Financing of Business: Retention of Profit, Lease Financing, Foreign Investments and Global Depository Receipt

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Retention of Profit

Like an individual, companies also set aside a part of their profits to meet future requirements of capital. The portion of the profits, which is not distributed among the shareholders but is retained and reinvested in business, is called retained earnings or ploughing back of profits. As per Indian Companies Act 1956, companies are required to transfer a part of their profits in reserves like General Reserve, Debenture Redemption Reserve and Dividend Equalisation Reserve etc. These reserves can be used to meet long-term financial requirements like purchase of fixed assets, renovation and modernisations etc. This method of financing long-term financial requirement is also called as Retention of Profit.

Image of Retention Of Profit/Merits/Limitations

Image of Retention of Profit/Merits/Limitations

Merits

Following are the benefits of retention of profit.

Cheap Source of Capital

No expenses are incurred when capital is available from this source. There is no obligation on the part of the company either to pay interest or pay back the money. It can safely be used for expansion and modernisation of business.

Financial Stability

A company which has enough reserves can face ups and downs in business. Such companies can continue with their business even in depression, thus building up its goodwill.

Benefits to the Shareholders

Shareholders are assured of a stable dividend. When the company does not earn enough profit, it can draw upon its reserves for payment of dividends. Not only that their holding size can improve with issue of bonus shares. Due to reserves, there is capital appreciation, i.e., the value of shares may go up in the share market.

Limitations

Following are the limitations of retention of profit:

High Profit Required

This method of financing is possible only when the company earns huge profits and that too for many years.

Dissatisfaction Among Shareholders

Accumulation of profits often leads to low dividend payment by companies. Not only that, the companies may not utilise it for issue of bonus shares to avoid higher dividend payment. This may create dissatisfaction among the shareholders.

Mismanagement of Funds

Capital accumulated through retained earnings encourages management to be less careful with utilisation of funds which may lead to low profitability. It is not in the long run interest of the shareholders.

Lease Financing

  • Lease is a contract whereby one can use the assets of the other with due permission of the owner on payment of rent without purchasing them. The owner of the asset is called ‘lessor’ and the user is called lessee. The period of use is called the lease period after which the lessee may opt for purchase of the asset.

  • So, leasing is an arrangement that enables a business enterprise to use and exercise complete control over the assets without owning it. The owner gets rent in return and at any time as per the terms of the contract he can cancel the agreement. This system helps the business to use the plants and machinery and other fixed assets for a long period of time without investing a large amount of money in purchasing them. At the end of the lease period the asset goes back to the owner. The owner of the assets also has the option of selling it to the user at a reduced price. Sometimes the user company may request the leasing company to purchase its existing assets and allow them to use the same assets on lease basis. This enables the company to save the long-term funds that can be utilised for other purposes. This is known as ‘sale and lease back’ system.

Foreign Investment

  • Funds for the business can also be raised from foreign sources by means of Foreign Direct Investment (FDI). It can be obtained by collaborating with the foreign companies. It enables the Indian companies to secure equity capital through subscription of foreign collaborators to their share capital.

  • The companies can also take loan from International Financial Institutions like The World Bank and International Finance Corporation either directly or by way of refinancing.

  • The sale of shares to the persons of Indian origin and nationality, living abroad (Non-resident Indians or NRIs) is another method of raising long-term funds of business. A non-resident Indian or a company controlled by non-resident Indians can invest within the prescribed limits of the paid-up capital of an Indian company.

Global Depository Receipt

  • The issue of Global Depository Receipts (GDRs) and American Depository Receipts (ADRs) are different methods of raising funds from foreign sources. Under this method the shares of Indian companies are issued in the forms of depository receipts (Global or American) that are traded on the foreign markets.

  • Under GDR, shares of the company are first converted into depository receipts by an international bank. These depository receipts are denominated in US dollars. Then these depository receipts are offered for sale globally through foreign stock exchanges. The holder of GDRs is entitled for dividend just like shareholders. But they do not enjoy the voting rights. many Indian companies like ICICI, Wipro etc. have raised foreign capital through issue of GDRs.

  • The depository receipts which are issued by a USA Bank for trading only in American Stock markets are known as American Depository Receipts (ADR). The ADRs are issued only to the American citizens.

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