with interest after expiry of the certain period. At that time the company’s goodwill acts as a security to the purchaser. Usually, those persons who have some excess money left as unutilized for the time being purchase commercial papers as an alternative of investment in shares. Generally, well known person, commercial bank, insurance company, pension fund etc. can arrange finance for a short time by selling commercial papers.

b) Advance from Purchaser

Many times, trustful and permanent customers pay as advance to the producing or selling firm the full amount or part of their total purchase, and as a result, this act as a source of finance to the seller for the time being.

c) Inventory Financing

For the purpose of short term financing, warehouse asset can be used. If any business firm uses its inventory as security of loan received from a well-known person or organization, it is called the inventory financing.

d) Village Moneylenders

From long days ago, rich people of the villages have been providing short term loans to the poor people. In this case, if the period of loan repayment is expired, the debtor has to pay high rate of interest. If the person fails to pay back the loan with interest within specified period, the moneylenders took the possession of his (debtor’s) tangible and intangible property. Village moneylenders count to impose interest on this loan on day basis, weekly basis and monthly basis.

Mid Term Financing

This type of loan extends for 1 to 5 years. A business firm uses this fund to meet the demand of long term needs of the current capital. Cost of capital or interest rate of this fund is higher than that of the short term sources of finance and less than that of the long term sources of finance. Sources of this type of loan according to their different features are discussed below:

a) Commercial Bank Loan

Loans which the commercial banks provide for mid-terms are usually given against security. Current capital or even fixed asset can be used as security for obtaining this type of loan. Huge amount of loan payment (at a time) may be a risky job for a commercial bank. So, when a commercial bank pays huge amount of loan, it creates syndication of a number of commercial banks together to bear in group the high risk of loan payment. Before sanctioning the loan, a commercial bank finalizes its interest rate by analyzing the interest rate fixed by Government Bank and the demand of the loan.

b) Specialized Financial Institution

Generally, some financial institutions are established under the government ownership which is engaged in the development of the country’s specialized sectors. These institutions provides term loan on favorable conditions to the relevant sectors. Industrial Bank, Agriculture Bank, and Cottage Industry, etc. are examples of such institutions.

c) Non-Government Institutions

There are different kinds of NGOs working in the world which provide mid-term loan to the business institutions. For example, Midas, BRAC, Grameen Bank, etc. are doing business as an NGO by getting legal entity. Besides providing fund, these institutions also provide consultancy, training, support in efficiency building activities etc. to the business organizations.

d) Capital Market Institutions

Different types of capital institutions such as insurance company, investment bank, finance mediatory institutions (underwriters) also provide mid-term loans.

Long Term Financing

Long term financing extends from 5 years to maximum till any duration. Long term financing has some distinctive features. We will now discuss about these features. First feature of long term finance is the amount is bigger than the mid or short term funds, so this fund is usually used to acquire fixed asset like- land, building, equipment etc. Another feature is related with the repayment schedule. If long term fund is collected through loan, it has to repay as per contracted payment schedule. Again if long term fund is collected through selling shares, then this fund is considered as owner’s capital, so this liability need not be repaid till the business dissolution. In sole proprietorship and partnership businesses, the owner’s capital too can usually be used for indefinite long period. The tax-related feature is that share dividend is taxable but interest of debenture is non-taxable. That’s why the cost incurred from share selling is higher than the finance through long term loan. Now we will discuss about the sources of long term fund.

a) Loan

Generally, any organization takes long term loans against security to bear the expenses of expensive equipment’s, machineries, buildings, land purchase, etc. Before sanctioning long term loans, banks analyze different information like income of the company, goodwill, amount of fixed asset, previous events of taking loan and loan repayment trends etc. Long term loan is collected for fixed investments, such as, expansion of scope of the business, factory construction, building construction, purchasing heavy equipment’s, etc. Before taking these investment decisions, the concerned business organization makes an estimate which is known as capital budgeting. Through this process future profit or loss is measured by adopting different procedures. If the financing organization is satisfied by this estimate of profit and loss, only then loan is sanctioned.

b) Debenture

In the case of debenture, fund is collected through selling the large amount of loan after dividing into small fractions. It is an alternative to share. But, debenture holders are bound to pay fixed rate of interest which is kept mentioned in debenture. Loan is taken for any long term starting from 5 years. Whether profit is earned or not, the business is bound to repay the interest of the lenders. Main advantage of financing through selling debenture is the long term existence of fixed rate of interest; and as interest rate is predetermined, financial managers can make an effective plan of financing.

c) Leasing

Leasing is an amazing method of long term financing. If an organization needs expensive machine, equipment’s, transport etc., then it has to purchase those things directly or instead of purchasing directly the organization can use those things through a lease contract from a leasing company. But at that case, company does not get the ownership of the machine. Leasing company is the owner of the machine. To enter into a leasing contract, the organization has to pay rent (like interest) to the leasing company at a fixed rate and thus it can get the opportunity of using the leased properties. Let us assume, a business firm takes a photocopy machine as lease from a leasing company for 3 years by pledging to pay a fixed amount of rent and returns it to the leasing company after the expiry of the period. That means, on a leasing contract, ownership of the property is retained to the leasing company. As an advantage of leasing, the organization needs not to take long term loan or to use savings fund. For this reason, leasing is a source of long term financing. Newly established companies or the small companies whose capital for investment is not sufficient also can use expensive machines, etc. through leasing. The leasing company provides repair and maintenance services for the lease properties.

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Bank and Client

Main ideology of bank is the relationship and belief between the Bank and Client. If any step of each party is against this belief and trust then relationship between them will be disrupted which will cause the business to be dissolved.

Nature of Bank-Client Relation

Person, institution, company involves in banking business is called “Banker”. Such a way client means that person who is involved with the bank through his account or any of the service of the bank. On the basis of the functions and services provided by the bank to its clients Bank – Client relationship can be considered as:

1. Debtor –Creditor Relationship: When client deposit money in the bank then bank is a debtor and oppositely other party is creditor. Thus this relationship grows through depositing money by the client.

2. Contractual Relationship: This relationship establishes through opening a bank account by the client. This relationship creates right and responsibilities for both the parties. Under this contract bank remain liable to return back the client’s deposited money.

3. Client’s trustee: Most of the time banks give protection to the client’s valuables, documents etc. through providing the locker services .This relationship can be considered as legal relationship.

4. Mortgage provider and receiver relationship: Bank provides loan against the client’s property. This relationship is the outcome of the client long term relation and belief on the bank and bank’s long term services delivering to the clients.

5. Agency relationship: Payment dues and collect receivables are on behalf of the clients are the responsibilities of bank.

Bank responsibilities towards the clients

According to the principle of banking business, doing welfare and protecting client’s interest are wholly the responsibilities of the bank.

1. Pay back money: Generally bank is bound to pay back the client’s money. But it is paid on the fulfillment of some condition specified by the contract. As an example: If money is deposited in the current or savings account then client can withdraw money by writing the Cheque and any approval of the bank is not needed.

2. Secrecy of account: Bank never discloses any information of the clients except asked or advised by the Court, Bangladesh Bank or respective client.

3. Carrying on depositor’s order: According to the order of the depositor bank utilizes the deposited money. As an example, if client orders bank to repay the dues to some specified person then bank does this as per order. Same way if client orders bank after meeting the condition to collect the receivable then bank also do the same.

4. Exchanging of interest and service fee: Bank collects money of receivable interest on behalf of the client and deposits properly to the client’s account.

5. Opportunity of easy loan repayment: Bank sanctions the loan on easy repayment schedule. Thus both of the parties will be benefited.

Client’s responsibilities towards the bank

As bank has responsibilities toward the client such a way client also has responsibilities towards the bank. Client’s responsibilities are following:

1. Honesty: Client should show the honesty to maintain the relationship towards the bank. From opening a bank account client should disclose all required information to the clients.

2. Loan repayment: Client should pay installment of loan as per repayment schedule. So if loan cannot be repaid according to contract then by the adoption of the law bank will collect money by selling the property of the client.

3. Cautiousness: Client should take proper care in writing Cheque. As an example: proper signature, date in right places and right time.

Cheque is a bill of exchange, generally two types of Cheque are available to use

1. Bearer Cheque: In case of this Cheque bank is bound by order of the client to pay the specified amount of money to the specified bearer within a specified time period.

2. Order Cheque: Generally in case of such kind of Cheque, bank pays to the payee or to the specified person by the order of the payee’s. Bank cannot pay cash on present of this Cheque but only through the account bank can clear this payment.

Secrecy of bank account and related information regarding this

Relationship between the bank and client are of trust. This relationship dissolves only when conspiracy, fallacy or illegal activities occur. The possible reasons those may dissolve the relationship between the bank and client:

1. Client has declared as bankrupt: If client is declared by the court as bankrupt then Bank-Client relationship dissolves.

2. Mental disorder: If client is not capable of doing the bank transaction or may not remember anything, at that time relationship will dissolve.

3. Garnishee order: If any Garnishee Order is enforced by the court then bank becomes bound to close the client account.

4. Bank’s own decision: If client doesn’t follow the bank’s rules and principles then bank may become bound to close the client’s account.

5. Client’s own Decision: If client is not interested to continue his account then relation comes to an end.

6. War and Enmity: If bank and client stay in a location on which division has taken place thus relationship breaks as usually.

7. Balance Transfer: If client orders on bank to transfer all his account balance to the other bank then client’s account automatically closes down.

8. Death of client: Due to this reason account comes to an end.

9. Non-active Account: If any client doesn’t make any transaction through the account for long time then account of this client will be closed automatically.

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Classification of Finance

Financial process is as important for a business organization so important for a nonprofit organization too. Every organization is involved with a financial process. Financial process takes different forms for different organizations. Now we will discuss about classification of this finance. Though our main concentration is business finance, we will also get a brief idea of the financial processes of some other organizations also.

Family Finance

In family finance, the sources and amount of income of the family is identified and how this income can be utilized for the overall welfare of the family members is determined. Among in-numerous necessary expenditures the most important expenditures are fulfilled on priority basis. If family income is not sufficient, loan can be taken from the relatives, familiar persons or friends. Regular expenditures are determined by considering the regular income. Bank loans can be arranged for fixed assets like television, freeze, car, building construction etc.. But, as the collected fund is limited, it needs proper utilization. If the collected money is excess, remaining amount can be saved for future use.

Public Finance

Every government has its own financial management. In the case of a government, how much on what areas will be the probable yearly expenditures of the government and how that money can be arranged from which sources are discussed in the public finance. Government has to spend a lot of money for overall development of the country in various sectors like- roads, bridge, government educational institutions, government hospital, law and order, defence, social infrastructure etc.. Government collects money to bear these expenses from different sources like- income tax, tat, gif tax, import custom, export custom, saving certificates, prize bond, treasury bill etc. In public finance, first the amount of expenditure is determined and then fund is collected according to the needs. The main objective of public finance is social welfare. Public finance is usually non-profitable. Expenditure may be greater than income in public finance.

International Finance

In international finance, export and import sectors are discussed and analyzed. A country every year huge amount of foodstuff, raw materials, machinery, medicine, petroleum etc. are imported from different countries. On the other hand, jute and jute products, ready-made garments, agricultural products etc. are being exported. Trade deficiency of large amount occurs as the volume of import is greater than the volume of export. Remittance sent by the foreign dwellers play vital role to compensate this deficiency. International finance covers discussion about export and import sectors and the way of management to compensate the trade deficiency.

Finance of Non-Profit Organization

In our society there are some institutions or organizations which are involved in the welfare of mankind, or providing services for the poor and distressed people. To run this type of business, money or products or services similar to money is required and it is necessary to utilize that money efficiently. In this connection, the role that the finance plays is identification of the sources of finance or wealth similar to money and ensuring its proper utilization for the purpose of achieving the service-oriented objectives. As an example it could be mentioned: an orphanage is not a profit making institution, but it also has need of finance. These types of institutions collect money through different grants. This collected money is spent in various development activities for the orphans. So source identification and proper utilization of fund to achieve its motto is the main objective of finance of non-profit organization.

Business Finance

The most important type of finance is business finance. An organization formed with the purpose of earning profit through the risk profit and loss is called a business organization. So, business finance is the process used to collect fund and invest it for business purposes. Business organizations are classified into three types: Sole Proprietorship Business, Partnership Business and Joint Capital Business organizations. General feature of these three types of organizations are fund collection and fund management. For fund collection, own capital and loan are used as sources. Business finance is the main theme of this lesson.

The most famous business organizations in the world are usually formed as sole proprietorship business and partnership business. Varieties small and cottage industries, hotel & restaurant business, grocery shop, saloon, boutique shop etc. are of these kinds of business. In sole proprietorship business, if profit if earned the owner enjoys it alone and if any loss occurs the owner’s personal properties also be used repair the loss.

In partnership business, the risk is distributed among all partners, so the partners are to be prepared use personal properties to bear the loss in business (if any). In these types of businesses – sole proprietorship or partnership – sources of finance are owner’s own capital, profit, loan from relatives, loan arranged on interest from bank or village money lenders. So, earning profit from investing own fund by proper utilization of money is the main objective of these types of business organizations.

The financial process of a joint stock company is different. Government approval is required to form such a company. Before giving approval, the government evaluates and analyses the minimum amount of capital, directors’ identity, business objectives and various documents. After getting approval, a company divides its expected big amount of total capital into small portions of equal amount and sells these as shares in the share market. For example, 10 million shares of $1000 may be sold to the public when the business has a capital of $100 million. As each share costs only $1000, small investors of remote places of the country also can purchase shares. Shareholders are the owners of the company and if the company is profitable they usually get dividend on a regular basis. Shareholders can convert their shares into cash by selling those in the share market like New York Stock Exchange. Other than shares, a joint stock business can raise fund by taking loans from the public through selling bonds and debentures to them. In that case, the company has to pay interest on regular basis at some certain rate to the debenture holders.

Banks and Financial Institutions

In any country, economic activities usually revolve centering the banks and financial institutions. Government and privately owned banks are profit-oriented organizations but their financial process is usually slightly different from business organizations. These banks collect small amounts of fund of the people, create deposit for different terms with this fund and provides fixed rate of interest to the depositors. Again, banks provide loans to the entrepreneurs in different businesses from this fund. Loans can also be taken for personal purposes. Banks impose interest on certain rate against these loans. But the rate at which a bank receives interest on granted loan is greater than the rate of interest the bank pays to the depositors. This difference of these two rates of interest is the profit of banks. In banking chapter we will learn in details about these institutions.

Principle of Business Finance

Business finance management means fund collection as per requirement, investment of this fund in short and long terms and the management of fund distribution. This management process follows some principles which are furnished below:

Liquidity VS Profitability Principle

A grocer may keep all the cash money (liquid property) earned from daily sales for the purpose of buying raw materials and other related expenses, or he may keep with him some portion of this cash for buying raw materials and deposit the rest amount in a bank account from which it is possible to get some amount of interest/ profit after a certain period. In this situation, the grocer has to decide on how much of earned cash should be retained with him to meet the current needs. If the grocer keeps large amount of cash with him to meet the daily expenses then income from bank will decrease. Again, if large amount of cash is deposited in bank, the business may fall in financial crisis which may hamper the daily activities. So, business people have to do financial management in such a way that can create balance between liquidity and investment. It means, as in one side business people need cash reserve to bear the daily expenses, thus in other side cash should be invested for making profit too. There is an inverse relationship between cash and liquidity. Huge cash decreases profitability, again excess investment for the purpose of high profit causes cash crisis. To maintain a balance between liquidity and profitability is one of the principles of finance.

Competence Principle

Acquiring current asset by short term fund and fixed asset by long term fund –is a principle of finance. Current asset is that money which is required to run the daily expenses of a business, like- raw materials purchase, payment of labor wages, etc. On the other hand, machinery purchase, building construction for the business etc. are fixed capital. As the amount of current capital is small, it also yields less; for this reason this type of capital should be collected from the short term source of finance. Commercial banks, different financial institutions, investment banks and debenture holders these types of sources provide long term loans. On the other hand, current capital should be managed from regular sales proceeds. High rate of interest has to be given to the loan providing institutions for collecting loan from the long term sources. So, if loan is collected from long term sources to bear the current expenses, then it appears that, repayment of interest from the earned income becomes impossible.

Diversification and Risk Distribution Principle

In the case of fund investment, if business products or services are as much as possible diversified, the risk is distributed and reduced. Every business organization tries to earn profit centering an uncertain future. So business has to face a lot of risk. These risks may be created for many reasons, like- changes of economic, political or social scenario, arrival of new products in the market, natural calamity, sudden accident etc. It is not possible for the managers to control these uncertain situations or take preparations for them. But through following the principle of risk distribution, profit is possible to be earned in this uncertain market. If a business person do business only for a single product, then profit earning becomes very risky. On the other hand, if the products of the business are different and diversified, then the risk is distributed. It means, in any situation if selling of a single product is deteriorate then the decreased amount of profit can be compensated by the profit earned from the other products; and as a result expected profit can be achieved in any situation. If a grocer sells both the Halal soap and the traditional soap, then customers of both kinds of soaps will arrive in his shop. If the grocer keeps only general or the traditional soaps, the customers of Halal soap will go to another shop to buy Halal soap and the total sales of the grocer will decrease. Sales of some products rise or fall due to the differences of weather or season also. As an example, demand of winter wears increases only in winter season. So, the sale of winter wears increases in that season. If a dress seller sells both summer and winter wears in his shop, then his profit earning will not be hampered for rise and fall of demand of the products in different seasons. If in a book stall only text books are sold and if in another shop text books, story books, religious books and different instructive books are sold, then it appears that maximum customers will prefer the second stall even to buy text books. Because, they can purchase different types of necessary books from a single shop at a time. Besides, if the book seller sells only text books, then though the sale may increase at the beginning of the year but in other times of the year this sale may decrease abruptly. This principle of risk distribution through diversification can be applied in fund collection. In the case of fund collection, priority is given on fund collection from different sources.

Functions of Financial Manager

Financial manager deals with the two types of decisions:

1. Income or Finance Decision

2. Expenditure or Investment Decision

Income or Financing Decision

Income decision mainly means the process of fund collection. The scope of this decision covers selection of the alternative sources of fund and taking financial plans by analyzing the advantages and disadvantages of these sources. Generally, to bear the current expenses fund is collected from short term sources, and to bear the fixed expenses fund is collected from long term sources. For the purpose of fund collection, it is collected through own capital and arranging loan from different sources. Besides, large companies may gather capital through selling shares. Shareholders are the real owners of a company. The portion of capital which an organization collects through loan increases the liability of the organization; again ownership right is established on the basis of the amount of capital collected through the owners’ fund. Thus, an institution becomes successful to create a balance between the liability of loan and the rights of the owners through a right finance decision.

Expenditure or Investment Decision

Machine purchasing decision is an investment decision for a tailoring shop. In the case of a grocery shop, decision for furniture purchasing or refrigerator purchasing is also an investment decision. For a production organization, production machines purchase or factory construction is also this type of decision. Through this decision a plan of expected inflow and outflow of fund has to be calculated. For example, a production organization decides to buy machines only when the selling of the machine-made products is greater than before and if thus profitability and inflow of fund are increased and if the total inflow of fund is greater than the purchase price of the machine.

That means, if it seems that the machines can be utilized for the 10 years, then, for the purpose of investment decision, comparison has to be made with the 10 years inflow of fund from sale proceeds for adding the new machines and the purchase price of these machines. So, it is possible to find out the 10 years cash flow from selling only by considering the product price in 10 years and the volume of sales. Production and other expenses are deducted from the sales earnings to measure the profit from the cash flow.

The investment decision is very tough for an organization because to measure the amount of selling in future and determining selling price is a very difficult task.

Other Decisions

Above two decisions are very important for the financial managers. Besides, financial managers have to take some other more decisions, such as:

1) Purchase of how much amount of raw materials is suitable and from which sources this fund can be collected – this type of decision is called current investment decision.

2) How much amount of cash reserve should be kept for daily expenses is another important decision too.

3) Dues payment for the sources of fund is another decision.

If fund is collected through bank loan and other loans like- bond, debenture etc., then payment of certain amount of interest at the right time is an important responsibility for the financial manager. In the same way, if fund is collected through selling of shares, then earning profit at the expected rate and distributing dividend is another important thing to be considered by the financial manager.

End

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