Security Finance - Sources of Finance, Accountancy and Financial Management | Accountancy and Financial Management - B Com PDF Download

Security Finance

If the finance is mobilized through issue of securities such as shares and debenture, it is called as security finance. It is also called as corporate securities. This type of finance plays a major role in the field of deciding the capital structure of the company.

Characters of Security Finance

Security finance consists of the following important characters:

1. Long-term sources of finance.
2. It is also called as corporate securities.
3. Security finance includes both shares and debentures.
4. It plays a major role in deciding the capital structure of the company.
5. Repayment of finance is very limited.
6. It is a major part of the company’s total capitalization.

Types of Security Finance 

Security finance may be divided into two major types:

1. Ownership securities or capital stock.
2. Creditorship securities or debt capital.

Ownership Securities

The ownership securities also called as capital stock, is commonly called as shares. Shares are the most Universal method of raising finance for the business concern. Ownership capital consists of the following types of securities.

• Equity Shares
• Preference Shares
• No par stock
• Deferred Shares

Equity Shares

Equity Shares also known as ordinary shares, which means, other than preference shares. Equity shareholders are the real owners of the company. They have a control over the management of the company. Equity shareholders are eligible to get dividend if the company earns profit. Equity share capital cannot be redeemed during the lifetime of the company. The liability of the equity shareholders is the value of unpaid value of shares.

Features of Equity Shares

Equity shares consist of the following important features:

1. Maturity of the shares: Equity shares have permanent nature of capital, which has no maturity period. It cannot be redeemed during the lifetime of the company.
2. Residual claim on income: Equity shareholders have the right to get income left after paying fixed rate of dividend to preference shareholder. The earnings or the income available to the shareholders is equal to the profit after tax minus preference dividend.
3. Residual claims on assets: If the company wound up, the ordinary or equity shareholders have the right to get the claims on assets. These rights are only available to the equity shareholders.
4. Right to control: Equity shareholders are the real owners of the company. Hence, they have power to control the management of the company and they have power to take any decision regarding the business operation.
5. Voting rights: Equity shareholders have voting rights in the meeting of the company with the help of voting right power; they can change or remove any decision of the business concern. Equity shareholders only have voting rights in the company meeting and also they can nominate proxy to participate and vote in the meeting instead of the shareholder.
6. Pre-emptive right: Equity shareholder pre-emptive rights. The pre-emptive right is the legal right of the existing shareholders. It is attested by the company in the first opportunity to purchase additional equity shares in proportion to their current holding capacity.
7. Limited liability: Equity shareholders are having only limited liability to the value of shares they have purchased. If the shareholders are having fully paid up shares, they have no liability. For example: If the shareholder purchased 100 shares with the face value of Rs. 10 each. He paid only Rs. 900. His liability is only Rs. 100.

Total number of shares = 100

Face value of shares = Rs. 10

Total value of shares = 100 *10 = 1,000

Paid up value of shares = 900 

Unpaid value/liability = 100

Liability of the shareholders is only unpaid value of the share (that is Rs. 100).

Advantages of Equity Shares

Equity shares are the most common and universally used shares to mobilize finance for the company. It consists of the following advantages

1. Permanent sources of finance: Equity share capital is belonging to long-term permanent nature of sources of finance, hence, it can be used for long-term or fixed capital requirement of the business concern.
2. Voting rights: Equity shareholders are the real owners of the company who have voting rights. This type of advantage is available only to the equity shareholders.
3. No fixed dividend: Equity shares do not create any obligation to pay a fixed rate of dividend. If the company earns profit, equity shareholders are eligible for profit, they are eligible to get dividend otherwise, and they cannot claim any dividend from the company
4. Less cost of capital: Cost of capital is the major factor, which affects the value of the company. If the company wants to increase the value of the company, they have to use more share capital because, it consists of less cost of capital (Ke ) while compared to other sources of finance.
5. Retained earnings: When the company have more share capital, it will be suitable for retained earnings which is the less cost sources of finance while compared to other sources of finance.

Disadvantages of Equity Shares 

1. Irredeemable: Equity shares cannot be redeemed during the lifetime of the business concern. It is the most dangerous thing of over capitalization.
2. Obstacles in management: Equity shareholder can put obstacles in management by manipulation and organizing themselves. Because, they have power to contrast any decision which are against the wealth of the shareholders.
3. Leads to speculation: Equity shares dealings in share market lead to secularism during prosperous periods.
4. Limited income to investor: The Investors who desire to invest in safe securities with a fixed income have no attraction for equity shares.
5. No trading on equity:When the company raises capital only with the help of equity, the company cannot take the advantage of trading on equity

Preference Shares 

The parts of corporate securities are called as preference shares. It is the shares, which have preferential right to get dividend and get back the initial investment at the time of winding up of the company. Preference shareholders are eligible to get fixed rate of dividend and they do not have voting rights.

Preference shares may be classified into the following major types:

• Cumulative preference shares: Cumulative preference shares have right to claim dividends for those years which have no profits. If the company is unable to earn profit in any one or more years, C.P. Shares are unable to get any dividend but they have right to get the comparative dividend for the previous years if the company earned profit.
• Non-cumulative preference shares: Non-cumulative preference shares have no right to enjoy the above benefits. They are eligible to get only dividend if the company earns profit during the years. Otherwise, they cannot claim any dividend.
• Redeemable preference shares: When, the preference shares have a fixed maturity period it becomes redeemable preference shares. It can be redeemable during the lifetime of the company. The Company Act has provided certain restrictions on the return of the redeemable preference shares.

Irredeemable Preference Shares 

Irredeemable preference shares can be redeemed only when the company goes for liquidator. There is no fixed maturity period for such kind of preference shares. 

Participating Preference Shares

Participatingpreference sharesholders have righttoparticipate extraprofits after distributing the equity shareholders.

Non-Participating Preference Shares

Non-participating preference sharesholders are not having any right to participate extra profits after distributing to the equity shareholders. Fixed rate of dividend is payable to the type of shareholders.

Convertible Preference Shares 

Convertible preference sharesholders have right to convert their holding into equity shares after a specific period. The articles of association must authorize the right of conversion.

Non-convertible Preference Shares

There shares, cannot be converted into equity shares from preference shares.

Features of Preference Shares 

The following are the important features of the preference shares:

1. Maturity period: Normally preference shares have no fixed maturity period except in the case of redeemable preference shares. Preference shares can be redeemable only at the time of the company liquidation.
2. Residual claims on income: Preferential sharesholders have a residual claim on income. Fixed rate of dividend is payable to the preference shareholders.
3. Residual claims on assets: The first preference is given to the preference shareholders at the time of liquidation. If any extra Assets are available that should be distributed to equity shareholder.
4. Control of Management: Preference shareholder does not have any voting rights. Hence, they cannot have control over the management of the company.

Advantages of Preference Shares

Preference shares have the following important advantages.

1. Fixed dividend: The dividend rate is fixed in the case of preference shares. It is called as fixed income security because it provides a constant rate of income to the investors.
2. Cumulative dividends: Preference shares have another advantage which is called cumulative dividends. If the company does not earn any profit in any previous years, it can be cumulative with future period dividend.
3. Redemption: Preference Shares can be redeemable after a specific period except in the case of irredeemable preference shares. There is a fixed maturity period for repayment of the initial investment.
4. Participation: Participative preference sharesholders can participate in the surplus profit after distribution to the equity shareholders.
5. Convertibility: Convertibility preference shares can be converted into equity shares when the articles of association provide such conversion.

Disadvantages of Preference Shares 

1. Expensive sources of finance: Preference shares have high expensive source of finance while compared to equity shares.
2. No voting right: Generally preference sharesholders do not have any voting rights. Hence they cannot have the control over the management of the company.
3. Fixed dividend only: Preference shares can get only fixed rate of dividend. They may not enjoy more profits of the company.
4. Permanent burden: Cumulative preference shares become a permanent burden so far as the payment of dividend is concerned. Because the company must pay the dividend for the unprofitable periods also.
5. Taxation: In the taxation point of view, preference shares dividend is not a deductible expense while calculating tax. But, interest is a deductible expense. Hence, it has disadvantage on the tax deduction point of view.

Deferred Shares 

Deferred shares also called as founder shares because these shares were normally issued to founders. The shareholders have a preferential right to get dividend before the preference shares and equity shares. According to Companies Act 1956 no public limited company or which is a subsidiary of a public company can issue deferred shares. These shares were issued to the founder at small denomination to control over the management by the virtue of their voting rights.

No Par Shares

When the shares are having no face value, it is said to be no par shares. The company issues this kind of shares which is divided into a number of specific shares without any specific denomination. The value of shares can be measured by dividing the real net worth of the company with the total number of shares.

Creditorship Securities

Creditorship Securities also known as debt finance which means the finance is mobilized from the creditors. Debenture and Bonds are the two major parts of the Creditorship Securities.

Debentures

A Debenture is a document issued by the company. It is a certificate issued by the company under its seal acknowledging a debt. According to the Companies Act 1956, “debenture includes debenture stock, bonds and any other securities of a company whether constituting a charge of the assets of the company or not.”

Types of Debentures 

Debentures may be divided into the following major types:

1. Unsecured debentures: Unsecured debentures are not given any security on assets of the company. It is also called simple or naked debentures. This type of debentures are treaded as unsecured creditors at the time of winding up of the company.
2. Secured debentures: Secured debentures are given security on assets of the company. It is also called as mortgaged debentures because these debentures are given against any mortgage of the assets of the company.
3. Redeemable debentures: These debentures are to be redeemed on the expiry of a certain period. The interest is paid periodically and the initial investment is returned after the fixed maturity period.
4. Irredeemable debentures: These kind of debentures cannot be redeemable during the life time of the business concern.
5. Convertible debentures: Convertible debentures are the debentures whose holders have the option to get them converted wholly or partly into shares. These debentures are usually converted into equity shares. Conversion of the debentures may be:
   • Non-convertible debentures
   • Fully convertible debentures
   • Partly convertible debentures
6. Other types: Debentures can also be classified into the following types. Some of the common types of the debentures are as follows:
   1. Collateral Debenture
   2. Guaranteed Debenture
   3. First Debenture
   4. Zero Coupon Bond
   5. Zero Interest Bond/Debenture 

Features of Debentures

1. Maturity period: Debentures consist of long-term fixed maturity period. Normally, debentures consist of 10–20 years maturity period and are repayable with the principle investment at the end of the maturity period.
2. Residual claims in income: Debenture holders are eligible to get fixed rate of interest at every end of the accounting period. Debenture holders have priority of claim in income of the company over equity and preference shareholders.
3. Residual claims on asset: Debenture holders have priority of claims on Assets of the company over equity and preference shareholders. The Debenture holders may have either specific change on the Assets or floating change of the assets of the company. Specific change of Debenture holders are treated as secured creditors and floating change of Debenture holders are treated as unsecured creditors.
4. No voting rights: Debenture holders are considered as creditors of the company. Hence they have no voting rights. Debenture holders cannot have the control over the performance of the business concern.
5. Fixed rate of interest: Debentures yield fixed rate of interest till the maturity period. Hence the business will not affect the yield of the debenture.

Advantages of Debenture 

Debenture is one of the major parts of the long-term sources of finance which of consists the following important advantages:

1. Long-term sources: Debenture is one of the long-term sources of finance to the company. Normally the maturity period is longer than the other sources of finance.
2. Fixed rate of interest: Fixed rate of interest is payable to debenture holders, hence it is most suitable of the companies earn higher profit. Generally, the rate of interest is lower than the other sources of long-term finance.
3. Trade on equity: A company can trade on equity by mixing debentures in its capital structure and thereby increase its earning per share. When the company apply the trade on equity concept, cost of capital will reduce and value of the company will increase.
4. Income tax deduction: Interest payable to debentures can be deducted from the total profit of the company. So it helps to reduce the tax burden of the company.
5. Protection: Various provisions of the debenture trust deed and the guidelines issued by the SEB1 protect the interest of debenture holders

Disadvantages of Debenture 

Debenture finance consists of the following major disadvantages:

1. Fixed rate of interest: Debenture consists of fixed rate of interest payable to securities. Even though the company is unable to earn profit, they have to pay the fixed rate of interest to debenture holders, hence, it is not suitable to those company earnings which fluctuate considerably.
2. No voting rights: Debenture holders do not have any voting rights. Hence, they cannot have the control over the management of the company.
3. Creditors of the company: Debenture holders are merely creditors and not the owners of the company. They do not have any claim in the surplus profits of the company.
4. High risk: Every additional issue of debentures becomes more risky and costly on account of higher expectation of debenture holders. This enhanced financial risk increases the cost of equity capital and the cost of raising finance through debentures which is also high because of high stamp duty.
5. Restrictions of further issues: The company cannot raise further finance through debentures as the debentures are under the part of security of the assets already mortgaged to debenture holders.