The sources of long-term finance refer to the institutions or agencies from, or through which finance for a long period can be procured. In case of sole proprietary concerns and partnership firms, long-term funds are generally provided by the owners themselves and by the retained profits. But, in case of companies whose financial requirement is rather large, the following are the sources from, or through which long-term funds are raised:
- Capital Market
- Special Financial Institutions
- Mutual Funds
- Leasing Companies
- Foreign Sources
- Retained Earnings
1. Capital Market
Capital market refers to the organisation and the mechanism through which the companies, other institutions and the government raise long-term funds. So, it constitutes all long-term borrowings from banks and financial institutions, borrowings from foreign markets and raising of capital by issuing various securities such as shares debentures, bonds, etc.
For trading of securities there are two different segments in capital market. One is primary market and the other is, secondary market. The primary market deals with new or fresh issue of securities and is, therefore, known as new issue market. The secondary market on the other hand, provides a place for purchase and sale of existing securities and is known as stock market or stock exchange.
The new issue market primarily consists of the arrangements, which facilitate the procurement of long-term finance by the companies in the form of shares, debentures and bonds. The companies usually issue those securities at the initial stages of their formation and so also later on for expansion and/or modernization of their activities. However, the selling of securities is not an easy task, as the companies have to fulfill various legal requirements and decide upon the appropriate timing and the method of issue. Hence, they seek assistance of various intermediaries such as merchant bankers, underwriters, stock brokers etc. to look after all these aspects. All these intermediaries form an integral part of the primary market.
The secondary market (stock exchange) is an association or organisation or a body of individuals established for the purpose of assisting, regulating and controlling the business of buying, selling and dealing in securities. It is called a secondary market because only the securities already issued can be traded on the floor of the stock exchange. This market is open only to its members, most of whom are brokers acting as agents of the buyers and sellers of securities. The main functions of this market lie in providing liquidity (ready encashment) to securities and safety in dealings. It is because of the availability of such facilities that people are ready to invest in securities.
2. Special Financial Institutions
A number of special financial institutions have been set up by the central and state governments to provide long-term finance to the business organisations. They also offer support services in launching of the new enterprises and so also for expansion and modernisation of existing enterprises.
Some of the important ones are Industrial Finance Corporation of India (IFCI), Industrial Investment Bank of India (IIBI), Industrial Credit and Investment Corporation of India (ICICI), Industrial Development Bank of India (IDBI), Infrastructure Development Finance Company Ltd. (IDFC), Small Industries Development Bank of India (SIDBI), State Industrial Development Corporations (SIDCs), and State Financial Corporations (SFCs), etc.
Since these institutions provide developmental finance, they are also known as Development Banks or Development Financial Institutions (DFI). Besides these development banks there are a few other financial institutions such as life Insurance Corporation of India (LIC), General Insurance Corporation of India (GIC) and Unit Trust of India (UTI) which provide long-term finance to companies and subscribe to their share and debentures.
The main functions of these institutions are:
- to grant loans for a longer period to industrial establishment;
- to help the establishment of business units that require large amount of funds and have long gestation period
- to provide support for the speedy development of the economy in general and backward regions in particular
- to offer specialized services operating in the areas of promotion, project assistance, technical assistance services and training and development of entrepreneurs
- to provide technical and professional management services and help in identification, evaluation and execution of new projects
Commercial banks usually provide short-term finance to business firms in the form of loans and advances, cash credit, overdraft, etc. But now-a-days, most of the commercial banks have also started term lending (long and medium term) and providing need based finance of different time periods to firms of all sizes. Consistent with the policy of liberalization, the banks have been allowed to evolve their own methods of assessing financial needs of the borrowers and extend them the term loans for larger size and longer periods.
Some of the banks have also started their industrial branches to finance exclusively to industrial enterprises. Thus, the commercial banks also now act as an important source of medium term and long term finance for the business.
A large number of cooperative banks are now operating in India. These banks have the license from the RBI to operate like commercial banks. They also some times provide long-term finances to small and medium scale cooperative industrial units like sugar factories, food-processing units, etc.
4. Non-Banking Financial Companies (NBFC)
There are various housing finance companies, investment companies, vehicle finance companies, etc. operating in private sectors. These companies are categories under Non-Banking Financial Companies, because they perform the twin functions of accepting deposits from the public and providing loans. However they are not regarded as banking companies as they do not carry on the normal banking activities.
They raise funds from the public by offering attractive rate of interest and give loans mainly to the wholesale and retail traders, small-scale industries and self-employed persons. The loans granted by these finance companies are generally unsecured and the interest charged by them ranges between 24 to 36 percent per annum.
Besides giving loans and advances, the NBFCs also have purchase and discount hundis, undertaken merchant banking, housing finance, lease financing, hire purchase business etc. In India, NBFCs have emerged as an important financial intermediary due to simplified loan sanction procedure, attractive rate of return on deposits, flexibility and timeliness in meeting the credit needs of the customers.
5. Mutual Funds
Mutual fund refers to a fund established in the form of a trust by a sponsor to raise money through one or more schemes for investing in securities. It is a special type of investment institution, which acts as an investment intermediary that collects or pools the savings of a large number of investors and invests them in a fairly large and well diversified portfolio of sound investments.
This minimizes their risk and ensures good returns to the investors. Thus, they act as an investment agency for small investors and a good source for long-term finance for the business.
6. Leasing Companies
Leasing arrangement is a method of long-term finance. This method has become quite common among the manufacturing companies. Leasing facility is usually provided through the mediation of leasing companies who buy the required plant and machinery from its manufacturer and lease it to the company that needs it for a specified period on payment of an annual rent.
For this purpose a proper lease agreement is made between the lessor (leasing company) and lessee (the company hiring the asset). Such agreement usually provides for the
purchase of the machinery by the lessee at the end of the lease period at a mutually agreed and specified price. The ownership remains with the leasing company during the lease period.
Sometimes, a company, to meet its financial requirements, may sell its own existing fixed asset (machinery or building) to a leasing company at the current market price on the condition that the leasing company shall lease the asset back to selling company for a specified period. Such an arrangement is known as ‘Sell and Lease Back’. The company in such arrangement gets the funds without having to part with the possession of the asset involved which it continues to use on payment of annual rent for the lease.
In any type of leasing agreement, the lease rent includes an element of interest besides the expenses and profits of the leasing company. The leasing company must earn a reasonable return on its investment in lease asset.
The leasing business in India was started, in seventies when the first leasing company of India was promoted by Chitambaram Group in 1973 in Chennai. The Twentieth Century Finance Company and four other finance companies joined the fray during eighties. Now their number is very large and leasing has emerged as an important source. It is very helpful for the small and medium sized undertakings, which have limited financial resources.
7. Foreign Sources
Foreign Sources also play an important part in meeting the long-term financial needs of the business in India. These usually take the form of:
- External borrowings
- Foreign investments
- Deposits from NRIs
8. Retained Earnings
Retained earnings refer to the undistributed profits of companies which is usually kept in the form of general reserve. Primarily, it is a hedge against low profits in future and is used for the issue of bonus shares by the company. But, in effect, it acts as an important source of long-term finance for the companies with Zero cost of capital.
The retained profits can be used for expansion and modernization programmes by the companies. The amount of retained earnings is determined by the quantum of profits, the dividend payout policy followed by the management, the legal provisions for dividend payment, and the rate of corporate taxes, etc.
It is an internal source, which does not involve any cost of floatation and the uncertainties of external financing. In fact, it is regarded as the most dependable source of long-term finance. It also strengthens the firm’s equity base, which enables to borrow at better terms and conditions. The main drawbacks of this source are (a) it is fully dependent on the accuracy of profits; and (b) possibility of reckless use of funds by the management.