How a Company Source Funds?

A company has to source funds to purchase fixed assets, to procure working capital and to fund its business. For the company to make a profit, the funds have to cost less than the return the company earns on their deployment.

Where does a company raise funds? What are the sources?

Companies raise funds from its shareholders and by borrowing. A company sources funds from shareholders by the issue of shares. Shareholders’ funds is the balance sheet value of shareholders’ interest in a company.

For the accounts of a company with no subsidiaries it is total assets minus total liabilities. For consolidated group accounts the value of minority interests is excluded. Minority interest refers to the portion of a subsidiary corporation’s stock that is not owned by the parent corporation.

Shareholders’ funds represent the stake shareholders have in the company, the investment they have made.

Share Capital

Share capital represents the shares issued to the public. This is issued in following ways:

• Private Placement - This is done by offering shares to selected individuals or institutions.
• Public Issue - Shares are offered to public. The details of the offer, including the reasons for raising the money are detailed in a prospectus and it is important that investors read this.
• Rights issues - Companies may also issue shares to their shareholders as a matter of right in proportion to their holding. So, if an investor has 100 shares and a company announces a 2:1 rights, the investor stands to gain an additional 200 shares. 

Rights issues come at a price which the investors must pay by subscribing to the rights offer. The rights issues were often offered at a price lower than the company’s market value and shareholders stood to gain. With the freedom in respect of pricing of shares now available, companies have begun pricing their offerings nearer their intrinsic value. Consequently, many of these issues have not been particularly attractive to investors and several have failed to be fully subscribed. However, strong companies find subscribers to their rights issues as investors are of the view that their long term performance would lead to increase in share prices.

Bonus shares - When a company has accumulated a large reserves out of profits, the directors may decide to distribute a part of it amongst the shareholders in the form of bonus. Bonus can be paid either in cash or in the form of shares. Cash bonus is paid in the form of dividend by the company when it has large accumulated profits as well as cash. Many a times, a company is not in a position to pay bonus in cash (dividend) in spite of sufficient profits because of unsatisfactory cash position or because of its adverse effects on the working capital of the company. In such a case, the company pays a bonus to its shareholders in the form of shares. Bonus shares are shares issued free to shareholders by capitalizing reserves. No monies are actually raised from shareholders. Nothing stops a company from declaring a bonus and dividend together if it has large accumulated profits as well as cash.

Reserves - Reserves are profits or gains which are retained and not distributed. Companies have two kinds of reserves - capital reserves and revenue reserves:

• Capital Reserves – Capital reserves are gains that have resulted from an increase in the value of assets and they are not freely distributable to the shareholders. The most common capital reserves one comes across are the share premium account arising from the issue of shares at a premium and the capital revaluation reserve, i.e. unrealized gain on the value of assets.
• Revenue Reserves - These represent profits from operations ploughed back into the company and not distributed as dividends to shareholders. It is important that all the profits are not distributed as funds are required by companies to purchase new assets to replace existing ones, for expansion and for working capital.

Loan Funds

The other source of funds a company has access to is borrowings. Borrowing is often preferred by companies as it is quicker, relatively easier and the rules that need to be complied with are much less. The loans taken by companies are either :

Secured loans - These loans are taken by a company by pledging some of its assets or by a floating charge on some or all of its assets. The usual secured loans a company has are debentures and term loans.

Unsecured loans - Companies do not pledge any assets when they take unsecured loans. The comfort a lender has is usually only the good name and credit worthiness of the company. The more common unsecured loans of a company are fixed deposits and short term loans. In case a company is dissolved, unsecured lenders are usually paid after the secured lenders have been paid. Borrowings or credits for working capital which fluctuate such as bank overdrafts and trade creditors are not normally classified as loan funds but as current liabilities.

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