UNIT - IV

PRINCIPLES OF ACCOUNTING & CAPITAL

1. INTRODUCITON
As you are aware, every trader generally starts business for purpose of
earning profit. While establishing business, he brings own capital, borrows money
from relatives, friends, outsiders or financial institutions. Then he purchases
machinery, plant , furniture, raw materials and other assets. He starts buying and
selling of goods, paying for salaries, rent and other expenses, depositing and
withdrawing cash from bank. Like this he undertakes innumerable transactions in
business. Observe the following transactions of small trader for one week during
the month of July, 1998.

1998 Rs.
July 24 Purchase of goods from Sree Ram 12,000
July 25 Goods sold for cash 5,000
July 25 Sold gods to Syam on credit 8,000
July 26 Advertising expenses 5,200
July 27 Stationary expenses 600
July 27 Withdrawal for personal use 2,500
July 28 Rent paid through cheque 1,000
July 31 Salaries paid 9,000
July 31 Received cash from Syam 5,000

The number of transactions in an organization depends upon the size of the

organization. In small organizations, the transactions generally will be in thousand
and in big organizations they may be in lakhs. As such it is humanly impossible to
remember all these transactions. Further, it may not by possible to find out the
final result of the business without recording and analyzing these transactions.
Accounting came into practice as an aid to human memory by maintaining a
systematic record of business transactions.

1.1 History of Accounting:

Accounting is as old as civilization itself. From the ancient relics of Babylon, it
can be will proved that accounting did exist as long as 2600 B.C. However, in
modern form accounting based on the principles of Double Entry System came into
existence in 17th Century. Fra Luka Paciolo, a Fransiscan monk and mathematician
published a book De computic et scripturies in 1494 at Venice in Italyl. This book
was translated into English in 1543. In this book he covered a brief section on
‘book-keeping’.

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1.2 Origin of Accounting in India:
Accounting was practiced in India thousand years ago and there is a clear
evidence for this. In his famous book Arthashastra Kautilya dealt with not only
politics and economics but also the art of proper keeping of accounts. However, the
accounting on modern lines was introduced in India after 1850 with the formation
joint stock companies in India.
Accounting in India is now a fast developing discipline. The two premier
Accounting Institutes in India viz., chartered Accountants of India and the Institute
of Cost and Works Accountants of India are making continuous and substantial
contributions. The international Accounts Standards Committee (IASC) was
established as on 29th June. In India the ‘Accounting Standards Board (ASB) is
formulating ‘Accounting Standards’ on the lines of standards framed by
International Accounting Standards Committee.

2. BOOK-KEEPING AND ACCOUNTING

According to G.A. Lee the accounting system has two stages.

1. The making of routine records in the prescribed from and according to set
rules of all events with affect the financial state of the organization; and
2. The summarization from time to time of the information contained in the
records, its presentation in a significant form to interested parties and its
interpretation as an aid to decision making by these parties.
First stage is called Book-Keeping and the second one is Accounting.

Book – Keeping: Book – Keeping involves the chronological recording of financial

transactions in a set of books in a systematic manner.
Accounting: Accounting is concerned with the maintenance of accounts giving
stress to the design of the system of records, the preparation of reports based on
the recorded date and the interpretation of the reports.

Distinction between Book – Keeping and Accountancy

Thus, the terms, book-keeping and accounting are very closely related,
through there is a subtle difference as mentioned below.
1. Object : The object of book-keeping is to prepare original books of Accounts.
It is restricted to journal, subsidiary book and ledge accounts only. On the other
hand, the main object of accounting is to record analyse and interpret the business
transactions.
2. Level of Work: Book-keeping is restricted to level of work. Clerical work is
mainly involved in it. Accountancy on the other hand, is concerned with all level of
management.

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3. Principles of Accountancy: In Book-keeping Accounting concepts and
conventions will be followed by all without any difference. On the other hand,
various firms follow various methods of reporting and interpretation in accounting.
3. Final Result: In Book-Keeping it is not possible to know the final result of
business every year,

2.1 Meaning of Accounting

Thus, book-keeping is an art of recording the business transactions in the
books of original entry and the ledges. Accountancy begins where Book-keeping
ends. Accountancy means the compilation of accounts in such a way that one is in a
position to know the state of affairs of the business. The work of an accountant is to
analyze, interpret and review the accounts and draw conclusion with a view to
guide the management in chalking out the future policy of the business.
2.2 Definition of Accounting:
Smith and Ashburne: “Accounting is a means of measuring and reporting the
results of economic activities.”
R.N. Anthony: “Accounting system is a means of collecting summarizing, analyzing
and reporting in monetary terms, the information about the business.
American Institute of Certified Public Accountants (AICPA): “The art of
recording, classifying and summarizing in a significant manner and in terms of
money transactions and events, which are in part at least, of a financial character
and interpreting the results thereof.”
Thus, accounting is an art of identifying, recording, summarizing and
interpreting business transactions of financial nature. Hence accounting is the
Language of Business.

2.3 Branches of Accounting:

The important branches of accounting are:
1. Financial Accounting: The purpose of Accounting is to ascertain the
financial results i.e. profit or loss in the operations during a specific period.
It is also aimed at knowing the financial position, i.e. assets, liabilities and
equity position at the end of the period. It also provides other relevant
information to the management as a basic for decision-making for planning
and controlling the operations of the business.
2. Cost Accounting: The purpose of this branch of accounting is to ascertain
the cost of a product / operation / project and the costs incurred for
carrying out various activities. It also assist the management in controlling
the costs. The necessary data and information are gatherr4ed form financial
and other sources.
3. Management Accounting: Its aim to assist the management in taking
correct policy decision and to evaluate the impact of its decisions and

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 actions. The data required for this purpose are drawn accounting and cost-
accounting.
4. Inflation Accounting: It is concerned with the adjustment in the values of
assets and of profit in light of changes in the price level. In a way it is
concerned with the overcoming of limitations that arise in financial
statements on account of the cost assumption (i.e recording of the assets
at their historical or original cost) and the assumption of stable monetary
unit.
5. Human Resource Accounting: It is a branch of accounting which seeks
to report and emphasize the importance of human resources in a
company’s earning process and total assets. It is concerned with the
process of identifying and measuring data about human resources and
communicating this information to interested parties. In simple words, it is
accounting for people as organizational resources.

3. FUNCTIONS OF AN ACCOUNTANT
The job of an accountant involves the following types of accounting works :
1. Designing Work: It includes the designing of the accounting system, basis
for identification and classification of financial transactions and events,
forms, methods, procedures, etc.
2. Recording Work: The financial transactions are identified, classified and
recorded in appropriate books of accounts according to principles. This is
“Book Keeping”. The recording of transactions tends to be mechanical and
repetitive.
3. Summarizing Work: The recorded transactions are summarized into
significant form according to generally accepted accounting principles. The
work includes the preparation of profit and loss account, balance sheet. This
phase is called ‘preparation of final accounts’
4. Analysis and Interpretation Work: The financial statements are analyzed
by using ratio analysis, break-even analysis, funds flow and cash flow
analysis.
5. Reporting Work: The summarized statements along with analysis and
interpretation are communicated to the interested parties or whoever has
the right to receive them. For Ex. Share holders. In addition, the accou8nting
departments have to prepare and send regular reports so as to assist the
management in decision making. This is ‘Reporting’.
6. Preparation of Budget: The management must be able to reasonably
estimate the future requirements and opportunities. As an aid to this
process, the accountant has to prepare budgets, like cash budget, capital
budget, purchase budget, sales budget etc. this is ‘Budgeting’.
7. Taxation Work: The accountant has to prepare various statements and
returns pertaining to income-tax, sales-tax, excise or customs duties etc.,
and file the returns with the authorities concerned.

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 8. Auditing : It involves a critical review and verification of the books of
accounts statements and reports with a view to verifying their accuracy. This
is ‘Auditing’

This is what the accountant or the accounting department does. A

person may be placed in any part of Accounting Department or MIS
(Management Information System) Department or in small organization, the
same person may have to attend to all this work.

5. ADVANTAGES FROM ACCOUNTING

The role of accounting has changed from that of a mere record keeping
during the 1st decade of 20th century of the present stage, which it is accepted as
information system and decision making activity. The following are the advantages
of accounting.

1. Provides for systematic records: Since all the financial transactions are
recorded in the books, one need not rely on memory. Any information required
is readily available from these records.
2. Facilitates the preparation of financial statements: Profit and loss
accountant and balance sheet can be easily prepared with the help of the
information in the records. This enables the trader to know the net result of
business operations (i.e. profit / loss) during the accounting period and the
financial position of the business at the end of the accounting period.
3. Provides control over assets: Book-keeping provides information regarding
cash in had, cash at bank, stock of goods, accounts receivables from various
parties and the amounts invested in various other assets. As the trader knows
the values of the assets he will have control over them.
4. Provides the required information: Interested parties such as owners,
lenders, creditors etc., get necessary information at frequent intervals.
5. Comparative study: One can compare the present performance of the
organization with that of its past. This enables the managers to draw useful
conclusion and make proper decisions.
6. Less Scope for fraud or theft: It is difficult to conceal fraud or theft etc.,
because of the balancing of the books of accounts periodically. As the work is
divided among many persons, there will be check and counter check.
7. Tax matters: Properly maintained book-keeping records will help in the
settlement of all tax matters with the tax authorities.
8. Ascertaining Value of Business: The accounting records will help in
ascertaining the correct value of the business. This helps in the event of sale
or purchase of a business.
9. Documentary evidence: Accounting records can also be used as an evidence
in the court to substantiate the claim of the business. These records are based

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 on documentary proof. Every entry is supported by authentic vouchers. As
such, Courts accept these records as evidence.
10. Helpful to management: Accounting is useful to the management in
various ways. It enables the management to assess the achievement of its
performance. The weakness of the business can be identified and corrective
measures can be applied to remove them with the helps accounting.

6. LIMITATIONS OF ACCOUNTING

The following are the limitations of accounting.

1. Does not record all events: Only the transactions of a financial character
will be recorded under book-keeping. So it does not reveal a complete
picture about the quality of human resources, locational advantage, business
contacts etc.
2. Does not reflect current values: The data available under book-keeping
is historical in nature. So they do not reflect current values. For instance, we
record the value of stock at cost price or market price, which ever is less. In
case of, building, machinery etc., we adopt historical cost as the basis.
Infact, the current values of buildings, plant and machinery may be much
more than what is recorded in the balance sheet.
3. Estimates based on Personal Judgment: The estimate used for
determining the values of various items may not be correct. For example,
debtor are estimated in terms of collectability, inventories are based on
marketability, and fixed assets are based on useful working life. These
estimates are based on personal judgment and hence sometimes may not be
correct.
4. Inadequate information on costs and Profits: Book-keeping only
provides information about the overall profitability of the business. No
information is given about the cost and profitability of different activities of
products or divisions.
7. BASIC ACCOUNTING CONCEPTS

Accounting has been evolved over a period of several centuries. During this
period, certain rules and conventions have been adopted. They serve as guidelines
in identifying the events and transactions to be accounted for measuring, recording,
summarizing and reporting them to the interested parties. These rules and
conventions are termed as Generally Accepted Accounting Principles. These
principles are also referred as standards, assumptions, concepts, conventions
doctrines, etc. Thus, the accounting concepts are the fundamental ideas or basic
assumptions underlying the theory and practice of financial accounting. They are
the broad working rules for all accounting activities developed and accepted by the
accounting profession.

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Basic accounting concepts may be classified into two broad categories.
1. Concept to be observed at the time of recording transactions.(Recording
Stage).
2. Concept to be observed at the time of preparing the financial accounts
(Reporting Stage)
BOOK KEEPING AND ACCOUNTING:
According to G.A.Lee the Accounting system has two stages.
First stage is Book keeping and the second stage is accounting.

[A]. BOOK KEEPING:

Book keeping involves the chronological recording of financial transactions in
a set of books in a systematic manner. “Book keeping is the system of
recording Business transactions for the purpose of providing reliable
information to the owners and managers about the state and prospect of
the Business concepts”.
Thus Book keeping is an art of recording business transactions in the books
of original entry and the ledges.

[B]. ACCOUNTING: Accounting begins where the Bookkeeping ends

1. SMITH AND ASHBUNNE: Accounting means “measuring and reporting the results
ofeconomic activities”.
2. R.N ANTHONY: Accounting is a system of “collecting, summarizing, Analyzing
and reporting in monster terms, the information about the Business”.
3. ICPA: Recording, classifying and summarizing is a significant manner and in
terms of money transactions and events, which are in part at least, of a financial
character and interpreting the results there.

Thus accounting is an art of recording, classifying, summarizing and interpreting

business transactions of financial nature. Hence accounting is the “Language of
Business”.

ADVANTAGE OF ACCOUNTING

The following are the advantages of Accounting…………

1. PROVIDES FOR SYSTEMATIC RECORDS: Since all the financial transactions

are recorded in the books, one need not rely on memory. Any information
required is readily available from these records.

2. FACILITATES THE PRPARATION OF FINANCIAL STATEMENTS: Profit and Loss

account and balance sheet can be easily prepared with the help of the

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 information in the records. This enables the trader to know the net result of
Business operations (i.e. profit/loss) during the accounting period and the
financial position of the business at the end of the accounting period.

3. PROVIDES CONTROL OVER ASSETS: Book keeping provides information

regarding cash in hand, cash at hand, stack of goods, accounts receivable
from various parties and the amounts invested in various other assets. As
the trader knows the values of the assets he will have control over them.

4. PROVIES THE REQUIRED INFORMATION: Interested parties such as owners,

lenders, creditors etc, get necessary information at frequent intervals.

5. COMPARITIVE STUDY: One can compare present performance of the

organization with that of its past. This enables the managers to draw useful
conclusions and make proper decisions.

6. LESS SCOPE FOR FRAUD OR THEFT: It is difficult to conceal fraud or theft

etc. because of the balancing of the books of accounts periodically. As the
work is divided among many persons, there will be check and counter check.

7. TAX MALTERS: Properly maintained Book keeping records will help in the
settlement of all tax matters with the tax authorities.

8. ASCERTAINING VALUE OF BUSINESS: The accounting records will help in

ascertaining the correct value of the Business. This helps in the event of sale
or purchase of a business.

9. DOCUMENTARY EVIDENCE: Accounting records can also be used as evidence

in the court of substantial the claim of the Business. Thus records are based
on documentary proof. Authentic vouchers support every entry. As such,
courts accept these records as evidence.

10.HELPFUL TO MANAGEMENT: Accounting is useful to the management in

various ways. It enables the management to assess the achievement of its
performance. The weaknesses of the business can be identified and
corrective measures can be applied to remove them with the help of
accounting.

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 LIMITATIONS OF ACCOUNTING

The following are the limitations of accounting…………..

1.DOES NOT RECORD ALL EVENTS: Only the transactions of a financial

character will be recorded under book keeping. So it does not reveal a complete
picture about the quality of human resources, locational advantages, business
contacts etc.

2.DOES NOT REFLECT CURRENT VLAUES: The data available under book
keeping is historical in nature. So they do not reflect current values. For instance
we record the values of stock at cost price or market price, whichever is less. In
case of building, machinery etc., we adapt historical case as the basis. Infact,
the current values of Buildings, plant and machinery may be much more than
what is recorded in the balance sheet.

3. ESTIMATES BASED ON PERSONAL JUDGEMENT: The estimates used for

determining the values of various items may not be correct. For example,
debtors are estimated in terms of collectibles, inventories are based on
marketability and fixed assets are based on useful working life. These estimates
are based on personal judgment and hence sometimes may not be correct.

4. INADEQUATE INFORMATION ON COSTS AND PROFITS: Book keeping

only provides information about overall profitability of the business. No
information is given about the cost and profitability of different activities of
products or divisions.

BASIC ACCOUNTING CONCEPTS

Accounting is a system evolved to achieve a set of objectives. In order to

achieve the goals, we need a set of rules or guidelines. These guidelines are termed
here as “BASIC ACCOUNTINGONCEPTS”. The term concept means an idea or
thought. Basic accounting concepts are the fundamental ideas or basic assumptions
underlying the theory and profit of FINANCIAL ACCOUNTING. These concepts help
in bringing about uniformity in the practice of accounting. In accountancy following
concepts are quite popular.
1. BUSINESS ENTITY CONEPT: In this concept “Business is treated as separate
from the proprietor”. All the Transactions recorded in the book of Business and not
in the books of proprietor. The proprietor is also treated as a creditor for the
Business.

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2. GOING CONCERN CONCEPT: This concept relates with the long life of
Business. The assumption is that business will continue to exist for unlimited period
unless it is dissolved due to some reasons or the other.

3. MONEY MEASUREMENT CONCEPT: In this concept “Only those transactions

are recorded in accounting which can be expressed in terms of money, those
transactions which cannot be expressed in terms of money are not recorded in the
books of accounting”.

4. COST CONCEPT: Accounting to this concept, can asset is recorded at its cost in
the books of account. i.e., the price, which is paid at the time of acquiring it. In
balance sheet, these assets appear not at cost price every year, but depreciation is
deducted and they appear at the amount, which is cost, less classification.

5. ACCOUNTING PERIOD CONCEPT: every Businessman wants to know the

result of his investment and efforts after a certain period. Usually one-year period is
regarded as an ideal for this purpose. This period is called Accounting Period. It
depends on the nature of the business and object of the proprietor of business.

6. DUAL ASCEPT CONCEPT: According to this concept “Every business

transactions has two aspects”, one is the receiving benefit aspect another one is
giving benefit aspect. The receiving benefit aspect is termed as “DEBIT”, where as
the giving benefit aspect is termed as “CREDIT”. Therefore, for every debit, there
will be corresponding credit.

7. MATCHING COST CONCEPT: According to this concept “The expenses incurred

during an accounting period, e.g., if revenue is recognized on all goods sold during
a period, cost of those good sole should also
Be charged to that period.

8. REALISATION CONCEPT: According to this concept revenue is recognized

when a sale is made. Sale is Considered to be made at the point when the property
in goods posses to the buyer and he becomes legally liable to pay.

ACCOUNTING CONVENTIONS
Accounting is based on some customs or usages. Naturally accountants here
to adopt that usage or custom. They are termed as convert conventions in
accounting. The following are some of the important accounting conventions.

1.FULL DISCLOSURE: According to this convention accounting reports should

disclose fully and fairly the information. They purport to represent. They should be
prepared honestly and sufficiently disclose information which is if material interest

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to proprietors, present and potential creditors and investors. The companies ACT,
1956 makes it compulsory to provide all the information in the prescribed form.

2.MATERIALITY: Under this convention the trader records important factor about
the commercial activities. In the form of financial statements if any unimportant
information is to be given for the sake of clarity it will be given as footnotes.

3.CONSISTENCY: It means that accounting method adopted should not be

changed from year to year. It means that there should be consistent in the
methods or principles followed. Or else the results of a year
Cannot be conveniently compared with that of another.

4. CONSERVATISM: This convention warns the trader not to take unrealized

income in to account. That is why the practice of valuing stock at cost or market
price, whichever is lower is in vague. This is the policy of “playing safe”; it takes in
to consideration all prospective losses but leaves all prospective profits.

KEY WORDS IN BOOK-KEEPING

1.TRANSACTIONS: Any sale or purchase of goods of services is called the

transaction. Transactions are two types.
 Cash transaction: cash transaction is one where cash receipt or payment is
involved in the exchange.
 Credit transaction: Credit transaction will not have cash, either received or
paid, for something given or received respectively.

2. GOODS: Fill those things which a firm purchases for resale are called
goods.

3.PURCHASES: Purchases means purchase of goods, unless it is stated

otherwise it also represents the Goods purchased.

4.SALES: Sales means sale of goods, unless it is stated otherwise it also

represents these goods sold.

5.EXPENSES: Payments for the purchase of goods as services are known as

expenses.

6.REVENUE: Revenue is the amount realized or receivable from the sale of

goods or services.

7.ASSETS: The valuable things owned by the business are known as assets.
These are the properties Owned by the business.

8.LIABILITIES: Liabilities are the obligations or debts payable by the enterprise

in future in the term of money or goods.

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 9. DEBTORS: Debtors means a person who owes money to the trader.

10. CREDITORS: A creditor is a person to whom something is owned by the

business.

11.DRAWINGS: cash or goods withdrawn by the proprietor from the Business

for his personal or Household is termed to as “drawing”.
12.RESERVE: An amount set aside out of profits or other surplus and designed
to meet contingencies.

13.ACCOUNT: A summarized statements of transactions relating to a particular

person, thing, Expense or income.

14.DISCOUNT: There are two types of discounts..

a. cash discount: An allowable made to encourage frame payment or before the
expiration of the period allowed for credit.
b. Trade discount: A deduction from the gross or catalogue price allowed to
traders who buys them for resale.

CLASSIFICATION OF BUSINESS TRANSACTIONS

All business transactions are classified into three categories:

1.Those relating to persons
2.Those relating to property(Assets)
3.Those relating to income & expenses
Thus, three classes of accounts are maintained for recording all business
transactions. They are:
1.Personal accounts
2.Real accounts
3.Nominal accounts

1.Personal Accounts: Accounts which are transactions with persons are called
“Personal Accounts”. A separate account is kept on the name of each person for
recording the benefits received from ,or given to the person in the course of
dealings with him.
E.g.: Krishna’s A/C, Gopal’s A/C, SBI A/C, Nagarjuna Finance Ltd.A/C, ObulReddy
& Sons A/C , HMT Ltd. A/C, Capital A/C, Drawings A/C etc.

2.Real Accounts: The accounts relating to properties or assets are known as

“Real Accounts” .Every business needs assets such as machinery , furniture etc, for
running its activities .A separate account is maintained for each asset owned by the
business.
E.g.: cash A/C, furniture A/C, building A/C, machinery A/C etc.

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3.NominalAccounts: Accounts relating to expenses, losses, incomes and gains are
known as “Nominal Accounts”. A separate account is maintained for each item of
expenses, losses, income or gain.
E.g.: Salaries A/C, stationery A/C, wages A/C, postage A/C, commission A/C,
interest A/C, purchases A/C, rent A/C, discount A/C, commission received A/C,
interest received A/C, rent received A/C, discount received A/C.

Before recording a transaction, it is necessary to find out which of the

accounts is to be debited and which is to be credited. The following three different
rules have been laid down for the three classes of accounts….

1.Personal Accounts: The account of the person receiving benefit (receiver) is to

be debited and the account of the person giving the benefit (given) is to be
credited.

Rule: “Debit----The Receiver

Credit---The Giver”

2.Real Accounts: When an asset is coming into the business, account of that asset
is to be debited .When an asset is going out of the business, the account of that
asset is to be credited.

Rule: “Debit----What comes in

Credit---What goes out”

3.Nominal Accounts: When an expense is incurred or loss encountered, the

account representing the expense or loss is to be debited . When any income is
earned or gain made, the account representing the income of gain is to be credited.

Rule: “Debit----All expenses and losses

Credit---All incomes and gains”

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JOURNAL

The first step in accounting therefore is the record of all the transactions in
the books of original entry viz., Journal and then posting into ledges.

JOURNAL: The word Journal is derived from the Latin word ‘journ’ which means a
day. Therefore, journal means a ‘day Book’ in day-to-day business transactions are
recorded in chronological order.

Journal is treated as the book of original entry or first entry or prime entry.
All the business transactions are recorded in this book before they are posted in the
ledges. The journal is a complete and chronological(in order of dates) record of
business transactions. It is recorded in a systematic manner. The process of
recording a transaction in the journal is called “JOURNALISING”. The entries made
in the book are called “Journal Entries”.

The proforma of Journal is given below.

Date Particulars L.F. Debit Credit

RS. RS.

1998 Jan Purchases account 10,000/- 10,000/-

1 To cash account
(being goods purchased for cash)

LEDGER

All the transactions in a journal are recorded in a chronological order. After a

certain period, if we want to know whether a particular account is showing a debit
or credit balance it becomes very difficult. So, the ledger is designed to
accommodate the various accounts maintained the trader. It contains the final or
permanent record of all the transactions in duly classified form. “A ledger is a book
which contains various accounts.” The process of transferring entries from journal
to ledger is called “POSTING”.

Posting is the process of entering in the ledger the entries given in the journal.
Posting into ledger is done periodically, may be weekly or fortnightly as per the
convenience of the business. The following are the guidelines for posting
transactions in the ledger.

1. After the completion of Journal entries only posting is to be made in the

ledger.

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 2. For each item in the Journal a separate account is to be opened. Further,
for each new item a new account is to be opened.
3. Depending upon the number of transactions space for each account is to be
determined in the ledger.
4. For each account there must be a name. This should be written in the top of
the table. At the end of the name, the word “Account” is to be added.
5. The debit side of the Journal entry is to be posted on the debit side of the
account, by starting with “TO”.
6. The credit side of the Journal entry is to be posted on the debit side of the
account, by starting with “BY”.

Proforma for ledger: LEDGER BOOK

Particulars account

Date Particulars Lfno Amount Date Particulars Lfno amount

Sales account

Date Particulars Lfno Amount Date Particulars Lfno amount

cash account

Date Particulars Lfno Amount Date Particulars Lfno amount

TRAIL BALANCE

The first step in the preparation of final accounts is the preparation of trail
balance. In the double entry system of book keeping, there will be credit for every
debit and there will not be any debit without credit. When this principle is followed

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in writing journal entries, the total amount of all debits is equal to the total amount
all credits.

A trail balance is a statement of debit and credit balances. It is prepared on a

particular date with the object of checking the accuracy of the books of accounts. It
indicates that all the transactions for a particular period have been duly entered in
the book, properly posted and balanced. The trail balance doesn’t include stock in
hand at the end of the period. All adjustments required to be done at the end of the
period including closing stock are generally given under the trail balance.

DEFINITIONS:
SPICER AND POGLAR: A trail balance is a list of all the balances standing on the
ledger accounts and cash book of a concern at any given date.
J.R.BATLIBOI: A trail balance is a statement of debit and credit balances extracted
from the ledger with a view to test the arithmetical accuracy of the books.

Thus a trail balance is a list of balances of the ledger accounts’ and cash book
of a business concern at any given date.

PROFORMA FOR TRAIL BALANCE:

Trail balance for MR…………………………………… as on …………
NO NAME OF ACCOUNT DEBIT CREDIT
(PARTICULARS) AMOUNT(Rs.) AMOUNT(Rs.)

CAPITAL
Introduction

Finance is the prerequisite to commence and vary on business. It is

rightly said to be the lifeblood of the business. No growth and expansion of
business can take place without sufficient finance. It shows that no business
activity is possible without finance. This is why; every business has to make
plans regarding acquisition and utilization of funds. However efficient a firm may
be in terms of production as well as marketing if it ignores the proper
management of flow of funds it certainly lands in financial crunch and the very
survival of the firm would be at a stake.

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 Function of finance

According to B. O. Wheeler, Financial Management is concerned with the

acquisition and utilization of capital funds in meeting the financial needs and
overall objectives of a business enterprise. Thus the primary function of finance
is to acquire capital funds and put them for proper utilization, with which the
firm’s objectives are fulfilled. The firm should be able to procure sufficient funds
on reasonable terms and conditions and should exercise proper control in
applying them in order to earn a good rate of return, which in turn allows the
firm to reward the sources of funds reasonably, and leaves the firm with good
surplus to grow further. These activities viz. financing, investing and dividend
payment are not sequential they are performed simultaneously and
continuously. Thus, the Financial Management can be broken down in to three
major decisions or functions of finance. They are: (i) the investment decision,
(ii) the financing decision and (iii) the dividend policy decision.

Investment Decision

The investment decision relates to the selection of assets in which funds will
be invested by a firm. The assets as per their duration of benefits, can be
categorized into two groups: (i) long-term assets which yield a return over a
period of time in future (ii) short-term or current assents which in the normal
course of business are convertible into cash usually with in a year. Accordingly,
the asset selection decision of a firm is of two types. The investment in long-
term assets is popularly known as capital budgeting and in short-term assets,
working capital management.

1. Capital budgeting: Capital budgeting – the long – term investment decision

– is probably the most crucial financial decision of a firm. It relates to the
selection of an assent or investment proposal or course of action that
benefits are likely to be available in future over the lifetime of the project.
The long-term investment may relate to acquisition of new asset or
replacement of old assets. Whether an asset will be accepted or not will
depend upon the relative benefits and returns associated with it. The
measurement of the worth of the investment proposals is, therefore, a major
element in the capital budgeting exercise. The second element of the capital
budgeting decision is the analysis of risk and uncertainty as the benefits from
the investment proposals pertain the future, which is uncertain. They have to
be estimated under various assumptions and thus there is an element of risk
involved in the exercise. The return from the capital budgeting decision
should, therefore, be evaluated in relation to the risk associated with it.

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 The third and final element is the ascertainment of a certain norm or
standard against which the benefits are to be judged. The norm is known by
different names such as cut-off rate, hurdle rate, required rate, minimum
rate of return and so on. This standard is broadly expressed in terms of the
cost of capital is, thus, another major aspect of the capital; budgeting
decision. In brief, the main elements of the capital budgeting decision are: (i)
The total assets and their composition (ii) The business risk complexion of
the firm, and (iii) concept and measurement of the cost of capital.

2. Working Capital Management: Working capital management is concerned

with the management of the current assets. As we know, the short-term
survival is a pre-requisite to long-term success. The major thrust of working
capital management is the trade-off between profitability and risk (liquidity),
which are inversely related to each other. If a firm does not have adequate
working capital it may not have the ability to meet its current obligations and
thus invite the risk of bankrupt. One the other hand if the current assets are
too large the firm will be loosing the opportunity of making a good return and
thus may not serve the requirements of suppliers of funds. Thus, the
profitability and liquidity are the two major dimensions of working capital
management. In addition, the individual current assets should be efficiently
managed so that neither inadequate nor unnecessary funds are locked up.

Finance Decision

The second major decision involved in financial management is the

financing decision, which is concerned with the financing – mix or capital
structure of leverage. The term capital structure refers to the combination of
debt (fixed interest sources of financing) and equity capital (variable – dividend
securities/source of funds). The financing decision of a firm relates to the choice
of the proportion of these sources to finance the investment requirements. A
higher proportion of debt implies a higher return to the shareholders and also
the higher financial risk and vice versa. A proper balance between debt and
equity is a must to ensure a trade – off between risk and return to the
shareholders. A capital structure with a reasonable proportion of debt and equity
capital is called the optimum capital structure.
The second aspect of the financing decision is the determination of an
appropriate capital structure, which will result, is maximum return to the
shareholders and in turn maximizes the worth of the firm. Thus, the financing
decision covers two inter-related aspects: (a) capital structure theory, and (b)
capital structure decision.

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 Dividend Policy decision

The third major decision of financial management is relating to dividend

policy. The firm has two alternatives with regard to management of profits of a
firm. They can be either distributed to the shareholder in the form of dividends
or they can be retained in the business or even distribute some portion and
retain the remaining. The course of action to be followed is a significant element
in the dividend decision. The dividend pay out ratio i. e. the proportion of net
profits to be paid out to the shareholders should be in tune with the investment
opportunities available within the firm. The second major aspect of the dividend
decision is the study of factors determining dividend policy of a firm in practice.

WORKING CAPITAL ANALYSIS

Finance is required for two purpose viz. for it establishment and to carry out
the day-to-day operations of a business. Funds are required to purchase the fixed
assets such as plant, machinery, land, building, furniture, etc, on long-term basis.
Investments in these assets represent that part of firm’s capital, which is blocked
on a permanent of fixed basis and is called fixed capital. Funds are also needed for
short-term purposes such as the purchase of raw materials, payment of wages and
other day-to-day expenses, etc. and these funds are known as working capital. In
simple words working capital refers that part of the firm’s capital, which is required
for financing short term or current assets such as cash, marketable securities,
debtors and inventories. The investment in these current assets keeps revolving
and being constantly converted into cash and which in turn financed to acquire
current assets. Thus the working capital is also known as revolving or circulating
capital or short-term capital.

Concept of working capital

There are two concepts of working capital:

1. Gross working capital

2. Net working capital

Gross working capital:

In the broader sense, the term working capital refers to the gross working
capital. The notion of the gross working capital refers to the capital invested in total
current assets of the enterprise. Current assets are those assets, which in the
ordinary course of business, can be converted into cash within a short period,
normally one accounting year.

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Examples of current assets:

1. Cash in hand and bank balance

2. Bills receivables or Accounts Receivables
3. Sundry Debtors (less provision for bad debts)
4. Short-term loans and advances.
5. Inventories of stocks, such as:
(a) Raw materials
(b) Work – in process
(c) Stores and spares
(d) Finished goods
6. Temporary Investments of surplus funds.
7. Prepaid Expenses
8. Accrued Incomes etc.

Net working capital:

In a narrow sense, the term working capital refers to the net working capital.
Networking capital represents the excess of current assets over current liabilities.

Current liabilities are those liabilities, which are intend to be paid in the
ordinary course of business within a short period, normally one accounting year out
of the current assets or the income of the business. Net working capital may be
positive or negative. When the current assets exceed the current liabilities net
working capital is positive and the negative net working capital results when the
liabilities are more then the current assets.

Examples of current liabilities:

1. Bills payable
2. Sundry Creditors or Accounts Payable.
3. Accrued or Outstanding Expanses.
4. Short term loans, advances and deposits.
5. Dividends payable
6. Bank overdraft
7. Provision for taxation etc.

Classification or kinds of working capital

Working capital may be classified in two ways:

a. On the basis of concept.

b. On the basis of time permanency

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 On the basis of concept, working capital is classified as gross working capital
and net working capital is discussed earlier. This classification is important from
the point of view of the financial manager. On the basis of time, working capital
may be classified as:

1. Permanent or fixed working capital

2. Temporary of variable working capital

1. Permanent or fixed working capital: There is always a minimum level of

current assets, which is continuously required by the enterprise to carry out
its normal business operations and this minimum is known as permanent of
fixed working capital. For example, every firm has to maintain a minimum
level of raw materials, work in process; finished goods and cash balance to
run the business operations smoothly and profitably. This minimum level of
current assets is permanently blocked in current assets. As the business
grows, the requirement of permanent working capital also increases due to
the increases in current assets. The permanent working capital can further be
classified into regular working capital and reserve working capital. Regular
working capital is the minimum amount of working capital required to ensure
circulation of current assets from cash to inventories, from inventories to
receivables and from receivable to cash and so on. Reserve working capital is
the excess amount over the requirement for regular working capital which
may be provided for contingencies that may arise at unstated period such as
strikes, rise in prices, depression etc.
2. Temporary or variable working capital: Temporary or variable working
capital is the amount of working capital, which is required to meet the
seasonal demands and some special exigencies. Thus the variable working
capital can be further classified into seasonal working capital and special
working capital. While seasonal working capital is required to meet certain
seasonal demands, the special working capital is that part of working capital
which is required to meet special exigencies such as launching of extensive
marketing campaigns, for conducting research etc.

Temporary working capital differs from permanent working capital in the

sense that it is required for short periods and cannot be permanently
employed gainfully in the business. Figures given below illustrate the
different between permanent and temporary working capital.

Importance of working capital

Working capital is refereed to be the lifeblood and nerve center of a business.

Working capital is as essential to maintain the smooth functioning of a business as
blood circulation in a human body. No business can run successfully with out an

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adequate amount of working capital. The main advantages of maintaining adequate
amount of working capital are as follows:

1. Solvency of the business: Adequate working capital helps in

maintaining solvency of the business by providing uninterrupted flow
of production.
2. Good will: Sufficient working capital enables a business concern to
make prompt payment and hence helps in creating and maintaining
good will.
3. Easy loans: A concern having adequate working capital, high solvency
and good credit standing can arrange loans from banks and others on
easy and favorable terms.
4. Cash Discounts: Adequate working capital also enables a concern to
avail cash discounts on the purchases and hence it reduces costs.
5. Regular supply of raw materials: Sufficient working capital ensures
regular supply of raw materials and continuous production.
6. Regular payments of salaries wages and other day to
daycommitments: A company which has ample working capital can
make regular payment of salaries, wages and other day to day
commitments which raises the morale of its employees, increases their
efficiency, reduces wastage and cost and enhances production and
profits.
7. Exploitation of favorable market conditions: The concerns with
adequate working capital only can exploit favorable market conditions
such as purchasing its requirements in bulk when the prices are lower.
8. Ability to face crisis: Adequate working capital enables a concern to
face business crisis in emergencies.
9. Quick and regular return on Investments: Every investor wants a
quick and regular return on his investment. Sufficiency of working
capital enables a concern to pay quick and regular dividends to its
investors, as there may not be much pressure to plough back profits.
This gains the confidence of its investors and creates a favorable
market to raise additional funds in the future.
10.High morale: Adequacy of working capital creates an environment of
security, confidence, and high morale and creates overall efficiency in
a business. Every business concern should have adequate working
capital to run its business operations. It should have neither redundant
excess working capital nor inadequate shortage of working capital.
Both, excess as well as short working capital positions are bad for any
business. However, out of the two, it is the inadequacy of working
capital which is more dangerous from the point of view of the firm.

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The need or objectives of working capital

The need for working capital arises mainly due to the time gap between
production and realization of cash. The process of production and sale cannot be
done instantaneously and hence the firm needs to hold the current assets to fill-up
the time gaps. There are time gaps in purchase of raw materials and production;
production and sales: and sales and realization of cash. The working capital is
needed mainly for the following purposes:

1. For the purchase of raw materials.

2. To pay wages, salaries and other day-to-day expenses and overhead cost
such as fuel, power and office expenses, etc.
3. To meet the selling expenses such as packing, advertising, etc.
4. To provide credit facilities to the customers and
5. To maintain the inventories of raw materials, work-in-progress, stores and
spares and finishes stock etc.

Generally, the level of working capital needed depends upon the time gap
(known as operating cycle) and the size of operations. Greater the size of the
business unit generally, larger will be the requirements of working capital. The
amount of working capital needed also goes on increasing with the growth and
expansion of business. Similarly, the larger the operating cycle, the larger the
requirement for working capital. There are many other factors, which influence the
need of working capital in a business, and these are discussed below in the
following pages.

Factors determining the working capital requirements

There are a large number of factors such as the nature and size of business, the
character of their operations, the length of production cycle, the rate of stock
turnover and the state of economic situation etc. that decode requirement of
working capital. These factors have different importance and influence on firm
differently. In general following factors generally influence the working capital
requirements.

1. Nature or character of business: The working capital requirements of a

firm basically depend upon the nature of its business. Public utility
undertakings like electricity, water supply and railways need very limited
working capital as their sales are on cash and are engaged in provision of
services only. On the other hand, trading firms require more investment in
inventories, receivables and cash and such they need large amount of
working capital. The manufacturing undertakings also require sizable working
capital.

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 2. Size of business or scale of operations: The working capital requirements
of a concern are directly influenced by the size of its business, which may be
measured in terms of scale of operations. Greater the size of a business unit,
generally, larger will be the requirements of working capital. However, in
some cases, even a smaller concern may need more working capital due to
high overhead charges, inefficient use of available resources and other
economic disadvantages of small size.
3. Production policy: If the demand for a given product is subject to wide
fluctuations due to seasonal variations, the requirements of working capital,
in such cases, depend upon the production policy. The production could be
kept either steady by accumulating inventories during stack periods with a
view to meet high demand during the peck season or the production could be
curtailed during the slack season and increased during the peak season. If
the policy is to keep the production steady by accumulating inventories it will
require higher working capital.
4. Manufacturing process/Length of production cycle: In manufacturing
business, the requirements of working capital will be in direct proportion to
the length of manufacturing process. Longer the process period of
manufacture, larger is the amount of working capital required, as the raw
materials and other supplies have to be carried for a longer period.
5. Seasonal variations: If the raw material availability is seasonal, they have
to be bought in bulk during the season to ensure an uninterrupted material
for the production. A huge amount is, thus, blocked in the form of material,
inventories during such season, which give rise to more working capital
requirements. Generally, during the busy season, a firm requires larger
working capital then in the slack season.
6. Working capital cycle: In a manufacturing concern, the working capital
cycle starts with the purchase of raw material and ends with the realization
of cash from the sale of finished products. This cycle involves purchase of
raw materials and stores, its conversion into stocks of finished goods through
work–in progress with progressive increment of labour and service costs,
conversion of finished stock into sales, debtors and receivables and
ultimately realization of cash. This cycle continues again from cash to
purchase of raw materials and so on. In general the longer the operating
cycle, the larger the requirement of working capital.
7. Credit policy: The credit policy of a concern in its dealings with debtors and
creditors influences considerably the requirements of working capital. A
concern that purchases its requirements on credit requires lesser amount of
working capital compared to the firm, which buys on cash. On the other
hand, a concern allowing credit to its customers shall need larger amount of
working capital compared to a firm selling only on cash.
8. Business cycles: Business cycle refers to alternate expansion and
contraction in general business activity. In a period of boom, i.e., when the

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 business is prosperous, there is a need for larger amount of working capital
due to increase in sales. On the contrary, in the times of depression, i.e.,
when there is a down swing of the cycle, the business contracts, sales
decline, difficulties are faced in collection from debtors and firms may have to
hold large amount of working capital.
9. Rate of growth of business: The working capital requirements of a
concern increase with the growth and expansion of its business activities. The
retained profits may provide for a part of working capital but the fast growing
concerns need larger amount of working capital than the amount of
undistributed profits.

SOURCE OF FINANCE

In case of proprietorship business, the individual proprietor generally invests

his own savings to start with, and may borrow money on his personal security or
the security of his assets from others. Similarly, the capital of a partnership from
consists partly of funds contributed by the partners and partly of borrowed funds.
But the company from of organization enables the promoters to raise necessary
funds from the public who may contribute capital and become members (share
holders) of the company. In course of its business, the company can raise loans
directly from banks and financial institutions or by issue of securities (debentures)
to the public. Besides, profits earned may also be reinvested instead of being
distributed as dividend to the shareholders.

Thus for any business enterprise, there are two sources of finance, viz, funds
contributed by owners and funds available from loans and credits. In other words
the financial resources of a business may be own funds and borrowed funds.

Owner funds or ownership capital:

The ownership capital is also known as ‘risk capital’ because every business
runs the risk of loss or low profits, and it is the owner who bears this risk. In the
event of low profits they do not have adequate return on their investment. If losses
continue the owners may be unable to recover even their original investment.
However, in times of prosperity and in the case of a flourishing business the high
level of profits earned accrues entirely to the owners of the business. Thus, after
paying interest on loans at a fixed rate, the owners may enjoy a much higher rate
of return on their investment. Owners contribute risk capital also in the hope that
the value of the firm will appreciate as a result of higher earnings and growth in the
size of the firm.

The second characteristic of this source of finance is that ownership capital

remains permanently invested in the business. It is not refundable like loans or

25 | P a g e
borrowed capital. Hence a large part of it is generally used for a acquiring long –
lived fixed assets and to finance a part of the working capital which is permanently
required to hold a minimum level of stock of raw materials, a minimum amount of
cash, etc.

Another characteristic of ownership capital related to the management of

business. It is on the basis of their contribution to equity capital that owners can
exercise their right of control over the management of the firm. Managers cannot
ignore the owners in the conduct of business affairs. The sole proprietor directly
controls his own business. In a partnership firm, the active partner will take part in
the management of business. A company is managed by directors who are elected
by the members (shareholders).

Merits:

Arising out of its characteristics, the advantages of ownership capital may be

briefly stated as follows:

1. It provides risk capital

2. It is a source of permanent capital
3. It is the basis on which owners ‘acquire their right of control over
management
4. It does not require security of assets to be offered to raise ownership capital

Limitations:

There are also certain limitations of ownership capital as a source of finance.

These are:

The amount of capital, which may be raised as owners fund depends on the
number of persons, prepared to take the risks involved. In a partnership confer, a
few persons cannot provide ownership capital beyond a certain limit and this
limitation is more so in case of proprietary form of organization.

A joint stock company can raise large amount by issuing shares to the public.
Bus it leads to an increased number of people having ownership interest and right
of control over management. This may reduce the original investors’ power of
control over management. Being a permanent source of capital, ownership funds
are not refundable as long as the company is in existence, even when the funds
remain idle. A company may find it difficult to raise additional ownership capital
unless it has high profit-earning capacity or growth prospects. Issue of additional
shares is also subject to so many legal and procedural restrictions.

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 Borrowed funds and borrowed capital: It includes all funds available by way
of loans or credit. Business firms raise loans for specified periods at fixed rates of
interest. Thus borrowed funds may serve the purpose of long-term, medium-term
or short-term finance. The borrowing is generally at against the security of assets
from banks and financial institutions. A company to borrow the funds can also issue
various types of debentures.

Interest on such borrowed funds is payable at half yearly or yearly but the
principal amount is being repaid only at the end of the period of loan. These
interest and principal payments have to be met even if the earnings are low or
there is loss. Lenders and creditors do not have any right of control over the
management of the borrowing firm. But they can sue the firm in a law court if there
is default in payment, interest or principal back.

Merits:

From the business point of view, borrowed capital has several merits.
1. It does not affect the owner’s control over management.
2. Interest is treated as an expense, so it can be charged against income and
amount of tax payable thereby reduced.
3. The amount of borrowing and its timing can be adjusted according to
convenience and needs, and
4. It involves a fixed rate of interest to be paid even when profits are very high,
thus owners may enjoy a much higher rate of return on investment then the
lenders.

Limitations:

There are certain limitations, too in case of borrowed capacity. Payment of

interest and repayment of loans cannot be avoided even if there is a loss. Default in
meeting these obligations may create problems for the business and result in
decline of its credit worthiness. Continuing default may even lead to insolvency of
firm.

Secondly, it requires adequate security to be offered against loans. Moreover,

high rates of interest may be charged if the firm’s ability to repay the loan in
uncertain.

Source of Company Finance

Based upon the time, the financial resources may be classified into (1)
sources of long term (2) sources of short – term finance. Some of these sources
also serve the purpose of medium – term finance.

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I. The source of long – term finance are:

1. Issue of shares
2. Issue debentures
3. Loan from financial institutions
4. Retained profits and
5. Public deposits

II. Sources of Short-term Finance are:

1. Trade credit
2. Bank loans and advances and
3. Short-term loans from finance companies.

Sources of Long Term Finance

1. Issue of Shares: The amount of capital decided to be raised from members

of the public is divided into units of equal value. These units are known as
share and the aggregate values of shares are known as share capital of the
company. Those who subscribe to the share capital become members of the
company and are called shareholders. They are the owners of the company.
Hence shares are also described as ownership securities.
2. Issue of Preference Shares: Preference share have three distinct
characteristics. Preference shareholders have the right to claim dividend at a
fixed rate, which is decided according to the terms of issue of shares.
Moreover, the preference dividend is to be paid first out of the net profit. The
balance, it any, can be distributed among other shareholders that is, equity
shareholders. However, payment of dividend is not legally compulsory. Only
when dividend is declared, preference shareholders have a prior claim over
equity shareholders.

Depending upon the terms of conditions of issue, different types of

preference shares may be issued by a company to raises funds. Preference
shares may be issued as:

1. Cumulative or Non-cumulative
2. Participating or Non-participating
3. Redeemable or Non-redeemable, or as
4. Convertible or non-convertible preference shares.

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Merits:

Many companies due to the following reasons prefer issue of preference

shares as a source of finance.

1. It helps to enlarge the sources of funds.

2. Some financial institutions and individuals prefer to invest in preference
shares due to the assurance of a fixed return.
3. Dividend is payable only when there are profits.
4. If does not affect the equity shareholders’ control over management

Limitations:

The limitations of preference shares relates to some of its main features:

1. Dividend paid cannot be charged to the company’s income as an expense;

hence there is no tax saving as in the case of interest on loans.
2. Even through payment of dividend is not legally compulsory, if it is not paid
or arrears accumulate there is an adverse effect on the company’s credit.
3. Issue of preference share does not attract many investors, as the return is
generally limited and not exceed the rates of interest on loan. On the other
than, there is a risk of no dividend being paid in the event of falling income.

1. Issue of Equity Shares: The most important source of raising long-term capital
for a company is the issue of equity shares. In the case of equity shares there is no
promise to shareholders a fixed dividend. But if the company is successful and the
level profits are high, equity shareholders enjoy very high returns on their
investment. This feature is very attractive to many investors even through they run
the risk of having no return if the profits are inadequate or there is loss. They have
the right of control over the management of the company and their liability is
limited to the value of shares held by them.

From the above it can be said that equity shares have three distinct characteristics:

1. The holders of equity shares are the primary risk bearers. It is the issue of
equity shares that mainly provides ‘risk capital’, unlike borrowed capital.
Even compared with preference capital, equity shareholders are to bear
ultimate risk.
2. Equity shares enable much higher return sot be earned by shareholders
during prosperity because after meeting the preference dividend and interest
on borrowed capital at a fixed rate, the entire surplus of profit goes to equity
shareholders only.

29 | P a g e
 3. Holders of equity shares have the right of control over the company.
Directors are elected on the vote of equity shareholders.

Merits:

From the company’ point of view; there are several merits of issuing equity
shares to raise long-term finance.

1. It is a source of permanent capital without any commitment of a fixed return

to the shareholders. The return on capital depends ultimately on the
profitability of business.
2. It facilities a higher rate of return to be earned with the help borrowed funds.
This is possible due to two reasons. Loans carry a relatively lower rate of
interest than the average rate of return on total capital. Secondly, there is
tax saving as interest paid can be charged to income as a expense before tax
calculation.
3. Assets are not required to give as security for raising equity capital. Thus
additional funds can be raised as loan against the security of assets.

Limitations:

Although there are several advantages of issuing equity shares to raise long-
term capital.

1. The risks of fluctuating returns due to changes in the level of earnings of the
company do not attract many people to subscribe to equity capital.
2. The value of shares in the market also fluctuate with changes in business
conditions, this is another risk, which many investors want to avoid.

2. Issue of Debentures:
When a company decides to raise loans from the public, the amount of loan
is dividend into units of equal. These units are known as debentures. A debenture is
the instrument or certificate issued by a company to acknowledge its debt. Those
who invest money in debentures are known as ‘debenture holders’. They are
creditors of the company. Debentures are therefore called ‘creditor ship’ securities.
The value of each debentures is generally fixed in multiplies of 10 like Rs. 100 or
Rs. 500, or Rs. 1000.

Debentures carry a fixed rate of interest, and generally are repayable after a
certain period, which is specified at the time of issue. Depending upon the terms
and conditions of issue there are different types of debentures. There are:

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 a. Secured or unsecured Debentures and
b. Convertible of Non convertible Debentures.

It debentures are issued on the security of all or some specific assets of the
company, they are known as secured debentures. The assets are mortgaged in
favor of the debenture holders. Debentures, which are not secured by a charge or
mortgage of any assets, are called unsecured debentures. The holders of these
debentures are treated as ordinary creditors.

Sometimes under the terms of issue debenture holders are given an option to
covert their debentures into equity shares after a specified period. Or the terms of
issue may lay down that the whole or part of the debentures will be automatically
converted into equity shares of a specified price after a certain period. Such
debentures are known as convertible debentures. If there is no mention of
conversion at the time of issue, the debentures are regarded as non-convertible
debentures.

Merits:
Debentures issue is a widely used method of raising long-term finance by
companies, due to the following reasons.

1. Interest payable on Debentures can be fixed at low rates than rate of return
on equity shares. Thus Debentures issue is a cheaper source of finance.
2. Interest paid can be deducted from income tax purpose; there by the amount
of tax payable is reduced.
3. Funds raised for the issue of debentures may be used in business to earn a
much higher rate of return then the rate of interest. As a result the equity
shareholders earn more.
4. Another advantage of debenture issue is that funds are available from
investors who are not entitled to have any control over the management of
the company.
5. Companies often find it convenient to raise debenture capital from financial
institutions, which prefer to invest in debentures rather than in shares. This
is due to the assurance of a fixed return and repayment after a specified
period.

Limitations:
Debenture issue as a source of finance has certain limitations too.

1. It involves a fixed commitment to pay interest regularly even when the

company has low earnings or incurring losses.
2. Debentures issue may not be possible beyond a certain limit due to the
inadequacy of assets to be offered as security.

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Methods of Issuing Securities: The firm after deciding the amount to be raised
and the type of securities to be issued, must adopt suitable methods to offer the
securities to potential investors. There are for common methods followed by
companies for the purpose.

When securities are offered to the general public a document known as

Prospectus, or a notice, circular or advertisement is issued inviting the public to
subscribe to the securities offered thereby all particulars about the company and
the securities offered are made to the public. Brokers are appointed and one or
more banks are authorized to collect subscription.

3. Loans from financial Institutions:

Government with the main object of promoting industrial development has set
up a number of financial institutions. These institutions play an important role as
sources of company finance. Besides they also assist companies to raise funds from
other sources. These institutions provide medium and long-term finance to
industrial enterprises at a reason able rate of interest. Thus companies may obtain
direct loan from the financial institutions for expansion or modernization of existing
manufacturing units or for starting a new unit. Often, the financial institutions
subscribe to the industrial debenture issue of companies some of the institutions
(ICICI) and (IDBI) also subscribe to the share issued by companies.

4. Retained Profits:

Successful companies do not distribute the whole of their profits as dividend

to shareholders but reinvest a part of the profits. The amount of profit reinvested in
the business of a company is known as retained profit. It is shown as reserve in the
accounts. The surplus profits retained and reinvested may be regarded as an
internal source of finance. Hence, this method of financing is known as self-
financing. It is also called sloughing back of profits.

Since profits belong to the shareholders, the amount of retained profit is

treated as ownership fund. It serves the purpose of medium and long-term finance.
The total amount of ownership capital of a company can be determined by adding
the share capital and accumulated reserves.

Merits:

This source of finance is considered to be better than other sources for the
following reasons.

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 1. As an internal source, it is more dependable than external sources. It is not
necessary to consider investor’s preference.
2. Use of retained profit does not involve any cost to be incurred for raising the
funds. Expenses on prospectus, advertising, etc, can be avoided.
3. There is no fixed commitment to pay dividend on the profits reinvested. It is
a part of risk capital like equity share capital.
4. Control over the management of the company remains unaffected, as there
is no addition to the number of shareholder.
5. It does not require the security of assets, which can be used for raising
additional funds in the form of loan.

Limitations:

However, there are certain limitations on the part of retained profit.

1. Only well established companies can be avail of this sources of finance. Even
for such companies retained profits cannot be used to an unlimited extent.
2. Accumulation of reserves often attract competition in the market,
3. With the increased earnings, shareholders expect a high rate of dividend to
be paid.
4. Growth of companies through internal financing may attract government
restrictions as it leads to concentration of economic power.

5. Public Deposits:

An important source of medium – term finance which companies make use of

is public deposits. This requires advertisement to be issued inviting the general
public of deposits. This requires advertisement to be issued inviting the general
public to deposit their savings with the company. The period of deposit may extend
up to three yeas. The rate of interest offered is generally higher than the interest
on bank deposits. Against the deposit, the company mentioning the amount, rate of
interest, time of repayment and such other information issues a receipt.

Since the public deposits are unsecured loans, profitable companies enjoying
public confidence only can be able to attract public deposits. Even for such
companies there are rules prescribed by government limited its use.

Sources of Short Term Finance

The major sources of short-term finance are discussed below:

1. Trade credit: Trade credit is a common source of short-term finance

available to all companies. It refers to the amount payable to the suppliers of

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 raw materials, goods etc. after an agreed period, which is generally less than
a year. It is customary for all business firms to allow credit facility to their
customers in trade business. Thus, it is an automatic source of finance. With
the increase in production and corresponding purchases, the amount due to
the creditors also increases. Thereby part of the funds required for increased
production is financed by the creditors. The more important advantages of
trade credit as a source of short-term finance are the following:

It is readily available according to the prevailing customs. There are no

special efforts to be made to avail of it. Trade credit is a flexible source of
finance. It can be easily adjusted to the changing needs for purchases.

Where there is an open account for any creditor failure to pay the
amounts on time due to temporary difficulties does not involve any serious
consequence Creditors often adjust the time of payment in view of continued
dealings. It is an economical source of finance.

However, the liability on account of trade credit cannot be neglected.

Payment has to be made regularly. If the company is required to accept a bill
of exchange or to issue a promissory note against the credit, payment must
be made on the maturity of the bill or note. It is a legal commitment and
must be honored; otherwise legal action will follow to recover the dues.

2. Bank loans and advances: Money advanced or granted as loan by

commercial banks is known as bank credit. Companies generally secure bank
credit to meet their current operating expenses. The most common forms are
cash credit and overdraft facilities. Under the cash credit arrangement the
maximum limit of credit is fixed in advance on the security of goods and
materials in stock or against the personal security of directors. The total
amount drawn is not to exceed the limit fixed. Interest is charged on the
amount actually drawn and outstanding. During the period of credit, the
company can draw, repay and again draw amounts with in the maximum
limit. In the case of overdraft, the company is allowed to overdraw its current
account up to the sanctioned limit. This facility is also allowed either against
personal security or the security of assets. Interest is charged on the amount
actually overdrawn, not on the sanctioned limit.

3. Short term loans from finance companies: Short-term funds may be

available from finance companies on the security of assets. Some finance
companies also provide funds according to the value of bills receivable or
amount due from the customers of the borrowing company, which they take
over.

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