UGSemsterSyllabus 1YEAR Commerce 10 English 1sem110 Commerce English BusinessOrganization
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FIRST YEAR SEMESTER - I
BUSINESS ORGANISATION
“We may forgo material benefits of civilization, but we
cannot forgo our right and opportunity to reap the benefits
of the highest education to the fullest extent...”
Dr.B.R.Ambedkar
Dr. B. R. AMBEDKAR OPEN UNIVERSITY
HYDERABAD
2017
1
COURSE TEAM
COURSE DEVELOPMENT TEAM COURSE TEAM (CBCS)
Editor Editor
Prof. O.R. Krishna Swami Prof.A.Sudhakar
Associate Editors Associate Editor
Sri K.Gangapapa Prof.A.Sudhakar
Dr.K.Koteswara Rao
Writers Writers
Prof.V.Nagaraju Naidu Dr.I.Anand Pawar (6,7,8 & 9)
Dr. P. N.Reddy Dr. D.T.Chary (1,2,3,4 & 5)
Dr.K. Seshaiah Dr.Vunnyale Narender(10,11 &14)
Prof. S. Shanmuka Sundaram Prof.A.Sudhakar ( 12 & 13)
Cover Design Cover Design
Chandra G.V.Swamy
Dr.B. R. Ambedkar Open University, Hyderabad
First Edition,2017
Copyright (c) 2017 Dr.B.R. Ambedkar Open University, Hyderabad,T.S
All rights reserved. No part of this book may be reproduced in any from without
permission in writing.
This text forms part of Dr.B.R.Ambedkar Open University Course. The complete
syllabus for the course appears at the end of the text
Further information on Dr.B.R.Ambedkar Open University Courses may be obtained
from:
The Director (Academic), Dr. B.R.Ambedkar Open University,
Road No.46, Jubilee Hills, Hyderabad- 500 033
L.r.No.
Printed at
2
PREFACE
This material deals with the topics in Business Organisation included
in the syllabus for the I Year First Semester of the B.Com., Programme
offered by Dr.B.R.Ambedkar Open University. These units cover the ‘Core’
area of the subject to be studied in the I Year of the Three Year Degree
Programme in Commerce (B.Com.,). The Syllabus for the sake of
convenience is divided into Blocks, each of which is subdivided into units.
Each Block covers a specific area of the subject. The units are prepared by
specialists in accordance with a format so designed as to enable the students
to study on their own and understand them with a lot of ease. Each unit
begins with a statement of its objectives followed by the contents and has at
its end, questions intended to test the student’s comprehension of its subject
matter. Technical (key) terms with which the student may not generally be
familiar, are given at the end of each unit under “Glossary”.
Business Organisation has emerged as a very important domain of
knowledge for the students of commerce. This is mainly due to the
importance various countries attach to the process of industrialisation and
the steps taken by them in this regard. This subject is essentially concerned
with the concepts of industry, business and trade, the process of organising
the same, patterns and forms of organisation. It also includes a
comprehensive presentation on the sources of finance for raising necessary
funds for smooth conduct of business firms. An understanding of this
subject is as much relevant to the traders, entrepreneurs, practicing
businessmen as to the academic community.
The University hopes that this material will help the student to get
acquainted with the principal issues in Business Organisation which make
for its distinctiveness and significance.
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4
CONTENTS
BLOCK – I : INTRODUCTION TO BUSINESS
Unit – 1 : Nature and Scope of Business 03-28
Unit – 2 : Social Responsibility of Business 29-46
Unit – 3 : Promotion of Business 47-58
BLOCK – II : FORMS BUSINESS ORGANIZATION – I
Unit – 4 : Sole Proprietirship and HUF 61-74
Unit – 5 : Partnership 75-94
Unit – 6 : Cooperatives 95-118
BLOCK – III : FORMS BUSINESS ORGANIZATION – II
Unit – 7 : Joint Stock Company 120-140
Unit – 8 : Incorporation of Company 141-153
Unit – 9 : Documents for Registration of Company 154-164
BLOCK – IV : SOURCES OF FINANCE
Unit – 10 : Introduction to Business Finance 167-186
Unit – 11 : Sources of Finance - Traditional 187-205
Unit – 12 : Sources of Finance - Modern 206-222
BLOCK – V : STOCK EXCHANGE AND
COMMODITY MARKET
Unit – 13 : Stock Exchange 225-245
Unit – 14 : Commodity Market 246-261
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6
BLOCK – I : INTRODUCTION TO BUSINESS
UNIT – 1 : NATURE AND SCOPE OF BUSINESS
UNIT – 2 : SOCIAL RESPONSIBILITY OF BUSINESS
UNIT – 3 : PROMOTION OF BUSINESS
1
2
BLOCK – I : INTRODUCTION TO BUSINESS
UNIT – 1 : NATURE AND SCOPE OF BUSINESS
Contents
1.0 Aims and Objectives
1.1 Introduction
1.2 Evolution of Business
1.3 Concept of Business, Trade, Industry and Commerce
1.3.1 Industry
1.3.2 Trade
1.3.3 Scope of Commerce
1.4 InterRelationship of Business Activities
1.5 Objectives Of Business
1.6 Functions of Business
1.7 Summary
1.8 Check Your Progress: Model Answers
1.9 Model Examination Questions
1.10 Glossary
1.11 Further Readings
1.0 AIMS AND OBJECTIVES
This unit aims at introducing the evolution of business and gives a brief description about
nature and scope of business.
After studying this unit, you should be able to:
• know the meaning of business;
• understand the evolution of business;
• analyze the concepts of trade, commerce and industry; and
• explain the nature and scope of business.
3
1.1 INTRODUCTION
The concept of business has emerged with an objective of making profit. Business is
human activity because it is concerned with producing and marketing of goods and services.
Human beings are continuously engaged in some activity or the other in order to satisfy their
unlimited wants. Business has become essential part of modern world. All of us need food,
clothing and shelter. We also have many other household requirements to be satisfied in our
daily lives. We meet these requirements from the shopkeeper. The shopkeeper gets from
wholesaler. The wholesaler gets from manufacturers. The shopkeeper, the wholesaler, the
manufacturer are doing business and therefore they are called as Businessmen. In this unit,
the meaning of business, development of commerce and evolution of business are explained.
In the second part, the concepts like business, trade, commerce and service enterprises are
explained. At the end, objectives of the business are outlined.
1.2 EVOLUTION OF BUSINESS
Meaning of Business
Business is an economic activity which is related with continuous and regular production
and distribution of goods and services for satisfying human wants. Business refers to all human
activities, which are concerned with the production or purchase of goods and services with
the intention of selling them at a profit. In includes economic activities such as manufacturing,
trading, transportation, insurance, warehousing, banking and finance. It included both commerce
and industry. A brief description of the origin and development of commerce and industry will
give us a clear picture of the evolution of the business. Hence an attempt is made to explain the
development of commerce and industry hereunder.
Development of Commerce
Commerce refers to and includes all those activities which are necessary to remove the
goods and services from the place of origin to the place of consumption. It includes trade (ie.
the buying and selling of goods) and the aids to trade (i.e., services such as transportation,
banking, insurance and warehousing). Modern commerce is a welldeveloped system of
exchange with well – organized transport, insurance, banking, warehousing and other services
which facilitate trader.
Today commerce includes a complex system of activities which try to maximize the profits
by offering products and services to the market (which consists both of individuals and other
companies) at the lowest production cost. A system of international trade has helped to develop
the world economy with bilateral or multilateral agreements to lower tariffs or to achieve free
4
trade, has paved the way to the thirdworld markets for their local products, technically
known as globalization.
Commerce is a wider system which is the outcome of a gradual evolution spread over a
long period of human history and in the process has passed through the following different
stages.
i) Household economy
This is the first stage of economic development. At this stage, division of labour was
unknown concept at the family level. Self sufficiency within the family was the basis of
economy and there was no commercial interrelationship between families. While men
were engaged in jobs like hunting, fishing, making weapons for hunting etc, women
were engaged in fruit gathering, cultivation of lands etc. Commerce was unknown at
this stage.
ii) Primitive Barter Economy
Gradually the needs of the families increased and families started specializing in different
occupations and the need for exchange of goods etc. between different families and
different places arose. Thus commerce originated with introduction of barter system.
In barter system, the goods are exchanged for goods only. During the period
currency was not used as a medium of exchange. Hence, barter system was considered
as a popular element of commerce.
iii) The Rise of Trade
In course of time, the needs of people got multiplied and the need for exchange
became greater. In the beginning, goods were exchanged at particular fixed places,
but gradually trade appeared on the scene. Home trade began to develop and assume
importance and with this, there arose a need for common medium of exchange money
appeared as an instrument and medium of exchange. Further, the systems of weights
and measurement also came into existence.
iv) Town Economy
At this stage, trade began to be undertaken for catering to the needs of local markets
which gradually developed into large towns. Further, traders were divided into
wholesale and retail merchants. Division of labour became significant and prices for
goods began to be fixed regularly and traders started using the credit system in their
transactions.
5
v) International Trade
At this stage, goods were produced not only for selling in the local markets but also in
foreign markets. This expansion of trade was due to the industrial revolution which
made large scale manufacturing of goods possible. Further, middlemen began to operate
between the producers and the consumers and also many specialized institutions like
commercial banks, insurance companies, transport companies, warehousing
companies, etc, began to be set up. These middlemen and specialized institutions
played an important role in the development of trade not only within the country but
also in foreign countries.
vi) ECommerce
Electronic commerce also known as ecommerce is the process by which businesses
and consumers buy and sell goods and services through an electronic medium.
Electronic commerce emerged as the latest development in the field of business, in
the early 1990s, and its use has increased at a rapid rate. In this system, the purchase
and sale of goods and services are made through online by use of internet or other
electronic modes. Today, a majority of companies have an online presence. In fact,
having the ability to conduct business through the Internet has become a necessity.
Everything from food and clothes to entertainment and all other household items can
be purchased through online.
Check Your Progress –I
Explain stages in the development of commerce?
Evolution of Industry
The evolution of industry has also passed through a number of stages, which are shown
below:
i) Handicraft system
Under this system, the artisans living in villages produced the requirements of local
people. They worked on the basis of yearly payment received from the farmers in
exchange of goods supplied or services rendered throughout the year. Thus in India,
even today we find Carpenters and Blacksmiths rendering services to the farmers
6
throughout the year and receiving generally in the harvest season a fixed payment for
them in kind. The special features of this system were as follows.
• the production process was single
• the use of machinery was minimal,
• the capital required was not considerable; and
• most of the work was done by hand.
ii) Guilds
The second stage in the evolution of industry was the development of guilds. In this
phase, the artisans of different crafts working in a local area or place formed
associations (which are called ‘Craft Guilds’) in order to protect and develop their
business interest and also to maintain high standards of production. Generally, a
separate guild was formed for each craft. These guilds, after functioning successfully
for a long period of time, declined in importance and finally withered away. Some
important reasons for their decline and disappearance were;
• the rigid outlook of membercraftsmen;
• restrictions on fresh entrants to the craft; and
• the emergence of new towns without guild authority.
iii) Domestic System
In this system, the merchants began to enter into contracts with artisans and workers
for regular supply of goods. With the demand for their products increasing the artisans
found it difficult to provide for the regular supply of the needed raw materials. Hence,
at this stage, the merchants took the responsibility of supplying raw materials required
by the artisans and also of marketing the finished products of artisans. The merchants
in this way became the entrepreneur and middlemen between the producer and
consumer.
In the 17th century, there were improvements in the techniques of manufacturing and
in the 18th century, a few inventions were made. These developments resulted in the
use of machines and tools by the workers. But the machines and tools were beyond
the means of workers. This led to the setting up of machines by merchants in their
own buildings who hired the workers for manufacturing the goods under their
supervision. This kind of domestic manufacturing became the forerunner of the modern
factory system and gave rise to capitalism and the emergence of the entrepreneurship.
The consequences of this change were that— 7
• the artisans lost their independence, and
• they became hired workers.
iv) Factory System
The industrial revolution, which started in England in the second half of the 18th century
soon spread to other countries. The old industrial order with small manufacturers
employing a small number of workers and using limited capital disappeared given
place to a new one based on largescale production. Domestic production was
replaced by the factory system. The workers worked in large factories located mostly
in cities. These factories produced goods in large quantities meant for meeting the
needs of consumers not only within the country but also in foreign countries.
To manufacture goods in large quantities, the old machines were replaced by new
machines, which were complicated and driven by power. Largescale production
increased the need for large investment of capital. This resulted in the capital becoming
a dominating factor of production and the ownership of the industrial unit passing into
the hands of the supplier of capital. This new system came to be known as the ‘factory
system’. It is the latest system in the development of industry.
8
CONCEPTS OF BUSINESS
Industry Commerce Direct Services
Extractive Generic Manufacturing Construction
Farming Poultry Farm Iron & Steel Roads Trade Aids to Trade
Mining Breeding of Plants Automobiles Dams (Ancillary
Fishing Fish Culture Spinning Bridges etc., Services)
Hunting Cattle Breeding Weaving etc.,
Home Trade International Trade Insurence.
Health,
Wholesale Retail Import Export Communication
etc.,
Banking Transport Insurance Warehousing Advertising
Chart: 1.1: Concepts of Business
9
1.3 CONCEPTS OF BUSINESS, TRADE, INDUSTRY AND
COMMERCE
There are various concepts related to business which are discussed hereunder.
Business: Meaning and definition
‘Business refers to all human activities, which are concerned with the production or
purchase of goods and services with the intention of selling them to a profit. It includes all
economic activities such as manufacturing, trading, transportation, insurance, warehousing,
banking and finance.
Stephenson defines business as, “The regular production or purchase and sale of
goods undertaken with an objective of earning profit and acquiring wealth through the
satisfaction of human wants.”
According to Dicksee, “Business refers to a form of activity conducted with an
objective of earning profits for the benefit of those on whose behalf the activity is conducted.”
Lewis Henry defines business as, “Human activity directed towards producing or acquiring
wealth through buying and selling of goods.”
“Business is a sum of all activities involved in the production and distribution of goods
and services for private profits” – Keith and Carlo
Thus, the term business means continuous production and distribution of goods and
services with the aim of earning profits under uncertain market conditions.
After careful analysis of the above definitions, business may be defined as an economic
activity, involves transfer or exchange of goods or services for a price with an objective of
earning profits.
Characteristics of Business
The important characteristics of business are:
i) Creation of utilities
Business makes goods more useful to satisfy human wants. It adds time, place, form
and possession utilities to various types of goods. In the words of Roger,“a business
exists to create and deliver value satisfaction to customers at a profit”. Business
enables people to satisfy their wants more effectively and economically. It carries
goods from place of surplus to the place of scarcity (place utility). It makes goods
available for use in future through storage (time utility).
10
ii) Dealing in goods and services:
Business consists of transactions relating to goods and services. The term goods
include both consumer goods like wheat, rice, oil, cloth etc. and producer goods
which are used for the production of consumer or capital goods like raw materials,
machinery, etc. The term ‘Services’ refers to such things as banking, insurance and
transportation of goods and passengers.
iii) Recurrence of dealings
In business, there is recurrence of purchase and sale. If a person sells his personal
scooter and earns a profit, his act is not part of business. But if he regularly purchases
and sells scooters then such an act is considered as business.
iv) Economic activity
Business is an economic activity of production and distribution of goods and services.
It provides employment opportunities in different sectors like banking, insurance,
transport, industries, trade etc. It is an economic activity concerned with creation of
utilities for the satisfaction of human wants. It provides a source of income to the
society. Business results into generation of employment opportunities thereby leading
to growth of the economy. It brings about industrial and economic development of
the country. Only economic activities are included in business. Noneconomic
activities do not form a part of business.
v) Profit Motive
The primary motive behind business is to earn profit. It is concerned with the production
and purchase of goods and services with a view to selling them at a profit.
vi) Risk
Profit from business depends on many factors like demand, price level, competition
etc., on which businessmen may not have control. Hence, business involves an element
of risk.
Business includes industry, trade and commerce. While industry is concerned
with the production of goods and materials, trade and commerce are concerned with
distribution.
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1.3.1 INDUSTRY
Industry is that branch of business which is concerned with production of goods and
services. The production side of business activity is referred to as industry. In a broader sense
industry is related to the producing, processing or manufacturing of products. The products
may be consumers’ goods or producers’ goods. Consumer goods are goods, which are used
finally by consumers. Ex: Food items, textiles, cosmetics, TVs Refrigerators etc. Producer’s
goods are the goods used by manufacturers for producing other consumer goods. e.g.
Machinery, tools, equipments, etc.
Classification of Industries
There are various types of industries. The following are the different types of industries:
i) Primary Industry
ii) Genetic Industry
iii) Extractive Industry
iv) Manufacturing Industry
v) Construction Industry
vi) Service Industry
vii) Quaternary Industry
1. Primary Industry
Primary industry is concerned with all types of farming and associated occupations
basically related with nature. It is a natureoriented industry, which includes all kinds
of work concerned with the extraction of natural resources from earth and sea.
Agriculture, farming, forestry, fishing, horticulture, etc are a few examples of primary
industries.
2. Genetic Industry
Genetic industry is engaged in reproduction and multiplication of certain spices of
plants and animals with the object of sale. The main aim is to earn profit from such
sale. Ex: plant nurseries, cattle rearing, poultry, cattle breeding, etc.
3. Extractive Industry
Extractive industry is concerned with extraction or drawing out goods from the soil,
air or water. Generally products of extractive industries come in raw form and they
12 are used by manufacturing and construction industries for producing finished products.
Ex: mining industry, coal, mineral, oil industry, iron ore, extraction of timber and rubber
from forests, etc.
4. Manufacturing Industry
Manufacturing industries are engaged in transforming raw material into finished product
with the help of machines and manpower. The finished goods can be either consumer
goods or producer goods. Ex: textiles, chemicals, sugar industry, paper industry, etc.
5. Construction Industry
Construction industries take up the work of construction of buildings, bridges, roads,
dams, canals, etc. This industry is different from all other types of industry because in
case of other industries goods can be produced at one place and sold at another
place. But goods produced and sold by constructive industry are erected at one
place.
6. Service Industry
Services sector plays an important role in the development of the nation and therefore,
it is named as service industry. The main industries, which fall under this category,
include hotel industry, tourism industry, entertainment industry, etc.
7. Quaternary Industry
Quaternary industry is a type which deals with information using technology (such as
computers). Information has been required by industries since the Industrial Revolution,
but the now widespread use of computers to do this much more efficiently has made
this an industry in its own right. It involve the use of high tech industries. People who
work for these companies are often highly qualified within their field of work. Research
and development companies are the most common types of businesses in this sector.
1.3.2 TRADE
Trade is a branch of commerce and it is concerned with the exchange of commodities.
It means the buying and selling of goods. It does not include aids to trade like banking,
insurance, transportation, warehousing etc. Trade can be classified into wholesale trade and
retail trade. Trade is also classified as local trade, regional trade, international trade or foreign
trade. The broad classification of trade is explained as below.
(a) Home or Domestic Trade
It involves of buying and selling of goods within the boundaries of a country and the
payment for the same is made in national currency either directly or through the banking
system. Internal trade may be further subclassified into wholesale trade and retail
trade. 13
(b) International or Foreign Trade
It refers to the exchange of goods and services between two or more countries.
International trade involves the use of foreign currency ( called foreign exchange)
ensuring the payment of the price of the exported goods and services to the
domestic exporters in domestic currency, and for making payment of the price of the
imported goods and services to the foreign exporter in that country’s national currency
(foreign exchange). International trade is again classified into three categories, viz,
Export trade, Import trade, Entrepot trade.
Aids to Trade
The other important element of commerce is ‘aids to trade’, also known as ancillary
services or auxiliaries. The auxiliaries help in the smooth conduct of trade. These are banking,
transportation, insurance, warehousing, advertising. The auxiliary functions have been briefly
discussed hereunder:
(a) Banking
Banks provide a device gateway through which payments for goods bought and sold
are made thereby facilitating the purchase and sale of goods on credit. Banks serve
the useful economic function of collecting the savings of the people and business
houses and making them available to those who may profitably use them. Banks
provide such finance to businessmen and also advance loans in the form of overdrafts,
cash credit and discounting of bills.
(b) Transportation
Transport performs the function of carrying goods from producers to wholesalers,
retailers, and finally customers. It provides the wheels of commerce. Transportation
removes the geographical gap between the producer and consumers. It has linked all
parts of the world by facilitating international trade.
(c) Warehousing
There is generally a time lag between the production and consumption of goods. This
problem can be solved by storing the goods in warehouse. Storage creates time
utility and removes the hindrance of time in trade. It performs the useful function of
holding the goods for the period they move from one point to another. Thus,
warehousing discharges the function of storing the goods both for manufacturers and
traders for such time till they decide to move the goods from one point to another.
14
(d) Insurance
Insurance provides a cover against the risk of loss of goods in the process of transit
and storage. An insurance company performs a useful service of compensating for
the loss arising from the damage caused to goods by fire, pilferage, theft and the
hazards of sea, transportation and thus protects the traders form the fear of loss of
goods. It charges insurance premium for the risk covered.
(e) Advertising
Advertising performs the function of bridging the information gap about the availability
and uses of goods between traders and consumers. In the absence of advertising,
goods would not be sold to a widely scattered market and customers would not
come to know about many of the new products because of the paucity of time,
physicalspatial distance, etc.
1.3.3 SCOPE OF COMMERCE
From the economic point of view, mere production of goods and services is no use at
all, until it has reached the ultimate consumer. It means goods produced should be delivered
to the door steps of consumers. ‘Commerce’, facilitates this function. Thus, commerce is that
part of business which is concerned with the exchange of goods and services and includes all
those activities which directly or indirectly facilitate that exchange.
Commerce involves the process of bringing the goods from the place of production to
the place of consumption. It helps in removing the hindrances relating to storing, grading,
packaging, financing, transporting, insuring, communicating, warehousing, etc. The main
function of commerce is to remove the hindrance of: (i) persons through trade; (ii) place
through transportation; (iii) risk through insurance and packaging; (iv) time through warehousing
and storage; and (v) knowledge through salesmanship, advertising, etc., arising in connection
with the distribution of goods and services until they reach the consumers.
Commerce provides the advantages of specialization. It provides the necessary link
between the producers and consumers of goods. It has brought countries close to one another
and the world has become one big market.
Large scale production is impossible without modern commerce. Commerce has
contributed significantly towards the economic development of society and the quality of life
of people. The basic aim of commerce is to ensure the supply of right goods at the right time
at the right place and to right persons.
Thus, commerce involves two aspects i.e. Trade and Aids to Trade
Commerce = Trade + Aids to Trade
15
Check Your Progress –2
Briefly explain the classification of Industry.
1.4 INTERRELATIONSHIP BETWEEN BUSINESS ACTIVITIES
Business is divided into two categories: industry and commerce. Commerce is again
subdivided into trade and aids to trade. Practically all of them are closely related to each
other. They are inseparable. All of them are parts of the whole business system.
Industry and commerce are closely related to each other. Industry cannot exist without
commerce and commerce cannot exist without industry, because every producer has to find
his market for his products to sell. But the producer has no direct connection with the buyers
or consumers. Hence, industry needs commerce.
Commerce is concerned with the sale, transfer or exchange of goods and services.
Hence commerce needs industry for the production of goods and services. Commerce makes
necessary arrangement for linking producers and ultimate consumers. It includes all those
activities that are involved in buying, selling, transporting, banking, warehousing of goods, and
insurance for safeguarding the goods.
Trade is concerned with the activity of buying and selling of goods, it provides support
to industry and ensures the smooth flow of commerce. Similarly trade without aidstotrade is
meaningless and they exist for trade.
Thus, industry, commerce, and trade are closely related to one another and are inter
dependent as shown in the figure below. Therefore, we can say that industry, trade and
commerce are interrelated with each other. Industry is concerned with production of goods
and services and commerce arranges its sales; but the actual operation of sales is in the hands
of trade. So they cannot work independently.
Interrelationship between Industry, Trade and Commerce
Industry
Commerce Trade
16
1. Comparison between Trade, Commerce and Industry
Though, Trade, Commerce and Industry are related with each other, the comparisons between
these three are discussed below.
Trade Commerce Industry
Purchase and sale of Activities involving Extraction, reproduction,
MEANING
goods and services. distribution of goods conversion, processing and
and services. construction of useful
products.
Comprises Comprises trade Consists of all activities
SCOPE exchange of goods and auxiliaries to involving conversion of
and services. trade. materials and semifinished
products into finished
products.
Capital is needed to Capital required is Generally large amount of
CAPITAL
maintain stock and comparatively less. capital is required.
grant credit.
RISK Relatively less risk is Relatively less risk is Risk involved is usually high.
involved. involved.
SIDE It represents both It represents demand It represents supply side
supply and demand. side of goods and of goods and services.
services.
1.5 OBJECTIVES OF BUSINESS
Every business enterprise has certain objectives which regulate and generate its
activities. Business objectives are clearly defined targets that are set by management
or business owners. They give directions and the mode in which the business should
operate. Business managers devise plans to meet these objectives and keep track of progress
and deviations.
Business should have an objective of earning a reasonable profit through customer
satisfaction. According to Prof. Urwick, ‘Profit can no more be the objective of a business
than eating is the objective of living’. Human beings do not live with the sole objective of 17
eating and similarly business cannot exist with the sole objective of earning profits. However,
profits play an important role as criterion for success and efficiency. It is the measuring rod of
business performance. Moreover, a firm has to avoid losses if it wants to survive for long
term. If the firm is rendering some useful service, it is necessary that it should continue to
function, since its closure may affect the producer, customers and employees. Hence, business
has to earn at least the profit that is required to sustain in the business.
According to Peter Drucker, customer is the foundation of a business and keeps it in
existence. Hence, the purpose of business is to cater to the needs of customers. Various
objectives of business may be classified into four broad categories shown as bellow:
1. Economic Objectives
Business is basically an economic activity. Therefore, its primary objectives are
economic in nature. The main economic objectives of business are as follows:
i) Earning profits
A business enterprise is established for earning some income. It is the hope of earning
profits that inspires people to start business. Profit is essential for the survival of every
business unit. Just as a person cannot live without food, a business firm cannot survive
without profit. Profits enable a businessman to stay in business by maintaining intact
the wealth producing capacity of its resources. Profit is also necessary for the
expansion and growth of business. Profits ensure continuous flow of capital for the
modernization and extension of business operations in future. Profit also serves as
the barometer of stability, efficiency and progress of a business enterprise.
ii) Creating customers
Profits are not created by God or by the force of nature. They arise from the
businessman’s efforts to satisfy the needs and wants of customers. A businessman
can earn profits only when there are enough customers to buy and pay for his goods
and services. In the words of Drucker, “There is only one valid definition of
business purpose; to create a customer. The customer is the foundation of
business and keeps it in existence. It is to supply the customer that society
entrusts wealthproducing resources to a business enterprise.” No business
can succeed without providing customers value for their money. Business exists to
satisfy the wants, tastes and preferences of customers. In order to earn profit, business
must supply better quality goods and services at reasonable prices. Therefore, creation
and satisfaction of customers is an important economic objective of business. Business
creates customers through advertising and salesmanship. It satisfies the needs of
18 customers by producing the required goods and services and by creating utilities.
iii) Improving Market Share
Businesses often compete to rule market by improving the their market share. It can
obtain increased market share by increasing revenues; Revenue increases as customers
buy more of your products. Improved market share also shows that your products or
services may be more desirable.
iv) Innovation
Business is an organ of dynamism and change. In these days of intense competition
a business can be successful only when it creates new designs, better machines,
improved techniques, new varieties, etc. Modern science and technology have created
a great scope for innovation in the business world. Innovation is not confined to the
invention of a new machines. It comprises all efforts made in perfecting the product,
minimizing the costs and maximizing benefits to customers. It involves improvements
in management, production, selling servicing, methods of personnel and accounting,
etc. Business firms invest money, time and efforts in Research and Development
(R&D) to introduce innovations. They develop new technology; introduce new designs
and new tools and processes to minimize costs and to satisfy ever increasing wants of
customers. In order to create customers business has to explore new markets and
attract more customers. It has also to retain old customers by providing better services
to them.
2. Social objectives
Business does not exist in a vacuum. It is a part of society. It cannot survive and grow
without the support of society. Business must, therefore, discharge social responsibilities in
addition to earning profits. According to Henry Ford, “the primary aim of business
should be service and subsidiary aim should be earning of profit.” The socials objectives
of business are as follows:
i) Production and supply of quality goods and services
The objective of business should be to produce better quality goods and supply them
at the right time and at a right price. It is not desirable on the part of the businessman
to supply adulterated or inferior goods which cause injuries to the customers.
Businessmen should charge a reasonable price according to the quality of the goods.
Similarly, the customers also expect timely supply of all their requirements. So it is
important for every business to supply those goods and services on a regular basis.
ii) Fair Remuneration to employees
Employees must be given fair compensation for their work. In addition to wages and
salary a reasonable part of profits should be distributed among employees in 19
recognition of their contribution. Such sharing of profits will help to increase the
motivation and efficiency of employees. It is the obligation of business to provide
healthy and safe work environment for employees. Good working conditions are
beneficial to the organization because these help to improve the productivity of
employees and thereby the profits of business. Employees work day and night to
ensure smooth functioning of business. It is, therefore, the duty of employers to provide
hygienic working and living conditions for workers.
iii) Employment Generation
Business should provide opportunities for gainful employment to members of the
society. In a country like India unemployment has become a serious problem and the
Government is unable to offer jobs to all. Therefore, provision of adequate and full
employment opportunities is a significant service to society. If unemployment problem
increases, the socioeconomic environment cannot be congenial for the growth of
business activities.
iv) Adoption of fair trade practices
The business enterprises must not create artificial scarcity of essential goods or raise
prices for the sake of earning more profits. All these activities earn a bad name and
sometimes make the businessmen liable for penalty and even imprisonment under the
law. Therefore, the objective of business should be to adopt fair trade practices for
the welfare of the consumers as well as the society.
v) Social welfare
Business should provide support to social, cultural and religious organizations. Business
enterprises can build schools, colleges, libraries, dharma shalas, hospitals, sports
bodies and research institutions. They can help NonGovernment Organizations
(NGOs) like CRY, Help Age, and others which render services to weaker sections
of society.
vi) Payment of Government Dues
Every business enterprise should pay tax dues (eg. income tax, GST) to the government
honestly and at the right time. These direct and indirect taxes provide revenue to the
Government for spending on public welfare. Business should also abide faithfully by
the laws of the country. Thus, businessmen should pursue those policies and take
those actions which are desirable in terms of the objectives and values of our society.
20
3. Human Objectives
Business is run by people and for people. Labour is a valuable human element in
business. Human objectives of business are concerned with the wellbeing of labour. These
objectives help in achieving economic and social objectives of business. Human objectives of
business are given below:
i) Economic well being of the employees
Employee welfare is one of the objectives of modern businesses. Employees must be
provided with fair remuneration and incentives for performance, benefits of provident
fund, pension and other amenities like medical facilities, housing facilities etc. By this
they feel more satisfied at work and contribute more for the business.
ii) Developing human resources
Employees must be provided the opportunities for developing new skills and attitudes.
Human resources are the most valuable asset of business and their development will
help in the growth of business. Business can facilitate self development of workers
by encouraging creativity and innovation among them. Development of skilled
manpower is necessary for the economic development of the country.
iii) Participative management
Employees should be allowed to take part in decision making process of business.
This will help in the development of employees. Such participation will also provide
valuable information to management for improving the quality of decisions. Workers’
participation in management will usher in industrial democracy.
iv) Labour management cooperation
Business should strive for creating and maintaining cordial employer employee relations
so as to ensure peace and progress in industry. Employees should be treated as
honorable individuals and should be kept informed.
4. National Objectives
National objectives of business are as follows:
i) Creation of employment: One of the important national objectives of business is to
create opportunities for gainful employment of people. This can be achieved by
establishing new business units, expanding markets, widening distribution channels,
etc.
21
ii) Promotion of social justice: As a responsible citizen, a businessman is expected to
provide equal opportunities to all persons with whom he/she deals. He/She is also
expected to provide equal opportunities to all the employees to work and progress.
Towards this objective special attention must be paid to weaker and backward sections
of the society.
iii) Development of backward areas
Business is expected to give preference to the industrialization of backward regions
of the country. Balanced regional development is necessary for peace and progress
in the country. It will also help to raise standard of living in backward areas. Government
offers special incentives to the businessmen who set up factories in notified backward
areas.
iv) Contribute to the revenue of the country
The business owners should pay their taxes and dues honestly and regularly. This will
increase the revenue of the government, which can be used for the development of
the nation.
Check Your Progress –3
Explain the objectives of business.
1.6 FUNCTIONS OF BUSINESS
Though the very objective of establishment of business enterprise is to earn profits, it
has to protect the interest of various interested parties who have stake in the business.
Interest groups
Various interest groups which have a stake in the business help and contribute to the
firm’s continuity and prosperity and in turn claim a return in different forms from the firm.
These stakeholders consist of consumers, employees, stock holders, creditors, suppliers,
distributors and the Government. A business firm’s continuity and prosperity depends upon
its relations with all these interest groups. The following diagram indicates the relations of the
business firm with different interest groups which constitute its stakeholders.
22
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As all the interest groups are protected in the working of a business enterprise, it needs to
have a multiplicity of objectives in order to reconcile the conflicting interests of the stakeholders
and to ensure harmony in its dealing with them. According to Peter F. Drucker, a business firm
should have the following objectives.
1. Creation of profitable markets
Every business should have the objectives of creating a profitable market. This can
be achieved by attracting customers. According to Roger Falk, ‘customer is the
foundation of all business and business is for the most part the creation of customers’.
As the fate of business depends on the customers, the businessman should establish
his standing in the market by constantly searching for customers who have the desire
and capacity to pay for his products.
2. Innovation
Another objective of business is innovation. Innovation involves the discovering of
ways and means for improving the product or service. This helps the enterprise in
becoming stable and dynamic and also in discharging its social obligation to the society.
23
3. Productivity
To achieve the objective of productivity, the firm should use its resources in the best
possible way and secure the greatest possible output with the minimum of input.
4. Adequate physical financial resources
Another objective of business is to secure adequate physical and financial resources
so as to be able to supply the goods and services needed by the customers.
5. Adequate return on capital
Yet another objective in the earning of adequate profit for expansion and growth of
business enterprise. Profit is essential for the survival of business and also for the
rendering of a distinct service to the community.
6. Development of human resources
In the efficient management of a business enterprise, the human factor plays an
important role. The development of human resources will act as a catalyst for the
other resources thereby influencing the performance of the business unit in other areas.
Hence, efforts should be made by the businessmen to develop human resources.
7. Social responsibility of business
Business enterprises should not only focus on earning profits, but also to some extent
responsible to the society in terms of rendering services to the society. Undertaking
various social responsibility activities by business enterprises is the topic of importance
by modern business enterprises.
Check Your Progress –4
Discuss the functions of business.
1.7 SUMMARY
Business is an economic activity which is undertaken with a profit motive. It involves
exchange of goods and services on continuous basis. Business creates utilities by producing
and selling goods and services to satisfy human wants. Business is undertaken with the help of
various auxiliary services. Hence, business involves two important components, i.e., Industry
and Commerce. Industry is concerned with production of goods and services, whereas
commerce deals with the distribution or exchange of goods and services. Further commerce
is classified into trade and aidstotrade. Various auxiliary services like transport, warehousing,
24 insurance, banking, advertising and publicity ensures smooth conduct of trade.
The purpose of business is not just to earn profit but to serve the different groups that
are connected with these business activities. The interest groups in the business are customers,
shareholders, employees, distributors, creditors, suppliers, competitors and finally the
Government. The business, apart from serving the interest groups, should have some objectives
like maintaining productivity, creation of market providing financial resources for the business.
1.8 CHECK YOUR PROGRESS: MODEL ANSWERS
1. The following are the stages of business:
• Household economy
• Primitive Barter Economy
• The Rise of Trade
• Town Economy
• International Trade
• ECommerce.
2. Classification of Industries:
• Primary Industry
• Genetic Industry
• Extractive Industry
• Manufacturing Industry
• Construction Industry
• Service Industry
• Quaternary Industry.
3. The major objectives of business are:
• Economic Objectives
• Social objectives
• Human objectives
• National objectives.
4. The functions of business are:
• Creation of profitable markets
• Innovation
• Productivity
• Adequate physical financial resources
• Adequate return on capital
• Development of human resources
• Social responsibility of business.
25
1.9 MODEL EXAMINATION QUESTIONS
I Short Answer Questions
1. What do you mean by Commerce?
2. What do you mean by AidstoTrade?
3. Briefly explain extractive industry
4. What is house economy?
5. What are Guilds??
II Long Answer Questions
1. Define Business. Discuss the characteristics of business.
2. Define Industry. Explain the different types of industries.
3. Explain the objectives of business.
4. Explain the interrelationship between Trade, Commerce and Industry.
5. Explain the functions of business.
III Objective Type Questions
A. Multiple Choice Questions
i) Barter System means:
a) Exchange of goods for goods
b) Exchange of goods for cash
c) Exchange of goods on credit
d) None of the above
ii) Any human activity, which is concerned with the production or purchase of goods
and services with the intention of selling them at a profit is known as
a) Commerce b) Trade
c) Industry d) Business
iii) Industry engaged in reproduction and multiplication of certain species of plants and
animals with the object of sale is an example of
a) Genetic Industry
b) Extractive Industry
c) Quaternary Industry
d) Manufacturing Industry
26
iv) Following is an example for trade where the exchange of goods and services between
two or more countries.
a) Domestic Trade
b) International Trade
c) State boarder Trade
e) Cross border Trade
v) Example of Aids to trade or auxiliaries to trade includes
a) Banking and insurance
b) Transportation
c) Warehousing
d) All the above
Answers: i) a ii) d iii) a iv) b v) d
B. Fill in the blanks
i) —————— includes trade and the aids to trade
ii) —————— includes industry, trade and commerce
iii) ——————is the process by which businesses and consumers buy and sell goods
and services through an electronic medium or through online
iv) ——————is concerned with extraction or drawing out goods from the soil, air
or water.
v) ——————creates time utility and removes the hindrance of time in trade
Answers: i) Commerce ii) Business iii) ecommerce
iv) Extractive v) Warehousing
C. Match the following
i) Agriculture, forestry and fishing ( ) a) Banking and Finance
ii) Provides a cover against the loss of goods ( ) b) Employment Generation
iii) Examples of services enterprises ( ) c) Primary Industry
iv) Example of Social objectives of Business ( ) d) Trade
v) Exchange of goods and services ( ) e) Insurance
Answers: i–c ii – e iii – a iv – b v–d
27
1.10 GLOSSARY
Business All human activities which are connected with the production or
purchase of goods and services with the intention of selling them
at a profit.
Commerce Includes all those activities which are necessary to bring goods and
services from the place of their origin to the places of their consumption.
It includes trade and aids to trade.
Trade Trade is a branch of commerce and it is concerned with the exchange
of commodities. It means the buying and selling of goods.
Aids to trade Aids to trade are also known as ancillary services or auxiliaries and
these n auxiliaries help in the smooth conduct of trade. These are
banking, transportation, insurance, warehousing, advertising.
1.11 FURTHER READINGS
Bhushan Y.K. : Fundamentals of Business Organizations and
Management, Sultan Chand and Sons, New Delhi
Krishnaswami O.R : Essentials of Commerce
Eagle Press Publication Division, Madras.
Reddy P.N. and Gulshan : Principles of Business Organization and
Management. Himalalya Publishing House,
Mumbai400004
Rao VSP : Business Organisation and Management
Himalalya Publishing House, Mumbai400004
Shaerlekar, Khushpat : Business Organisation, Himalalya Publishing
Jain and Apexa Jain House, Mumbai400004
28
UNIT – 2 : SOCIAL RESPONSIBILITY OF BUSINESS
Contents
2.0 Aims and Objectives
2.1 Introduction
2.2 Concept CSR
2.3 Features of CSR
2.4 Scope of CSR
2.5 Importance of CSR
2.6 Components or Areas of CSR
2.7 Implementation of CSR
2.8 Summary
2.9 Check Your Progress: Model Answers
2.10 Model Examination Questions
2.11 Glossary
2.12 Further Readings
2.0 AIMS AND OBJECTIVES
This unit presents the meaning and definition of social responsibility of business, concept,
features and importance of Corporate Social Responsibility.
After studying this unit, you should be able to:
• understand the concept of Corporate Social Responsibility (CSR);
• know the scope of Corporate Social Responsibility;
• discuss the importance of Corporate Social Responsibility; and
• evaluate the implementation of CSR by the Indian corporates.
2.1 INTRODUCTION
Social responsibility is an ethical framework and suggests that an entity, be it an
organization or individual, has an obligation to act for the benefit of society at large. The
obligation of any business to protect and serve public interest is known as social
29
responsibility of business. Social responsibility is the idea that businesses should balance
profitmaking activities with activities that benefit society; it involves developing businesses
with a positive relationship to the society in which they operate. The social responsibility of
business refers to such decisions of a business concern which promote the welfare of society
as a whole along with its own interest. The business concern acts in such a manner that it will
realize social gains (social output) along with the traditional economic gains (economic output)
which the business concern seeks.
Prof. Andrews, says: ‘by social responsibility we mean the intelligent and objective
concern for the welfare of society that restrains individual and corporate behaviour from
ultimately destructive activities, no matter how immediately profitable, and leads in the direction
of positive constructions to human betterment variously as the latter may be defined.” Thus,
the responsibility of involves the pursuing of such policies, the making of such decisions or the
following of such lines of action as are desirable in terms of the objectives and values of
society.
2.2 CONCEPT OF CORPORATE SOCIAL RESPONSIBILITY
Business today has emerged as one of the most powerful institutions on the earth.
Some of the biggest companies in the world are in fact, bigger in size than some of the
developing countries of the world. Globalization makes the world smaller, and business
worldwide is expanding like never before. Companies are expanding their operations and
crossing geographical boundaries. Indian companies too have made their way into the business
boom and are today globally acknowledged as major players. India is currently amongst the
fastest growing countries in the world. The globalization and liberalization of the Indian economy
has helped in stepping up growth rates. Integration of the Indian economy with the global
economy has also resulted in Indian businesses opening upto international competition and
thereby increasing their operations.
The companies are facing increased pressure for transparency and accountability,
being placed on them by their employees, customers, shareholders, media and civil society.
Business does not operate in isolation and there is today, an increased realization that not only
can companies affect society at large, but they are also in a unique position to influence
society and make positive impact. These ideas have given rise to the concept of Corporate
Social Responsibility (CSR). The concept of CSR goes beyond charity or philanthropy and
requires the company to act beyond its legal obligations and to integrate social, environmental
and ethical concerns into its business process. Corporate Social Responsibility is defined as
“achieving commercial success in a way that honors ethical values and respect people,
communities, and the environment”.
30
CSR may also be referred to as “Corporate Citizenship” and can involve incurring
shortterm costs that do not provide an immediate financial benefit to the company, but instead
promote positive social and environmental change.
A widely quoted definition by the World Business Council for Sustainable Development
states that ”Corporate Social Responsibility is the continuing commitment by business to behave
ethically and contribute to economic development while improving the quality of life of the
workforce and their families as well as of the local community and society at large”.
The term CSR has been defined under the CSR Rules of New Companies Act 2013,
which includes but is not limited to:
“Projects or programs relating to activities specified in the Schedule; or Projects or
programs relating to activities undertaken by the Board in pursuance of recommendations of
the CSR Committee as per the declared CSR policy subject to the condition that such policy
covers subjects enumerated in the Schedule”.
2.3 FEATURES OF CORPORATE SOCIAL RESPONSIBILITY
The core characteristics of CSR are the essential features of the concept that tend to
be visible in CSR practice. These are the main points of focus around which the practice of
CSR manifest itself. The main features of CSR are summarized below:
i) Voluntary
CSR should be a representative of all set of corporate initiatives which are discretionary
and extend beyond what the law has prescribed. The views of government and other
stakeholders in all developing countries emphasize this characteristic. Many companies
are by now familiar and more willing to consider responsibilities beyond the legal
minimum, and in fact the development of selfregulatory CSR initiatives from corporate
bodies is often seen as a way of reducing or avoiding additional regulation through
compliance with societal moral norms.
ii) Internalizing or managing externalities
Externalities in CSR refers to all sorts of factors that have impact on different
stakeholders’ rights that are not directly taken care of in the decision making process
of a business organization. Environmental degradation is typically regarded as an
externality since the general public feel the impact of the production process. Regulation
can force firms to internalize the cost of the externalities, such as pollution fines, but
CSR remains as a viable discretionary approach of managing externalities like taking
more safety measures and reduction of pollution by going green. Much CSR activity
deals with externalities involving workers rights, minimization of rationalization impact, 31
good stakeholder relationship management to reduce unsatisfied legitimate claims pile
up and discarding production process and products that are not demanded, harmful
or classified as dangerous products.
iii) Multiple stakeholder orientation
The central theme of stakeholder management is to identify stakeholders orientations
based on the three attributes which defines their power, legitimacy of claim and urgency.
CSR involves considering a range of interests and impacts among a variety of different
stakeholders other than just shareholders. Various other stakeholders’ interest such
as consumers, employers, suppliers, and local communities also should be considered
for not only surviving but also for prospering.
iv) Alignment of social and economic responsibilities
This balancing of different stakeholder interests leads to another core feature of CSR.
The concept of economic responsibility should not conflict with profitability. As per
corporate priorities of CSR practices economic and ethical responsibilities comes
first before legal responsibility philanthropy comes last in terms of priority. But in few
cases philanthropy may be accorded a high level priority and shareholders are more
concerned with economic responsibility than ethical and legal but philanthropy is highly
valued. Hence there must be proper alignment of these two responsibilities to satisfy
various stakeholders.
v) Practices and values
CSR is clearly about a particular set of business practices and strategies that deal with
social issues. It is also about something like a philosophy or set of values that underpins
these practices. CRS initiatives must focus on the relationship between personal values
and CSR initiatives of managers. The CSR practices are influenced or affected by the
personal values of managers, because they formulate the CSR policies of the business
organization and their personal attitude is part of their individualistic characteristics
which affects the way they behave.
vi) Beyond philanthropy
In some regions of the world, CSR is mainly about philanthropy i.e. corporate
discretionary responsibility or voluntarism towards the general public. CSR is currently
a mandatory practice backed by regulations and accepted international standard which
is shifting from altruistic to instrumentality or strategic CSR. It is no longer altruistic in
nature only but more than just philanthropy and community development projects,
because of the impacts it has on profitability, human resource management, marketing,
32
and logistic support which are all part of the core functions of business organizations.
CSR extends beyond philanthropy because of its viability to be instrumental or strategic
in satisfying stakeholder expectations and its potential capability to achievement of
organizational objectives.
Check Your Progress 1
Identify the key features of CSR.
2.4 SCOPE OF CORPORATE SOCIAL RESPONSIBILITY
The scope of CSR is conceptually applicable to many fields. The debate between the
private sector, civil society and governments focuses on a few key issues. As there is no
single, commonly accepted definition of CSR, there is also no commonly accepted classification
of the main components of CSR. The scope of CSR is understood with reference to the
following aspects.
i) Environmental protection
Over the past several years, environmental responsibility has expanded to involve
substantially more than compliance with all applicable government regulations or even
a few initiatives such as recycling or energy efficiency. Many citizens, environmental
organizations and leadership companies now define environmental responsibility as
evolving a comprehensive approach to a company’s operations, products and facilities
that includes assessing business products, processes and services; eliminating waste
and emissions; maximizing the efficiency and productivity of all assets and resources;
and minimizing practices that might adversely affect the enjoyment of the planet’s
resources by future generations.
ii) Labor Security
It includes freedom of association and the effective recognition of the right to collective
bargaining; the elimination of all forms of forced and compulsory labor; the effective
abolition of child labor; and the elimination of discrimination in respect of employment
and occupation. By treating employees fairly and ethically, companies can also
demonstrate their corporate social responsibility.
iii) Human rights
Business practices can profoundly affect the rights and dignity of employees and
communities. The main focus is on developing workplaces free from discrimination 33
where creativity and learning can flourish, decent codes of professional conduct, and
where a proper balance can be maintained between work and other aspects of our
lives. Behaving irresponsibly on the issue of human rights could be costly because
their reputation and bottom line is at stake. Paying workers a living wage and protecting
them from harassment may cost a little more in the short run, but if it improves morale
and reduces turnover then it may lead for growth of enterprise in the long run.
iv) Community involvement
Community involvement of corporate entities includes, community partnership,
employee giving, global community involvement, philanthropy, product and services
donations, release time, volunteerism etc. Corporate community involvement refers
to a wide range of actions taken by companies to maximize the impact of their donated
money, time, products, services, influence, management knowledge and other
resources on the communities in which they operate. When strategically designed
and executed, these initiatives not only bring value to recipients, but also enhance the
reputation of companies and their brands, products and values in local communities
where they have significant commercial interests as well as around the world.
v) Business standards
It covers a broad area of corporate activities such as ethics, financial returns,
environmental protection, human rights and labor standards. The standards are usually
accepted at corporate, business association, industry or country level. The rise of
international trade, globalization, and instant communication has led to increasing
pressure on corporate entities to meet the new business standards.
vi) Marketplace
Marketplace issues is another element of CRS in modern times. It covers a wide
range of business activities that define a company’s relationship with its customers.
These activities may be grouped into six categories: (1) product manufacturing and
integrity; (2) disclosure, labeling and packaging; (3) marketing and advertising; (4)
selling practices; (5) pricing; and (6) distribution. In each of these areas, companies
are redesigning their business strategies to address new issues like privacy and
technology, competition, increased customer expectations on product safety and
environmental impact, increased scrutiny by consumers and nongovernmental
organizations etc.
vii) Enterprise and economic development
This includes, competitiveness, development of local SMEs, entrepreneurship,
community economic development, micro finance in emerging economies etc.) The
34 drive of entrepreneurs in developing countries can provide the catalyst to lift an
economy onto an upward growth spiral. In many cases, however, the lack of an
enabling business framework and a scarcity of support structures for new businesses
can work to undermine and defeat entrepreneurial endeavor. Increasingly, multinational
companies (MNCs), with their wealth of financial, technical and managerial expertise,
are being called upon to provide a focal point of support for local businesses. At the
same time, MNCs can help governments understand the ways in which an enabling
business framework can be developed to fuel domestic entrepreneurial efforts. Business
involvement in Community Economic Development (CED) is the application of a
company’s core business functions, as well as foundation and contributing dollars, to
business endeavors in lowincome and underserved communities for the mutual
economic benefit of community and company.
viii) Health Promotion
The workplace is now recognized as an important setting for health promotion in
industrialized countries, and interest is growing in the wider role that business can
play as a partner in healthy development. Private sector plays a dominant role as the
driver of current global economic development, and globalization is bringing new
social and economic challenges. For those concerned with promoting wellbeing, it is
essential that policies and programs are adjusted to address this new reality and that
the business community is, as far as possible, engaged as a partner in the promotion
of wellbeing.
ix) Education and Leadership Development
As educations is one of the key elements of sustainable development and propoor
growth, businesses, working together with public sector and civil society, can make
an important contribution to providing access to quality education for all. Companies
can also make more critical impact on the development process by raising standards
in corporate education and leadership development, and bringing best practices to
their partners in developing and transitional economies.
Check Your Progress 2
Describe the scope of CSR.
35
2.5 IMPORTANCE OF CORPORATE SOCIAL RESPONSIBILITY
CSR is becoming one of the most challenging issues that private and public sector,
civil society and corporate leaders, and other practitioners are faced with. The CSR offers a
bundle of benefits to all the stakeholders. Following are the advantages of CSR.
1. Improves Public Image
Companies that demonstrate their commitment to various causes are perceived as
more philanthropic than companies whose corporate social responsibility endeavors
are nonexistent. A corporation’s public image is the outcome of its social responsibility
programs and how aware consumers are of these programs. Consumers feel good
associating with good organizations that help the community. Corporations can improve
their public image by supporting nonprofit oriented activities through monetary
donations, volunteerism, inkind donations of products and services, and strong
partnerships. By publicizing their efforts and letting the general public know about
their philanthropy, companies increase their chances of becoming favorable in the
eyes of consumers.
2. More Efficient Operations
Utilization of CSR framework in corporate business strategy can result in high efficiency
in operations, for instance, improved efficiency in the use of energy and natural
resources; reduced waste such as reducing emissions of gases; and selling recycling
materials. Business operation also benefits from better human resources. In the human
resources arena, worklife programs that result in reduced absenteeism and increased
retention of employees often save companies money through increased productivity
and by a reduction in hiring and training costs.
3. Improved Financial Performance
By adopting CSR practices, business entities, can improve their financial performance
through increased sales, increased business and increased market share. Hence,
socially responsible business organizations have better financial performance.
4. Increased Sales and Customer Loyalty
Through CSR initiatives there will be a larger and growing market for the products
and services produced by socially responsible companies. While businesses must
first satisfy customers’ key buying criteria – such as price, quality, appearance, taste,
availability, safety and convenience. CSR concerned consumers will prefer to buy
36 products produced by reputated companies with high social consciousness.
5. Creating New Business Opportunities
Open and effectiveway of communication with the stakeholders not only improves
the company’s reputation but also opens up new business opportunities. Close
cooperation with key stakeholders and communities and responding to CSR constraints
by revising business practices and strategies and accepting triple bottom line concepts
also provide opportunities through innovation, creative thinking, better relations with
key stakeholders, and introduction of new products and markets. Creative thinking is
highly stimulated by addressing issues of CSR and taking into consideration the
ecological and social costs.
6. Attracting and Retaining Quality Investors and Business partners
Sound CSR practices help companies attract and retain quality investors and business
partners. These benefits can be classified into four broader categories. viz, a) Increased
shareholder value b) Lower cost of capital c) Access to Socially Responsible
Investment Fund d) Reducing risks by adopting best practices. Demand for investment
capital increases and companies can raise capital at a lower cost. Investors usually
prefer to invest in companies with sound business practices. At the same time, investors
are looking for good corporate governance, business ethics and corporate social
responsibility policies and practices. Cost saving became a high risk, damage on
reputation, and thus eventually a high cost. “Reputational risk” that arises from
irresponsible social and environmental business practices, for instance, environmental
damages, violation of human rights, and child labor etc, is an additional risk, and
doing business with socially and environmentally irresponsible partner brings
reputational risk to the company. Therefore, worldclass companies started helping
their suppliers to adopt similar CSR practices thus reducing reputational and other
forms of risk.
7. Government Support
Many governments give financial incentives for sound CSR initiatives, including
environmentally friendly innovations. Companies that demonstrate they are engaging
in practices that satisfy and go beyond regulatory compliance requirements are being
given less scrutiny and freer reign by both national and local government entities.
2.6 COMPONENTS (AREAS) OF CSR
After understanding the concept and importance of social responsibility of business,
let us look into the various responsibilities that a business has towards different groups with
whom it interacts. The business generally interacts with owners, investors, employees, suppliers, 37
customers, competitors, government and society. They are called interest groups because by
each and every activity of business, the interest of these groups is affected directly or indirectly.
i) Responsibility towards owners
Owners are the persons who own the business. They contribute capital and bear the
business risks. The primary responsibilities of business towards its owners includes:
• Ensuring of the full participation of owners in the management of the affairs of
the company.
• Proper utilization of capital and other resources.
• Growth and appreciation of capital.
• Regular and fair return on capital invested
• Disclosure of financial statements and other related information.
ii) Responsibility towards customers
No business can survive without the support of customers. As a part of the responsibility
of business towards them the business should provide the following facilities:
• ·Products and services must be able to take care of the needs of the
customers.
• Products and services must be qualitative
• There must be regularity in supply of goods and services
• Price of the goods and services should be reasonable and affordable.
• All the advantages and disadvantages of the product as well as procedure to
use the products must be informed to the customers.
• There must be proper and effective aftersales service.
• Grievances of the consumers, if any, must be settled quickly.
• Unfair means like under weighing the product, adulteration, etc. must be
avoided.
iii) Responsibility towards employees
Business needs employees or workers to work for it. These employees put their best
effort for the benefit of the business. So it is the prime responsibility of every business
to take care of the interest of their employees. If the employees are satisfied and
efficient, then the only business can be successful. The responsibilities of business
38 towards its employees include:
• Timely and regular payment of wages and salaries.
• Proper working conditions and welfare amenities.
• Opportunity for better career prospects.
• Job security as well as social security like facilities of provident fund, group
insurance, pension, retirement benefits, etc.
• Better living conditions like housing, transport, canteen, crèches etc.
• Timely training and development.
iv) Responsibility towards suppliers
Suppliers are businessmen who supply raw materials and other items required by
manufacturers and traders. The responsibilities of business towards these suppliers
are:
• Giving regular orders for purchase of goods
• Dealing on fair terms and conditions
• Availing reasonable credit period.
• Timely payment of dues.
v) Responsibility towards Government
Business activities are governed by the rules and regulations framed by the government.
The various responsibilities of business towards government are:
• Setting up units as per guidelines of government
• Payment of fees, duties and taxes regularly as well as honestly.
• Not to indulge in monopolistic and restrictive trade practices.
• Conforming to pollution control norms set up by government.
• Not to indulge in corruption through bribing and other unlawful activities.
vi) Responsibility towards society
A society consists of individuals, groups, organizations, families etc. Business, being a
part of the society, must maintain its relationship with all other members of the society.
Thus, it has certain responsibilities towards society, which may be described as follows:
• To help the weaker and backward sections of the society
• To preserve and promote social and cultural values and provide grants for
social welfare activities, 39
• To generate employment
• To protect the environment
• To conserve natural resources and wildlife
• To promote sports and culture
• To provide assistance in the field of developmental research on education,
medical science, technology etc.
Check Your Progress 3
State the component of CSR.
2.7 IMPLEMENTATION OF CSR
Implementation of CSR by the Indian Corporate World
New Companies Act 2013 (Companies Act) has introduced several new provisions
which change the face of Indian corporate business. One of such new provisions is Corporate
Social Responsibility (CSR). The concept of CSR rests on the ideology of give and take.
Companies take resources in the form of raw materials, human resources etc from the society.
By performing the task of CSR activities, the companies are giving something back to the
society. Ministry of Corporate Affairs has recently notified Section 135 and Schedule VII of
the Companies Act as well as the provisions of the Companies (Corporate Social Responsibility
Policy) Rules, 2014 (CRS Rules) which has come into effect from 1 April 2014.
Applicability
Section 135 of the Companies Act provides the threshold limit for applicability of the
CSR to a Company i.e. (a) net worth of the company to be Rs 500 crore or more; (b)
turnover of the company to be Rs 1000 crore or more; (c) net profit of the company to be Rs
5 crore or more. Further as per the CSR Rules, the provisions of CSR are not only applicable
to Indian companies, but also applicable to branch and project offices of a foreign company
in India.
As per the new CSR Policy initiatives every qualifying company requires spending of
at least 2% of its average net profit for the immediately preceding 3 financial years on CSR
activities. Further, the qualifying company will be required to constitute a committee (CSR
40
Committee) of the Board of Directors (Board) consisting of 3 or more directors. The CSR
Committee shall formulate and recommend to the Board, a policy which shall indicate the
activities to be undertaken (CSR Policy); recommend the amount of expenditure to be incurred
on the activities referred and monitor the CSR Policy of the company. The Board shall take
into account the recommendations made by the CSR Committee and approve the CSR Policy
of the company.
Activities under CSR
The activities that can be done by the company to achieve its CSR obligations include
eradicating extreme hunger and poverty, promotion of education, promoting gender equality
and empowering women, reducing child mortality and improving maternal health, combating
human immunodeficiency virus, acquired, immune deficiency syndrome, malaria and other
diseases, ensuring environmental sustainability, employment enhancing vocational skills, social
business projects, contribution to the Prime Minister’s National Relief Fund or any other fund
set up by the Central Government or the State Governments for socioeconomic development
and relief and funds for the welfare of the Scheduled Castes, the Scheduled Tribes, other
backward classes, minorities and women and such other matters as may be prescribed.
CSR Practices by the Indian Corporate World
Tata consultancy services (TCS)
Tata consultancy services is India’s largest software service company and has won
the Asian CSR award for initiating community development work and implementing various
programs and devoting leadership and sincerity as ongoing commitment in incorporating ethical
values. Major focus of the company is on education sector. Company is working upon literacy
program that cares TCS designed computer based literacy model to teach adults and this
program is known as “adult literacy program”. Company is also working upon environment
policy and has been developing environment friendly products and service.
Mahindra and Mahindra
As part of CSR initiatives Mahindra and Mahindra is focusing on the girl child, youth
and farmers through programs like free education, public health and environment protection.
Mahindra pride schools provide livelihood training to youth from socially and economically
disadvantaged communities and has already trained over 13,000 youth in Pune, Chennai,
Patna, Chandigarh and Srinagar. M&M sponsors the Lifeline Express trains that take medical
treatment to far flung communities. Then it undertook Project Hariyali, which has planted 7.9
million trees till 2016, including four million trees in the tribal belt of Araku Valley. M&M has
also constructed 4,340 toilets in 1.171 locations across 11 states and 104 districts specifically
for girls in Government schools as part of Swacch Bharath Swacch Vidyalaya. It has incurred
an expenditure of Rs.83.24 crore which accounts for 2 percent of PAT. 41
CocaCola India
CocaCola India has supported community programs with a focus on education,
health and water conservation. The Company has commissioned 400 rainwater harvesting
systems and provided clean drinking water to more than 100 schools. Similarly, it supported
school projects and driven reform in sustainable packaging, disaster relief and rehabilitation.
Steel Authority of India Limited
SAIL has supported maintenance of monuments in Delhi’s Lodhi Gardens, and Vedvyas,
Saraswati kund in Rourkela. To take care of distinct features of tribal culture, a 5day
Chhattisgarh Lok Kala Mahotsav is celebrated every year in Bhilai and nearby places in
which more than 600 artistes participate. To promote local culture and games, various Gramin
Lokotsavs and Gramin athletics competitions are organized by SAIL at different locations
throughout the year.
L & T Company Ltd
Through its CSR initiatives, L&T contribute towards to inclusive growth by empowering
communities and accelerating development in four thrust areas viz, 1) Education/ Literacy
Enhancement: 2) Skill Development/ Empowerment (Improving the capabilities and
employability of persons in disadvantaged sections of the society through skill development
programs and vocational training programs) 3) Healthcare/ Medical facility 4) Drinking water/
Sanitation. The corpus of 2% of the average Net Profit made by the Company during
immediately preceding three financial years is kept to meet these activities.
2.8 SUMMARY
The social responsibility of business refers to such decisions of a business concern
which promote the welfare of society as a whole along with its own interest. The concept of
Corporate Social Responsibility (CSR) goes beyond charity or philanthropy and requires the
company to act beyond its legal obligations and to integrate social, environmental and ethical
concerns into its business process. Corporate Social Responsibility is defined as “achieving
commercial success in ways that honor ethical values and respect people, communities, and
the environment. CSR is becoming one of the most challenging issues that private and public
sector, civil society and corporate leaders, and other practitioners are faced with.
The CSR offers a bundle of benefits to all the stakeholders. In this unit the meaning
and definition of social responsibility of business, concept, features and importance of Corporate
Social Responsibility is discussed. Similarly, various components of CSR like responsibility
towards owners, responsibility towards customers, responsibility towards employees and
responsibility towards Government and society are also analysed. Finally, the unit concluded
with implementation of CSR by the Indian Corporate world highlighting a few corporate CSR
42 practices.
2.9 CHECK YOUR PROGRESS: MODEL ANSWERS
1. The key features of CSR are:
• Voluntary
• Internalizing or managing externalities
• Multiple stakeholder orientation
• Alignment of social and economic responsibilities
• Practices and values
• Beyond philanthropy.
2. Scope of the CSR is as follows:
• Environmental protection
• Labor Security
• Human rights
• Community involvement
• Business standards
• Marketplace
• Enterprise and economic development
• Health Promotion
• Education and Leadership Development.
3. The components / (areas) of CSR are:
• Responsibility towards owners
• Responsibility towards customers
• Responsibility towards suppliers
• Responsibility towards employees
• Responsibility towards Government
• Responsibility towards society.
2.10 MODEL EXAMINATION QUESTIONS
I. Short Answer Questions
1. What do you mean by ‘social responsibility of business’?
2. State the New Companies Act 2013 Rules of CSR
3. State the responsibilities of business towards its customers
4. Narrate the CSR practices of Mahindra & Mahindra Company Ltd. 43
II. Long Answer Questions
1. Explain the concept and features of Corporate Social Responsibility of Business
2. Explain the importance of CSR in modern business world
3. Outline the various components of social responsibility of business towards owners,
employees and the society at large.
4. Explain the CSR implementation practices by the Indian Corporate entities.
III. Objective Type Questions
A. Multiple Choice Questions
(i) The definition of Corporate Social Responsibility recognizes that:
a) Companies have a responsibility for their impact on society and environment
b) The natural environment should be the main focus of CSR activities.
c) Business ethics is a complex issue.
d) Companies must pay equal attention to business ethics and sustainability.
(ii) What is the main characteristic of the stakeholder approach?
a) The idea that many different groups have a legitimate interest in the corporation
b) It is a critical perspective on corporations and business
c) A focus on social and environmental responsibilities of a corporation
d) The assumption that shareholders are not the main stakeholders in the
corporation
(iii) Which of the following is NOT an example of a genuine business innovation?
a) Development of less polluting fuel
b) Investment in alternative energy sources
c) New product targeted at lowincome customers
d) Charitable donation to an ecological organization
(iv) Opportunities for social innovation are greatest when:
a) CSR is aligned with a firm’s core skills and capabilities.
b) CSR spending of a firm is larger than that of its competitors
c) CSR is pursued by a firm to improve its reputation.
44 d) CSR is pursued by a firm to enhance human capital
(v) Benefits derived from social responsibility include;
a) Enhanced organizational efficiency
b) Producing better and quality products
c) Increased image of the business
d) All of the above
Answers: (i) a (ii) a (iii) d (iv) a (v) d
B. Fill in the blanks
(i) As per social responsibility concept the organizations must respond to the needs of
____________.
(ii) According to the concept of ____________ corporate social performance and
financial performance enhance each other.
(iii) _________ is the study of moral obligation, or separating right from wrong
(iv) The process by which companies identify the most important stakeholders is called
_____________ .
(v) CSV refers to ________ in CSR.
Answers: (i) All the Stakeholders (ii) Virtuous Cycle (iii) Ethics
(iv) Stakeholder impact analysis (v) Creating Shareholder Value
C. Match the Following
i) ISO standard focuses on Social Responsibility a) Philanthropic approach
ii) CSR addresses b) Legal CSR
iii) First Generation CSR c) 26000
iv) Maximizing profits while obeying the law d) 2013
v) New Companies Act e) Social & Environmental
Answer: i – c ii – e iii – a iv – b v–d
45
2.11 GLOSSARY
Social Responsibility of Business : Refers to such decisions of a business
concern which promote the welfare of the
society as a whole alongwith its own interests,
i.e., the business concern acts in a manner
that will accomplish social gains along with
traditional economic gains which the
business concern seeks.
Corporate Social Responsibility : Corporate social responsibility is the
continuing commitment by business to
behave ethically and contribute to
economic development while improving the
quality of life of the workforce and
their families as well as of the local community
and society at large.
2.12 FURTHER READINGS
David Crowther and Guler Aras : Corporate Social Responsibility
Subhasis Ray, S. Siva Raju : Implementing Corporate Social
Responsibility: Indian Perspectives.
Sanjay K Agarwal : Corporate Social Responsibility in India.
46
UNIT – 3: PROMOTION OF BUSINESS
Contents
3.0 Aims and Objectives
3.1 Introduction
3.2 Concepts of Promotion
3.3 Business Promotion and Promoter
3.4 Characteristics of Business Promoter
3.5 Steps in Business Promotion
3.6 Summary
3.7 Check Your Progress: Model Answers
3.8 Model Examination Questions
3.9 Glossary
3.10 Further Readings
3.0 AIMS AND OBJECTIVES
This unit presents the meaning of business promotion, characteristics and steps in
promotion. After studying this unit, you should be able to:
• know the meaning of promotion and promoter;
• identify the characteristics of promotion; and
• explain the steps in Business promotion.
3.1 INTRODUCTION
In the earlier units, the concept of business, objectives, and functions of business and
the social responsibility of business were studied. In this unit, you will learn the meaning of
promotion; promoter and the characteristics of the business promotion, followed by the study
of different steps involved in business promotion and finally the different factors affecting the
choice of organization.
3.2 CONCEPT OF PROMOTION
A business enterprise does not come into existence on its own. It comes into existence
as a result of the efforts of an individual or a group of people or an institution. In other words
it has to be promoted by some person or persons. The process of business promotion begins 47
with the conception of an idea and ends when that idea is translated into action i.e., the
establishment of the business enterprise and commencement of its business. In order to have
a clear idea of the meaning of the term ‘promotion’, let us consider the definition given by
some well known authors.
According to Harry G. Guthmann and Herbert E. Dogull, “Promotion starts
with the conception of the idea from which the business is to be evolved and continues down
to the point at which the business is fully ready to begin operations as a going concern”.
Henry E. Hoaghland defines promotion as “the process of creating a specific
business enterprise”. Its scope, according to him, is very broad and numerous individuals are
frequently asked to make their contribution to the programme. In any specific case, promotion
begins when someone gives serious consideration to the formulation of the ideas upon which
the business in question is to be based. From this time, until a corporation is organized and
plans are completed to exploit the idea, the aggregate of activities contributed by all those
participating in the building of the enterprise constitute promotion’.
Another author Mr. C.W. Gerstenberg, defines promotion as “the discovery of
business opportunities and the subsequent organization of funds, property and managerial
ability into a business concern for the purpose of making profits from there”.
3.3 BUSINESS PROMOTION AND PROMOTER
The process of setting up a business enterprise is known as promotion and
the persons who carry out this process are called promoters. Promotion of a business
enterprise involves several decisions. Promotion of a new business enterprise is like the birth
of a child. The person who has a business idea and takes steps to launch a business
enterprise is known as an ‘entrepreneur’.
Promoting enterprises particularly in 21st century is not only confined to the traditional
aspects of mere establishment of business establishments but also to focus more about
strengthening the institutions and governance systems which nurture enterprises strong. The
efficient institutions must support with strong market base to ensure that human, financial and
natural resources are combined equitably and efficiently in order to bring about innovation
and enhance productivity. This calls for new forms of co.operation between government,
business and society to ensure that the quality of present and future life (and employment) is
optimized whilst safeguarding the sustainability of the planet.
The importance of enterprise as the principal source of growth and employment cannot
be overstated. Economic growth is fuelled, first and foremost, by the creativity and hard work
of entrepreneurs and workers. Driven by the quest for profits, enterprises innovate, invest and
48 generate employment and wage income. Enterprises need to ensure that their core business
activities continue to add value and are undertaken efficiently and effectively. Enterprises also
need a supportive enabling environment characterized by, among other things, the existence
of open, rule based, predictable and nondiscriminatory markets and a noncorrupt and well
governed economy. Enterprises benefit from operating in value chains characterized by high
quality industries, with prosperous consumers and investors. Enterprises also benefit from
enterpriselevel, sectoral and national mechanisms for effective social dialogue.
The promoter is a person who conceives the idea of starting a business and takes all
the measures required for bringing the enterprise into existence. Promoters are of different
types such as professional promoters, occasional promoters, promoter companies, financial
promoters, entrepreneurs, lawyers and engineers. But in the context of business promotion
particularly in changing dimensions and definitions of business concepts, the role of promoters
is very crucial. They must be strategic thinkers, technology savvy, having broad idea about
crisis management and environmental forecasting.
Definition of Promoter
Following definitions clarify the status and role of a promoter.
“A promoter is the one, who undertakes to form a company with reference to a given
object and sets it going and takes the necessary steps to accomplish that purpose.”
— Justice C. J. Cokburn
“A promoter is the person conscious of the possibility of transforming an idea into a
business capable of yielding a profit; who brings together various persons concerned and who
finally, superintendents the various steps necessary to bring the new business into existence.”
— Arthur Dewing
Legal Position of Promoter in case of a company
The company law has not given any legal status to promoters. A promoter is neither
an agent nor a trustee of the company because it is a nonentity before incorporation. Some
legal cases have tried to specify the status of a promoter. He stands in a fiduciary position. The
promoter moulds and creates the company and under his supervision it comes into existence.
It is the duty of the promoter to get maximum benefits for the company. He should not get
secret profits from the company. If he sells his property to company, then he should explain his
interest in such property.
Check Your Progress 1
Define the term ‘promotion’
49
3.4 CHARACTERISTICS OF BUSINESS PROMOTER
1. Characteristics
From the definitions given above, we can identify the chief characteristics of promotion.
They are as follows:
(i) Promotion of a business enterprise is a process consisting of the following steps:
(i) discovery of a business idea;
(ii) investigation of the business ideas;
(iii) assembling of the inputs like capital, land, labour etc, and
(Iv) formation of the appropriate business organization such as sole proprietorship
or a partnership or company by complying with all the required legal formalities.
(ii) Promotion refers to the starting of a new business. New business means not only the
discovery of new ideas and the establishing of a new business but also the exploitation
of an already existing idea and the finding of new business.
(iii) Promotion refers not only to the establishment of the company form of organization
but also to other forms of organization, such as Sole Proprietorship, Joint Hindu
Family firm, Partnership and Cooperative organization. Whatever is the form, the
broad steps involved are the same for all, but the nature and complexity of work to
be done may vary according to the form. For example, the process of formation of
the company form of organization is more complex than that of other forms like sole
proprietorship and partnership. In the case of sole trading concern, there is no problem
of registration, whereas in the case of a company, registration is compulsory which
involves a cumbersome and lengthy legal procedure.
3.5 STEPS IN BUSINESS PROMOTION
The promotion of a new enterprise is having a number of problems. The entrepreneur
or promoter has to invest huge amounts and he experts a good return on his investment. To
arrive at a decision to promote an enterprise, he has to consider carefully many factors;
otherwise, he may have to face problems at a later stage. Further, the promoter has to make
a large number of decisions in connection with the promotion of an enterprise.
The various steps involved in the process of promotion of a business enterprise are:
1. Development of idea;
50 2. Determination of objectives and broad policies;
3. Product analysis and market survey;
4. Selection of the form of organization;
5. Determination of the size and location;
6. Physical facilities;
7. Financial planning;
8. Recruitment of labour force; and
9. Designing the internal organization structure.
1. Development of Idea
The first problem of an entrepreneur is to conceive the idea of a specific business
opportunity. This idea may strike him on account of his awareness of unexploited natural
resources or unused supply of raw materials or potential demand for a certain product or
profitability of certain lines of business or government’s encouragement for certain lines of
businesses. A business idea may be discovered from any of the following sources.
a) Observing Markets: The promoter should study the market to find out the demand
and supply position for various products. He should then estimate the future demand
after taking into account the anticipated changes in income levels, fashions etc. market
surveys can also reveal competition and price trends. From the data collected through
market surveys, the promoter should try to identify those products and industries
where demand exists and supply needs to be increased.
b) Prospective Consumers: Contacts with prospective consumers can give an idea of
the features that should be built into the product/service. It is also important to collect
data on customer needs and preferences before choosing the product to be
manufactured. A market test of the prototype product can be conducted before
launching the product in the market.
c) Study of Project Profiles: Various publications of public and government agencies
on various projects and industries are an important source of business ideas. Such
project profiles describe in detail the prevailing market situation and the technical and
financial requirements of different projects. A careful analysis of such details can bring
out the most promising projects which can then be taken up for further evaluation.
d) Developments in Other Nations: An entrepreneur can discover good business
ideas by keeping good knowledge about developments in advanced nations of the
world. Underdeveloped and developing countries prove to be a good market for
51
those products which are the “in things” in developed nations. An entrepreneur can
also visit foreign markets to explore the possibility of a foreign collaboration and to
discover other types of business ideas.
e) Trade Fairs and Exhibitions: A visit to national and international trade fairs and
exhibitions can provide information about various products. It is also a good place to
explore possibilities of collaboration and dealership and gives a fair idea of the existing
competition in the market.
2. Determination of Objectives and Broad Policies
After arriving at a decision to establish a business in a particular line, the entrepreneur
has to determine the objectives of the enterprise. The decision relating to the objective is very
important because the future of the concern and its working are determined by its objectives.
Further, the objectives of the enterprise must be such that it should be possible for the concern
to achieve them.
3. Product Analysis and Market Survey
It is also necessary for an entrepreneur to conduct an analysis of the product and its
market from the point of view of the customer. For this, he has to collect data on consumer
preferences and needs through market research techniques and to find out the saleability of
the proposed product within a given price range. Further, the market research also should
cover consumer preferences in respect of design, colour, size and shape. In addition, the
entrepreneur should try to find out the total demand, trends in demand, potential demand and
the degree of competition for the proposed product.
4. Selection of the Form of Organization
Another important decision to be taken by entrepreneur relates to the selection of
from of business ownership, i.e., whether it should be sole proprietorship, partnership, joint
Hindu family firm, joint stock company or a cooperative form of organization. Each form of
organization has its own merits and demerits. The promoter has to select the form of organization
by considering a large number of factors such as nature of business activity, availability of
capital, demand conditions for the product of the proposed enterprise, marketing facilities,
available infrastructure, incentives from government, tax advantages and the degree of risk
involved. It may be noted here that in the case of some business like banking and insurance,
the form has to be that of an incorporated company and hence, the promoter has no choice in
that regard. Again, if the enterprise to be started is of a very large size, ‘company’ is the only
feasible form of organization.
52
5. Determination of the Size and Location
Size of the firm: The next problem relates to the size of the enterprise. The decision
regarding the size of the enterprise is influenced by the nature of the enterprise proposed and
the form of organization. In fact, the size of the unit and the form of organization are inter
dependent. The other factors which an entrepreneur has to consider in deciding the size of the
proposed enterprise are the technical, managerial, marketing and financial aspects. By
considering all the factors, the entrepreneur tries to arrive at the most economical and efficient
size.
Location: The decision relating to location is to be taken only by taking into account a large
number of factors. The factors to be considered are:
i) nearness to the market to be served;
ii) transportation facilities;
iii) availability of adequate supply of water, power and fuel.
iv) regional tax situation;
v) nearness to the source of raw materials;
vi) availability of labour;
vii) regulations imposed by the Government; and
viii) climatic conditions.
Thus, the factors to be considered are many. But no single place may fulfill all these
considerations. Hence, the promoter has to evaluate the relative advantages of alternative
places in relation to the above mentioned factors and select that place which provides the
greatest measure of net advantage.
Selection of site: After deciding the area for locating the business, the promoter has to select
the exact site. For this purpose, he has to consider the following factors:
i) availability of adequate land area and its development cost;
ii) availability of water, power etc.,
iii) drainage and soil conditions;
iv) nearness to other plants or institutions which the new enterprise may serve or
from which it may get materials or services;
v) railway facilities for receiving raw materials and for transporting the finished
goods;
vi) government regulations and restrictions;
vii) proximity to the main road; and
viii) nearness to local market in the case of a small enterprise. 53
6. Physical Facilities
Promotion also involves consideration of such problems which may include provision
for plant, building, equipment and proper layout. The provision of physical facilities involves
decisions regarding the character of the building, yard space, general layout of the establishment
and the proper installation of equipment and machinery. Decision relating to equipment and
machinery and their layout and type of building depend on the nature of process, sequence of
manufacturing operations, volume of production and cost and efficiency of various types of
machinery and equipment. The promoter has to take correct decisions relating to physical
facilities because the efficient functioning of the enterprise depends upon them.
7. Financial Planning
Capital is required for investment in fixed assets like land, building, machines and
equipment and current assets like supplies, material etc. Capital is also required for meeting
daytoday expenses of business. An entrepreneur while doing the financial planning will have
to take decisions in the following areas. In the case of a small concern, the entrepreneur
himself arranges it from his own resources, but in the case of a joint stock company, finances
have to be secured from an outside source by issuing shares. Hence, financial planning is one
of the important steps in promotion of a business enterprise. The entrepreneur has to do
financial planning which involves the following:
i) determination of the total amount of capital required for the proposed
enterprise;
ii) determination of the capital structure ( i.e., the sources of capital and their
relative proportions);
iii) administration of funds
iv) estimation of the return on the investment;
v) gestation period of the proposed concern; and
vi) determination of the time appropriate for financing the enterprise.
8. Recruitment of Labour Force
Yet another problem in promotion is to secure adequate and desired labour force,
both skilled and unskilled. The promoter has to make an estimate of the number of workers of
different categories required for various departments and sections and arrange for their
recruitment. There are different sources of labour from which requirements may be made.
Sometimes labour may be drawn from other concerns which are in existence. In such cases,
54
the entrepreneur has to see that such labourers are not those rejected by the original concern
because of their inefficient performance.
9. Designing the Internal Organization Structure
The next and final step in promotion process is to design the internal organization structure for
the proposed concern. This involves breaking up of the total work of the enterprise into major
functions like production, marketing, finance, personnel, purchase, engineering etc. and the
dividing of each of them into sections. While the major functions are under the control of
departmental heads like production manager, marketing manager, financial manager/controller,
etc., the sections are supervised by the section officers or heads. Further, the entrepreneur
has to stipulate the functions of different departments and their interrelationships. The efficient
functioning of the concern depends to a large extent on the nature of the structure and hence,
the entrepreneur has to carefully plan the organization structure of the enterprise.
Check Your Progress 2
What are the steps involved in business promotion?
3.6 SUMMARY
Business promotion is an important issue in the development of business. The business
promoter plays a crucial role in the promotion of the business. This unit dealt with the concept
and characteristics of business promotion. The different steps that are involved in the process
of business promotion are described. Special care was taken to analyze the merits and
demerits of each step in the promotion of business. Among all the steps in business promotion,
the location of business, physical facilities, financial planning and finally the recruitment of
labour are given top priority by the business promoters.
3.7 CHECK YOUR PROGRESS: MODEL ANSWERS
1. Mr. C.W. Gerstenberg, defines ‘promotion as the discovery of business opportunities
and the subsequent organization of funds, property and managerial ability into a business
concern for the purpose of making out profits there from’.
2. i) discovery of a business idea
ii) investigation of business ideas
55
iii) assembling of the inputs like land, labour and capital; and
iv) formation of appropriate form of organization.
3.8 MODEL EXAMINATION QUESTIONS
I. Short Answer Questions
1. Define ‘promotion’?
2. Who is a promoter?
3. List out the factors to be considered for selecting the form of organization.
4. What is ‘Market Survey’?
II. Long Answer Questions
1. What do you mean by promotion? Explain the chief characteristics of business
promotion.
2. Explain the various steps involved in promoting a new business enterprise.
III. Objective Type Questions:
A. Multiple Choice Questions
i) An entrepreneur is someone who assumes the major risks of a new business by
committing which of the following?
a) Equity. b) Time.
c) Career. d) all of the above.
ii) Which of the following is not a personal characteristic often found in an
entrepreneur?
a) Selfconfident. b) independentminded.
c) Perceptive. d) Follower.
iii) Which of the following is usually included in a business plan?
a) Detailed description of the product or service.
b) Marketing and promotional plans.
c) Management and staffing.
d) all of the above.
56
iv) Who said that the job of the entrepreneur is “creative destruction”?
a) Peter Drucker.
b) Pierre Trudeau.
c) Joseph Schumpeter.
d) Brian Mulron
v) The First step in promotion of a new enterprise is
a) Selection of the form of organization
b) Development of idea
c) Determination of objectives and broad policies
d) Product analysis and market survey
Answers: (i) d (ii) d (iii) d (iv) c (v) b
B. Fill in the blanks
(i) The process of setting up a business enterprise is known as ________.
(ii) The persons who carry out business process are called ____________.
(iii) _______ conducts the analysis of the product.
(iv) The promoter of business should study the _________ to find out his products.
(v) Capital is required for investment in ____________.
Answers: (i) Promotion (ii) Promoters (iii) Entrepreneur
(iv) Market, demand (v) Fixed assets
C. Match the following:
(i) Business starts with (a) Risk taker
(ii) Entrepreneur (b) Quest for Profits
(iii) Financial Planning (c) Estimating the capital Required
(iv) Promoters (d) Providing services
(v) Service Enterprise (e) an Idea
Answers: (i) e (ii) a (iii) c (iv) b (v) d
57
3.9 GLOSSARY
Financial Planning : The process of estimating the amount of capital to be
raised, etermining the form and proportion of amount
of securities to be issued and laying down the policies
concerning the implementation of the plan.
Minimum Subscription : It is the minimum amount which in the opinion of the
directors is necessary to provide for preliminary
expenses, underwriting commission, working
capital, etc.
Promoter : The person or persons who undertake the
responsibility of bringing the company into
existence.
Promotion : The process of discovering a business proposition
and taking all the required steps to implement it.
Service Enterprise : The enterprises which are engaged in providing
services,e.g., cinema houses and transport
companies.
3.10 FURTHER READINGS
Bhushan Y.K. : Fundamentals of Business Organization and
Management, New Sultan Chand and Sons, Delhi.
Krishnaswamy O.R : Essentials of Commerce,Eagle Press Publication
Division, Madras.
Reddy P.N and Gulshan : Principles of Business Organization and
Management, S.Chand and Co., Ltd., New Delhi.
58
BLOCK – II : FORMS BUSINESS
ORGANZATION - I
UNIT – 4 : SOLE PROPRIETORSHIP AND HUF
UNIT – 5 : PARTNERSHIP
UNIT – 6 : COOPERATIVES
59
60
BLOCK – II FORMS BUSINESS ORGANZATION-I
UNIT – 4 : SOLE PROPRIETORSHIP AND HUF
Contents
4.0 Aims and Objectives
4.1 Introduction
4.2 Forms of Business Organization
4.3 Characteristics of Ideal Form of Organization
4.4 Sole Proprietorship
4.5 Advantages and Disadvantages of Sole proprietorship
4.6 Joint Hindu Family (HUF)
4.6.1 Features
4.6.2 Advantages
4.6.3 Disadvantages
4.7 Sole Proprietorship Vs. Joint Hindu Family
4.8 Summary
4.9 Check Your Progress: Model Answers
4.10 Model Examination Questions
4.11 Glossary
4.12 Further Readings
4.0 AIMS AND OBJECTIVES
After studying this unit, you will be able to:
• explain different forms of business organization;
• analyze the characteristics of an ideal form of organization;
• discuss the features, advantages and disadvantages of proprietary form
Joint Hindu Family form of organization; and
• compare between sole proprietorship and joint Hindu family business. 61
4.1 INTRODUCTION
In the previous units, the business concepts, environments, business promotion were
discussed and this unit presents different forms of organizations and the characteristics of an
ideal form of organization. It would also give a detailed idea on the sole proprietorship and
Joint Hindu Family forms of organization.
4.2 FORMS OF BUSINESS ORGANISATION
Business concerns are established with the objective of making profits. They are
engaged in one or more lines of business such as manufacturing and marketing or trading, or
aidstotrade such as banking, insurance and transportation. They can be established either,
by one person or by a group of persons in the private sector or by the Government or other
public bodies in the public sector. A business started only by one person is called ‘sole
proprietorship’; while the business started by a group of persons can be either Joint Hindu
Family or partnership or joint stock company or a cooperative form of organization.
Thus, there are various forms of business organization, viz..
a) Sole Proprietorship
b) Joint Hindu Family Business
c) Partnership Firm
d) Joint Stock Company
e) Cooperative Society
Forms of business organization are legal forms in which a business enterprise may be
organized and operated. These forms of organization refer to such aspects as ownership,
risk bearing, control and distribution of profits. Any one of the above mentioned forms may be
adopted for establishing a business, but usually one form is more suitable than the other for a
particular enterprise. The choice will depend upon various factors like the nature of business,
the objective, capital required, scale of operation, state control, legal requirements and so on.
Out of the forms of private ownership listed above the first three forms (a, b & c) may
be described as ‘noncorporate’ and the remaining two (d & e) as corporate forms of
ownership. The basic difference between these two categories is that a noncorporate form
of business can be started without registration while a corporate form of business cannot be
set up without registration under the laws governing their functioning.
62
Check Your Progress - 1
List out various forms of business organization.
4.3 CHARACTERISTICS OF AN IDEAL FORM OF
ORGANISATION
Before we analyse the features, merits and demerits of different forms of organization,
let us know the characteristics of an ideal form of organization. The characteristics of an ideal
form of organization are found in varying degrees in different forms of organization. The
entrepreneur, while selecting a form of organization for his business, should consider the
following factors:
1. Ease of formation
It should be easy to form the organization. The formation should not involve many
legal formalities and it should not be time consuming.
2. Adequacy of Capital
The form of organization should facilitate the raising of the required amount of capital
at a reasonable cost. If the enterprise requires a large amount of capital, the
preconditions for attracting capital from the public are: a) safety of investment; b) a
fair return on investment; and c) transferability of the holding.
3. Limit of Liability
A business enterprise may be organized on the basis of either limited or unlimited
liability. From the point of view of risk, limited liability is preferable. It means that the
liability of the owner as regards the debts of the business is limited only to the amount
of capital agreed to be contributed by him. Unlimited liability means that even the
owners’ personal assets will be liable to be attached for the payment of the business
debts.
4 Direct Relationship Between Ownership, Control and Management
The responsibility for management or control of management must be in the hands of
the owners of the firm. If, the owners have no control on the management, the firm
may not be managed efficiently.
63
5 Continuity and stability
Stability is essential for any business concern. Uninterrupted existence enables the
entrepreneur to formulate longterm plans for the development of the business concern.
6 Flexibility of Operation
Another ideal characteristic of a good form of organization is flexibility of operations.
Changes may take place either in market conditions or the State’s policy towards
industry or in the conditions of supply of various factors of production. The nature of
organization should be such as to be able to adjust itself to the changes without much
difficulty.
7 Low Tax Burden
All forms of organization are subject to levy of taxes by the State. But some forms are
liable to pay taxes at higher rates while some other may be liable to pay tax at lower
rates. Hence, other things being equal, the ideal form of organization is one which is
subject to taxation at a lower rate.
4.4 SOLE PROPRIETORSHIP
Meaning
A sole proprietorship or one man’s business is a form of business organization owned
and managed by a single person. He is entitled to receive all the profits and bears all risks of
ownership.
Features
The important features of Sole Proprietorship are:
a) The business is owned and controlled by only one person.
b) The risk is borne by a single person and hence he derives the total benefit.
c) The liability of the owner of the business is unlimited. It means that his personal assets
are also liable to be attached for the payment of the liabilities of his business.
d) The business firm has no separate legal entity apart from that of the sole proprietor,
and so the business lacks perpetuity.
e) To set up sole proprietorship, no legal formalities are necessary, but there may be
legal restrictions on setting up of particular types of business. For example, an individual
cannot start a bank or an insurance company. If anyone wants to start a cycle shop or
64 a book shop, he may do so without any legal formalities. But in some cases, a licence
may be necessary. For example if one wants to start a restaurant, he will have to
obtain licence from the Municipal Corporation.
f) The proprietor has complete freedom of action and he himself takes decisions relating
to his firm.
g) The proprietor may take the help of the members of his family in running the business.
4.5 ADVANTAGES AND DISADVANTAGES OF SOLE
PROPRIETORSHIP
Advantages
The advantages of the sole proprietorship form of organization are as follows:
i) Ease of Formation: It is easy to start a sole proprietorship as no legal formalities are
required to be observed. Even a person with limited amount of money can start a
business of his own.
ii) Motivation: As all the profits of the business is being enjoyed by one person, the
owner is motivated to take personal interest in his business and manages it effectively
and efficiently.
iii) Freedom of Action: The proprietor himself takes the decisions relating to his business
and there is none to interfere with his authority. This type of freedom of action promotes
initiative and selfreliance.
iv) Quick Decision: There is no need for the proprietor to consult any other person
relating to his business affairs and so he is in a position to take quick decisions.
v) Flexibility: Because of the quick decisions that can be taken by the proprietor, he
can adapt himself to the changing needs with comparative ease. Further, flexibility is
facilitated by the small investment.
vi) Personal Touch: As the proprietor, he manages the business; he can maintain close
contact with the customers of his business and also attend to their needs promptly.
This helps him to earn goodwill for his business.
vii) Business Secrecy: As only one man is concerned with the business decisions,
methods and policies, it is easy to maintain business secrecy. Maintaining business
secrecy is very important in today’s competitive world.
viii) Social Utility: Sole proprietorship ensures that too much wealth does not concentrate
in a few hands, as the business is a small one. This is desirable from the social point of
view, as it promotes and encourages independent living. 65
Disadvantages
Some of the disadvantages of the Sole Proprietorship are;
i) Limited Resources: As only one person contributes the capital of the business, the
capital is limited to his capacity. Because of limited resources, the expansion of business
cannot easily take place.
ii) Limited Managerial Ability: The managerial abilities are also limited. Because of
this, it may not be possible for one person to own and manage a large business.
iii) Unlimited Liability: The sole proprietor’s liability is unlimited and his personal assets
are also liable to be attached for the payment of business liabilities. Because of this,
the owner is discouraged from expanding his business even when there are good
prospects for earning more than what he has been doing.
iv) Lack of Continuity: Uncertain future is another handicap of this form of business. If
the sole proprietor dies, his business may come to an end. Because of this, there is no
security for the employees and also long term stability cannot be achieved.
v) No Economies of Large Scale: As the proprietor’s concern is of a small scale size,
the owner cannot secure the economies of large scale manufacturing, buying and
selling. This may raise the cost of production.
Suitability of Sole Proprietorship Business
From the above discussion of the advantages and disadvantages of sole proprietorship, it is
clear that this form of business organization is most suited where:
i) the amount of capital is small;
ii) the risk involved is relatively low;
iii) the nature of business is simple in character requiring quick decisions to be taken;
iv) direct contact with the customers is essential; and
v) the size of demand is not very large
These conditions are satisfied by various types of small business such as retail shops,
legal or medical or accounting profession, tailoring, services like dry cleaning or vehicle repair
etc. Hence, sole proprietary form of organization is mostly suitable for these lines of business.
This form of organization also suits those individuals who have a strong drive for independent
thinking and highly venturesome in their attitude.
66
Check Your Progress- 2
What is unlimited liability?
4.6 JOINT HINDU FAMILY (HUF)
Meaning
The Joint Hindu Family firm is also known as Hindu Undivided Family business and
this is one of the important forms of noncorporate form of business organization. It is a firm
belonging to a Joint Hindu Family. It comes into existence by the operation of law and not out
of contract.
In Hindu Law, there are two schools of thought viz., a) Dayabhaga which is applicable
in Bengal and Assam, and b) Mitakshara which is applicable in the rest of India. According
to Mitakshara school, the property of the Joint Hindu Family is inherited by a Hindu family
from his father, grandfather and great grandfather. Thus three successive generations in the
male line (son, grandson and great grandson) can simultaneously inherit the ancestral property.
They are called Co-parcenars interest and the senior most member of the family is called
‘Karta’. The Hindu Succession Act, 1956, has extended the line of coparcenary interest to
female relatives of the deceased coparcener or male relatives claiming through such female
relatives. Under the Dayabhaga Law, the male heirs become members only on the death of
the father.
4.6.1 Features
Some of the important features of the Joint Hindu Family firm are as follows:
i) the business is generally managed by the father or some other senior member of the
family and he is called Karta or Manager;
ii) except the Karta, no other member of the family has any right to participate in the
management of a Joint Hindu Family firm;
iii) the other members of the family cannot question the authority of the Karta and their
only remedy is to get the family dissolved by mutual agreement;
iv) if the Karta has misappropriated the funds of the business, he has to compensate the
other coparceners to the extent of their share in the joint property of the family; 67
v) for managing the business, the Karta has the power to borrow funds, but the other
coparceners are liable only to the extent of their share in the business. In other
words, the Karta’s liability is unlimited;
vi) the death of any member of the family does not dissolve the business or the family;
and
vii) dissolution of Joint Hindu Family can take place only through mutual agreement.
4.6.2 Advantages
The following are some of the advantages of the Joint Hindu Family firm:
i) Stability: The existence of the Joint Hindu Family firm does not come to an end with
the death of any coparcener. Hence, stability is there in this form of business.
ii) Knowledge and Experience: There is a scope for younger members of the family
to get the benefit of the knowledge and experience of the elder members of the
family.
iii) No Interference: The Karta has full freedom to run the business without any
interference by the other members. Hence, he can take business decisions without
the interference of others.
iv) Maximum Interest: As the Karta’s liability is unlimited, he takes the maximum interest
in running the business.
v) Protection: Members of the family, who are unable to work because of sickness, old
age, etc., are looked after by the other members of the family.
vi) Specialization: By assigning the work to the members as per their knowledge and
experience, the benefits of specialization and division of work may be secured.
vii) Discipline: The firm provides an opportunity to its members to develop the virtues of
discipline, selfsacrifice and cooperation.
viii) Worthiness Credit: When compared to sole proprietorship, the worthiness credit
of the family business is definitely more than that of the former.
4.6.3 Disadvantages
The Joint Hindu Family firm suffers from certain disadvantages. Following are the
disadvantages of Joint Hindu family business:
i) No Encouragement: As the benefit of the hard work of some members is shared by
all the members of the family, there is no encouragement to work hard among other
family members of this business.
68
ii) Lazy and Inactive: The Karta takes the responsibility to manage the firm. This may
result in the other members of the family becoming lazy and inactive.
iii) Members’ Initiative: The Karta alone has full control over the business and the
other members cannot interfere with the management of the firm. This may hamper
the members’ initiative.
iv) Duration: The life of the business is shortened if family quarrels take precedence
over business interests.
v) Abuse of Freedom: There is scope for the Karta to misuse his freedom in managing
the business for his personal benefits.
Check Your Progress - 3
Explain Mitakshara schools of thought.
4.7 SOLE PROPRIETORSHIP VS. JOINT HINDU FAMILY
Following are the difference between Proprietorship and Joint Hindu Family Firm.
Sr. No Basis Proprietorship Joint Hindu Family
1 Meaning It is owned and managed It is an ancestral business,
by a single person run by joint Hindu family
2 Membership Only single person business No limit on membership
3 Ownership Business assets and properties All the family members are
are owned by the proprietor joint owners
4 Liability The liability of sole trader is Only Karth’s liability is
unlimited unlimited and other co
parceners liability is limited
5 Financial Financial resources are also More funds are
Resources limited available than sole
proprietorship form of
business
69
6 Stability Lack of stability of business Comparatively more stable.
since the existence of the After the death of karta, the
business depends upon the next senior family member
survival of sole trader. takes over and continues
business activities
7 Profit and Sole trader enjoys the entire The profit and losses are
Losses profits and responsible for all shared by all the co
losses parceners
4.8 SUMMARY
There are various forms of business organization of which each business is destined to
follow any one form. The various forms of organization are: (1) Sole proprietorship; (2) Joint
Hindu Family; (3) Partnership firm; (4).Joint Stock Company; and (5) Cooperatives. Of all
these categories of forms of business enterprises, Sole proprietorship and Joint Hindu Family
form of organizations are termed as traditional forms of organizations.
The selection of any form of organization depends on many aspects and at the same
time it should possess certain characteristics. They are simplicity, mobilization of capital,
flexibility of operation, limit to liability and continuity in its operations.
The sole proprietorship is a traditional form of organization. It is managed by a single
person and he bears the responsibility for the profits and risks arising out of the trade. Though
there are many advantages of sole trading business, there are a few shortcomings too. They
are: limited resources, unlimited liability and there are no large scale economies. In the light of
the above disadvantages, it has become imminent to invest in another form of organization i.e.,
Joint Hindu Family form of organization. This form of organization belongs to all the members
of the Joint Hindu Family and it comes into existence by operation of law. The three successive
generations, i.e., son, grandson and great grandson can simultaneously inherit the ancestral
property. The senior most member/ head of the family is called ‘Karta’.
The Karta of the family will manage the whole business. Karta has full powers as
regards the business and he undertakes unlimited liability to organize the business. The
creditworthiness of this form of organization is more than the sole proprietorship and the Joint
Hindu Family form of organization gives an opportunity to its members to develop qualities of
discipline, self sacrifice and cooperation. In this unit the advantages and disadvantages of sole
proprietorship and Joint Hindu family business have been discussed and finally the differences
between sole proprietorship and Join Hindu family business are also presented.
70
4.9 CHECK YOUR PROGRESS: MODEL ANSWERS
1. i) Sole Proprietorship
ii) Joint Hindu Family Firm
iii) Partnership Firm
iv) Joint Stock Company
v) Cooperative Society
2. Unlimited liability refers to the legal obligations of sole proprietor, who is liable for all
business debts if the business can’t pay its liabilities. In other words, sole proprietors
are responsible for paying off all of the business debts personally if the firm can’t
make its payments. The liability which extends to the personal assets of an individual
apart from his share of contribution is known as unlimited liability.
3. The Mitakshara school of thought is applicable in the rest of India except Bengal and
Assam. According to Mitakshara School, the property of the Joint Hindu Family is
inherited by a Hindu family from his father, grandfather and great grandfather. Thus
three successive generations in the male line (son, grandson and great grandson) can
simultaneously inherit the ancestral property. They are called Coparceners interest
and the senior most member of the family is called ‘Karta.
4.10 MODEL EXAMINATION QUESTIONS
I. Short Answer Questions
1. State the various forms of business organization.
2. Mention the characteristics of an ideal form of organization.
3. Define unlimited liability.
4. What is a Joint Hindu Family firm?
II. Long Answer Questions
1. What do you mean by sole proprietorship? Explain the features of sole proprietorship
form of organization.
2. Discuss the advantages and disadvantages of sole proprietorship form of organization.
3. Explain the features of the Joint Hindu Family business.
4. Discuss the advantages and disadvantages of the Joint Hindu Family business.
71
5. Compare the sole proprietorship with Joint Hindu Family Firm and state which form
of business enterprise is suitable in Indian context?
III. Objective Type Questions
A. Multiple Choice Questions
i) Limitations of sole Proprietorship do not include.
a) Limited Capital
b) Lack of Continuity
c) Unlimited size
d) Lack of Managerial Expertise.
ii) One of the primary disadvantages of the sole proprietorship is
a) Ease of dissolution
b) No Special Taxation
c) Direct control of business
d) Losses all go to the owner
iii) Characteristics of JHF do not include
a) Membership by birth
b) Unlimited Liability of Karta
c) Unaffected by death
d) Youngest Member of family is Karta.
iv) Members of Joint Hindu Family are known as:
a) Partners
b) Members
c) Coparceners
d) Owners
v) Which of the following is NOT one of the three major ownership categories?
a) Sole proprietorship
b) Trust Agreement
c) Partnership
d) Cooperatives
Answers: (i) c (ii) d (iii) d (iv) c (v) b
72
B. Fill in the blanks
i) The sole proprietor may not be able to raise adequate __________ for the expansion
of business.
ii) In sole proprietory firm, the life of the business depends on the life of the
______________ .
iii) Due to limited financial resources and limitation of the expertise of the owner, the
business may lack professional _____________ .
iv) The liability of karta in Joint Hindu Family business is —————————.
v) Oldest member of the Joint Hindu Undivided family is known as ______.
Answers: i) Capital ii) Owner iii) Management iv) Unlimited v) Karta
C. Match the following
i) Business managed by family members a) Unlimited liability
ii) Personal responsibility of the owners for all debts b) Sole proprietorship
iii) Head of joint Hindu family business c) Dayabhaga
iv) Simple form of business ownership d) Hindu undivided family
business
v) Applicable in Bengal and Assam e) Karta
Answers: i) – (d) ii) – (a) iii) - (e) iv) - (b) v) – (c)
4.11 GLOSSARY
Sole Proprietorship : A form of business organization owned and
managed by a single person.
Joint Hindu Family Business : A firm belonging to a Joint Hindu Family
governed by Hindu law.
Unlimited Liability : If the assets of the firm are insufficient to satisfy the
claims of the creditors of the firm, even the personal
property of the owners/partners can be attached to
meet such claims
Karta : Head of the Joint Hindu Family business
73
4.12 FURTHER READINGS
Bhushan Y.K. : Fundamentals of Business Organizations and
Management, Sultan Chand and Sons, New Delhi
Krishna Swami O.R : Essentials of Commerce
Eagle Press Publication Division, Madras.
Reddy P.N. and Gulshan : Principles of Business Organization and
Management.
Himalalya Publishing House, Mumbai400004
Rao VSP : Business Organisation and Management
Himalalya Publishing House, Mumbai400004
Sherlekar, Khushpat Jain : Business Organisation, Himalalya Publishing
and Apexa Jain House, Mumbai400004
74
UNIT-5: PARTNERSHIP
Contents
5.0 Aims and Objectives
5.1 Introduction
5.2 Features of Partnership
5.3 Kinds of partners and partnership
5.4 Partnership Registration
5.5 Partnership Agreement
5.6 Rights, Obligations and Powers of partners
5.7 Advantages and Disadvantages of partnership
5.8 Partnership Vs. Sole Proprietorship
5.9 Partnership Vs. Joint Hindu Family
5.10 Summary
5.11 Check Your Progress: Model Answers
5.12 Model Examination Questions
5.13 Glossary
5.14 Further Readings
5.0 AIMS AND OBJECTIVES
After studying this unit, you should be able to:
• explain the meaning and definition of partnership;
• identity kinds of partners and partnership;
• describe the features, advantages and disadvantages of partnership; and
• compare partnership with sole proprietorship and joint Hindu family business.
5.1 INTRODUCTION
Generally, when a proprietor finds it difficult to handle the problems of expansion, he
thinks of taking a partner. In other words, once a business grows beyond the capacity of a
sole proprietorship and or Joint Hindu Family, it becomes unarguably necessary to form
75
partnership. It means that partnership grows out of the limitations of oneman business in
terms of limited financial resources, limited managerial ability and unlimited risk. Partnership
represents the second stage in the evolution of ownership forms.
In simple words, a partnership is an association of two or more individuals who agree
to carry on business together for the purpose of earning and sharing profits. However a formal
definition is provided by Partnership Act, 1932.
Definition
Section 4 of the Partnership Act, 1932 defines Partnership as “the relation between
persons who have agreed to share the profits of a business carried on by all or any of
them acting for all”.
Essential Elements of Partnership
The following are essential elements of Partnership:
i) Plurality of Persons: For constituting a partnership, there must be an association of
two or more persons.
ii) Contractual Relationship: The partnership is created by an agreement between
persons called ‘partners’. The partnership arises from contract and not from status.
On the contrary, a Joint Hindu Family firm is not a partnership because a person
becomes coparcener in that form of organization on the basis of his status, but not
on the basis of contract.
iii) Profit Sharing: There should be an agreement among the partners to share the profits
of the business.
iv) Existence of Business: The purpose of partnership should be to do some business.
If the purpose is to undertake some charitable work, it will not be a partnership.
v) Principal-Agent Relationship: The business must be carried on by all or one or
more partners acting for all the partners. In other words, there is mutual agency.
Each partner is an agent of all the partners.
Check Your Progress - 1
List out the elements of partnership
76
5.2 FEATURES OF PARTNERSHIP
The important features of partnership are as follows:
i) Simple Procedure of Formation: The formation of partnership does not involve
any complicated legal formalities. By an oral or written agreement, a Partnership can
be created. Even the registration of the agreement is not compulsory.
ii) Capital: The capital of a partnership is contributed by the partners but it is not
necessary that all the partners should contribute equally. Some may become partners
without contributing any capital. This happens where such partners have special skills,
abilities or experience. The partnership firm can also raise additional funds by borrowing
from banks and others.
iii) Control: The control is exercised jointly by all the partners. No major decision can
be taken without the consent of all the partners. However, in some firms, there may
be partners known as sleeping or dormant partners who do not take an active part in
the conduct of the business.
iv) Management: Every partner has a right to take active part in the management of the
firm. But, generally, the Partnership Deed may provide that one or more than one
partner will look after the management of the affairs of the firm. Sometimes, the
Partnership Deed may provide for the division of responsibilities among the different
partners depending on their specialization (e.g., one partner may take care of purchases,
the other may be in charge of production, the third may look after sales and so on).
v) Duration of Partnership: The duration of the partnership may be fixed or may not
be fixed by the partners. In case the duration is fixed, it is called ‘partnership for a
fixed term’. When the fixed period is over, such a partnership comes to an end.
vi) Unlimited Liability: The liability of each partner in respect of the debts of the firm is
unlimited. The liability of partners is also joint and several and, therefore any one of
the partners can be asked to clear the firm’s debts, in case the assets of the firm are
inadequate for it.
vii) No Separate Legal Entity: The Partnership firm has no independent legal existence
apart from that of the persons who constitute it. Partnership is dissolved when any
partner retires or dies. Thus it lacks continuity.
viii) Restriction on Transfer of Shares: A partner cannot transfer his share to an outsider
without the consent of all the other partners.
77
Check Your Progress - 2
Describe the features of partnership:
5.3 KINDS OF PARTNERS AND PARTNERSHIP
A) Kinds of Partners
A partnership firm can have different types of partners with different roles and liabilities.
Various kinds of partners, based on their rights and responsibilities are discussed below.
I. Based on the extent of participation: The extent of involvement by the partners in
the day today activities of partnership business, partners may be classified as;
a) Active partner or Working partner: Partners who actively participate in the day to
day business operations are known as active partner or working partner. Since he
takes active interest in the conduct and management of the business of the firm he is
also known as managing partner.
b) Sleeping or dormant partner: A sleeping partner is a partner who does not take
active part in the management of the business. Such a partner only contributes to the
share capital of the firm, is bound by the actions of the other partners, and shares the
profits and losses of the business.
II. Based on sharing of profits: On the basis of sharing of profits, partners may be
classified as;
a) Nominal Partner: A nominal partner is one who does not have any real interest in
the business but allows the firm to use his name as partner. He does not contribute
any capital, and doesn’t share the profits of the business. A nominal partner is admitted
with the purpose of taking advantage of his name or reputation. He also does not
usually have a voice in the management of the business of the firm, but he is liable to
outsiders for all the acts of the firm.
b) Partner in Profits: A person who shares the profits of the business without being
liable for the losses is known as partner in profits. This is applicable only to the
minors who are admitted to the benefits of the firm and their liability is limited to
their capital contribution.
78
III. Based on Liability: Based on the liability of partners, they are classified as;
a) Limited Partners: The liability of limited partners is limited to the extent of
their capital contribution. These type of partners found in limited partnership
firms in European countries and USA. So far these are not allowed in India.
However, the limited liability partnership act is very much under consideration
in the parliament.
b) General Partners: The partners with unlimited liability are called as general
partners or partners with unlimited liability. It may be noted that, every partner
who is not a limited partner is treated as a general partner. Majority of the
partnership firms have these types of partners in India.
IV. Based on the Behaviour Exhibited: Partners may also be classified on the basis of
their behaviour and conduct exhibited when they are dealing with outsiders. These
are;
a) Partner by Estoppel: A person, who behaves in such a way as to give an impression
by his words or conduct, that he is a partner of the firm, he is called as ‘partner by
estoppel’. Such partners are not entitled to share the profits of the firm, but are fully
liable if somebody suffers because of his/her false representation.
b) Partner by Holding out: A partner or partnership firm declares that a articular person
is a partner of their firm, and such a person does not disclaim it, then he/she is known
as ‘partner by holding out’. Such partners are not entitled to profits but are fully
liable as regards the firm’s debts.
V. Based on the Age
a) Minor partner: A partnership is created by an agreement and if a partner is incapable
of entering into a contract, he cannot become a partner. Thus, at the time of creation
of a firm a minor (i.e., a person who has not attained the age of 18 years) cannot be
one of the parties to the contract. But under section 30 of the Indian Partnership Act,
1932, a minor ‘can be admitted to the benefits of partnership’, with the consent of all
partners. A minor partner is entitled to his share of profits and to have access to the
accounts of the firm for purposes of inspection and copy. A minor partner will have
only limited liability, limited by his share in the partnership capital. Within six months
of attaining the age of majority, he has to give public notice about his desire to
continue with the firm. If he chooses to continue, he will be regarded as a fullfledged
partner with unlimited liability.
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B) Kinds of Partnership
In a partnership, each person contributes something to the business, such as ideas,
money, property, or some combination of these. Management rights, profit share,
and personal liability will vary depending on kinds of partnership forms the business;
Viz, General partnership, Limited partnership, or Limited liability partnership (LLP).
Below are basic summaries of the main types of business partnerships.
i) General Partnerships
A general partnership involves two or more owners carrying out a business purpose.
General partners share equal rights and responsibilities in connection with management
of the business, and any individual partner can bind the entire group to a legal obligation.
Each individual partner assumes full responsibility for all of the business’s debts and
obligations. Although such personal liability is daunting, it comes with a tax advantage:
partnership profits are not taxed to the business, but pass through to the partners,
who include the gains on their individual tax returns at a lower rate.
ii) Limited Partnerships
A limited partnership allows each partner to restrict his or her personal liability to the
amount of his or her business investment. Not every partner can benefit from this
limitation at least one participant must accept general partnership status, exposing
himself or herself to full personal liability for the business’s debts and obligations. The
general partner retains the right to control the business, while the limited partner(s)
does not participate in management decisions. Both general and limited partners benefit
from business profits.
iii) Limited Liability Partnerships (LLP)
Limited Liability Partnerships (LLP) retain the tax advantages of the general partnership
form, but offer some personal liability protection to the participants. Individual
partners in a limited liability partnership are not personally responsible for
the wrongful acts of other partners, or for the debts or obligations of the
business. Because the LLP form changes some of the fundamental aspects of the
traditional partnership, some state tax authorities may subject a limited liability
partnership to nonpartnership tax rules. The Internal Revenue Service views these
businesses as partnerships, however, and allows partners to use the pass through
technique.
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5.4 PARTNERSHIP REGISTRATION
Partnership Act does not make it compulsory for a partnership to be registered with
the Registrar of Firms nor does it impose any penalty for nonregistration. But the Act imposes
certain disabilities on the partners of an unregistered firm so as to make registratio desirable.
i) Procedure for Registration
A Partnership firm can be registered at any time with the Registrar of Firms by paying
the prescribed fee. The application for registration should be made in the prescribed
form, furnishing the following particulars:
a) name of the firm;
b) principal place of its business;
c) names of other places, if any, where the firm is carrying on business;
d) the date on which each partner has joined the firm; and
e) names and full addresses of all the partners.
If there are any changes in the above mentioned particulars, they should be
communicated to the Registrar of Firms within a reasonable time. The Registrar of Firms will
register the particulars in a register maintained by him.
ii) Effects of Non-registration
The Act lays down that an unregistered firm will not be able to enforce its claims
against third parties if the suit is for more than Rs.100. Further, no partner of a firm
which is unregistered can file a suit to enforce his right under the Partnership Deed.
Third Parties can, however, file suits against the firm and the partners even though
their firm is not registered. The nonregistration of a firm does not affect the following:
(a) the right of a partner to sue for dissolution of the firm or for accounts, and his
share in the dissolved firm;
(b) the power of an Official Assignee to realize the property of an insolvent
partner;
(c) suits not exceeding Rs.100; and
(d) suits arising in respect of anything other than under a contract; for instance, a
suit against third party for infringement of the trademarks of the firm can be
filed.
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5.5 PARTNERSHIP AGREEMENT
A partnership can be formed either by oral or written agreement. But in order to
avoid misunderstanding and litigation, generally the partners enter into a written agreement.
When it is registered, it is called a ‘Partnership Deed’. It is not a public document like a
Memorandum of Association of a Company and only binds third parties in so far as they have
notice of it. Each partner is given a copy of the Deed.
Contents of the Partnership Deed
The Deed generally contains the following particulars:
(a) name of the firm;
(b) nature of business:
(c) the town and place where business will be carried on;
(d) details concerning the amount of capital contributed by each partner;
(e) details relating to the sharing of profit and losses;
(f) loans and advances by partners and the interest payable on them;
(g) the amounts that can be withdrawn by partners and the rate of interest;
(h) the duties, power and obligations of the partners;
(i) maintenance of accounts and arrangement for audit;
(j) salary, if any, payable to any partner for managing the firm;
(k) rate of interest, if any, allowed on capital;
(l) the method of valuation of goodwill on admission or death or retirement of a partner;
(m) the method by which a partner may retire and the arrangement for the payment of the
dues of a retired or deceased partner;
(n) method of revaluation of assets and liability on admission or retirement or death of a
partner;
(o) arrangements in case a partner becomes insolvent;
(p) arbitration in the case of disputes among partners;
(q) settlement in the case of dissolution of partnership; and
(r) any other clause or clauses which may be desired in any particular kind of business.
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Check Your Progress - 3
What is partnership deed?
5.6 RIGHTS, OBLIGATIONS AND POWERS OF PARTNERS
Generally, a Partnership Deed defines the rights and obligations of the partners. In
case the Deed is not prepared, the provisions of the Partnership Act apply. Even if the Deed
is prepared and if it is silent on any point, the relevant provision of the Partnership Act becomes
applicable.
i) Rights of a Partner
Some of the important rights of a partner are as follows:
(a) he has a right to share equally in the profits of the firm or as per any other proportion
specified in the agreement;
(b) he has a right to take part in the management of the firm;
(c) he has the right to inspect books and copy from any other books of the firm;
(d) in case he has given a loan to a firm over and above his capital, he is entitled to an
interest at the rate of 6% per annum on such loan;
(e) he has a right to express his opinion on the matters related to the firm. Though ordinary
matters are decided by the majority vote of the partners, no change can be made in
fundamental matters without the consent of all the partners;
(f) in case he has made any payment or incurred any losses in the conduct of the business,
he has a right to be indemnified by the firm;
(g) he has a right to retire according to the provision of the Partnership Deed or with
the consent of the other partners; and
(h) he has the right to continue in the firm unless he is expelled by the other partners in
accordance with the provisions of the partnership deed;
83
ii) Obligations of the Partners to the Firm and to One Another
The following are the obligations of a partner:
(a) every partner should share the losses of the firm equally with other partners unless
otherwise agreed upon;
(b) all partners of the firm must be just and faithful to one another;
(c) in case any partner earns a profit for himself by making use of the firm’s property or
name, he should pay it to the firm;
(d) if the firm incurs any loss because of the negligence of any partner, he should indemnify
the firm for such a loss;
(d) every partner must make every effort to prevent the firm from incurring any loss to
the best of his ability;
(e) every partner must maintain correct accounts of the firm and should not prevent other
partners from inspecting the accounts;
(f) every partner must act within the scope of the authority given to him by the Partnership
Deed and in case he exceeds his power, he must indemnify the firm; and
(g) no partner can transfer his interest in the firm to a third party without taking the
consent of all the other partners in the firm.
iii) The Partners’ Liabilities to Third Parties
(a) The partners are jointly and severally liable for all the debts of the firm. In other
words, the creditors of the firm can file a suit in the court either against any one or all
of the partners. In case the assets of the firm are not sufficient to clear the firm’s
debts, the personal properties of individual partners are liable to be attached for the
payment of the debts of the firm.
(b) A partner who is retiring is also liable for the firm’s debts incurred while he was a
partner. But if there is any express agreement with the creditors and other partners to
absolve him, he can be free from the liability.
(c) The firm is liable to make good the loss to any third party who is made to incur loss
by a partner acting within the scope of his powers.
iv) Powers of Partners
In partnership business, every partner is the agent of the firm and his copartner for
the purposes of carrying on the business of the firm and each is bound by the other’s
84 act in carrying on the business. This authority of a partner to act on behalf of the firm
may be either express or implied. In the case of express authority, the authority is
expressly given to a partner by the partnership agreement. The firm is bound by all
the acts related to business done by a partner by virtue of any express authority given
to him.
Implied authority means, the authority which arises on account of the implication of
law. By implied authority, the act of a partner which is done in connection with the
business binds the firm provided that the act is done in the firm’s name or in any
manner expressing or implying an intention to bind the firm.
v) Implied Authority of a Partner
Every partner has an implied authority to bind the firm by the following acts:
(a) he may sell the goods of the firm;
(b) he may purchase the goods for the firm;
(c) he may receive payment of debts due to the firm and issue valid receipts; and
(d) he may hire employees or remove employees of the partnership business.
In the case of trading firm (business involving only buying and selling of goods), a
partner has the following additional powers:
(a) he may accept cheques or issue cheques in the firm’s name;
(b) he may make bills of exchange and promissory notes in the firm’s name;
(c) he may borrow money on the firm’s credit and pledge the firm’s goods for the
purpose; and
(d) he may employ an attorney on behalf of the firm.
5.7 ADVANTAGES AND DISADVANTAGES OF PARTNERSHIP
I. Advantages
The following are the advantages of partnership as a form of business organization:
(a) Ease of Formation
Partnership can be easily formed without much expenditure and legal formalities.
Even the registration of the firm is not compulsory.
(b) Large Resources
When compared to soleproprietorship, the partnership will have larger resources.
Hence, the scale of operations can be increased if conditions warrant it.
85
(c) Better organization of business
As the talent, experience, managerial ability and power of judgment of two or more
persons are combined in partnership, there is a scope for a better organization of the
business:
(d) Great Interest in Business
As the partners are the owners of the business and as profit from the business depends
on the efficiency with which they manage, they take as much interest as possible in the
business.
(e) Prompt Decisions
As partners meet very often, they take decisions regarding business policies very
promptly. This helps the firm in taking advantage of changing business conditions.
(f) Balanced Judgment
As partners possess different types of talent necessary for handling the problems of
the firm, the decisions taken jointly by the partners are likely to be balanced.
(g) Flexibility
Partnership is free from legal restrictions for changing the scope of its business. The
line of business can be changed at any time with the mutual consent of the partners.
No legal formalities are involved in it.
(h) Diffusion of Risk
The losses of the firm will be shared by all the partners. Hence, the share of each
partner will be less than that sustained in sole proprietorship.
(i) Protection to minority interests
In important matters like change in the nature of business, unanimity among partners is
necessary. Hence, the minority interest is protected.
(j) Influence of Unlimited Liability
The principle of unlimited liability helps in two ways. First, the partners will be careful
in their business dealings because of the fear of their personal properties becoming
liable under the principle of unlimited liability. Secondly, it helps the firm in raising
loans for the business as the financiers are assured of the realization of loans advanced
by them.
II. Disadvantages
Against the advantages, there are certain disadvantages in the case of partnership
86 form of organization.
(a) Great Risk
As the liability is joint and several, any one of the partners can be made to pay all the
debts of the firm. This affects his share capital in the business and his personal properties
also.
(b) Lack of Harmony
Some frictions, misunderstandings and lack of harmony among the partners may
arise at any time which may ultimately lead to the dissolution of the partnership.
(c) Limited Resources
Because of the legal ceiling on the maximum number of partners (10 in case of banking
business and 20 in the case of any other business), there is a limit to the amount of
capital that can be raised. This is a great handicap specially when it requires more
capital for expansion.
(d) Tendency to Play Safe
Because of the principle of unlimited liability, the partners tend to play safe and pursue
unduly conservative policies.
(e) No Legal Entity
The partnership has no independent existence apart from that of the persons constituting
it, i.e., it is not a legal entity.
(f) Instability
The death, retirement or insolvency of a partner leads to the dissolution of the
partnership. Further, even any one partner, if dissatisfied with the business, can bring
about the dissolution of partnership. Hence, partnership lacks continuity.
(g) Lack of Public Confidence
No legal regulations are followed at the time of the formation of partnership and also
there is no publicity given to its affairs. Because of these reasons, a partnership may
not enjoy public confidence.
III. Suitability of Partnership
The advantages and drawbacks of partnership stated above indicate that the partnership
organization tends to be useful only for relatively small businesses such as retail trade, mercantile
houses of moderate size, professional services or small scale industries and agency business.
But when compared to sole proprietorship, partnership is suitable for a business bigger in
size and operations.
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5.8 PARTNERSHIP VS SOLE PROPRIETORSHIP
S.no Basis Sole Proprietorship Partnership
1 Meaning It is owned and managed by The relation between two or more
a single person persons who have agreed to share
profits of the business
2 Membership Only single person business It is owned by two or more persons
subject to the limit of 10 in banking
business and 20 in case of other
business
3 Formation It is formed quite easily as it It is formed through an agreement
is the outcome of a single which may be oral or in writing.
person’sdecision without any
legal approval.
4 Registration It needs no registration The registration is not
compulsory.excepting some
compliance.
5 Regulating law There is no specific statutory It is governed by the rules contained
law to govern the functioning under the Indian Partnership Act, of
sole proprietors business. 1932.
6 Capital It has a limited financial There is more scope for raising a
capability. Hence, the scope larger amount of capital as there is
for rising capital is naturally more than one person.
least.
7 Management The sole proprietorship is self Every partner has the right to take
managed one and few active part in the management of the
employees may support him. affairs of the business.
However, the decision of the
proprietor is final and binding.
8 Risk The risk of the sole proprietor The risk connected with the business
is greater than that of is comparatively less as it is shared
partnership form of business. by all the partners.
9 Quick The decision making in sole Decisionmaking is comparatively
decision proprietor is prompt as he delayed as the partners arrive at
making need not consult anyone. decision after consultation with one
88 another.
5.9 PARTNERSHIP VS JOINT HINDU FAMILY
Following are the differences between Partnership and Joint Hindu Family Firm.
S. no Basis Joint Hindu Family Partnership
1 Meaning It is an ancestral business, run The relation between two or more
by joint Hindu family which is persons who have agreed to share
inherited as per Hindu Law. profits of the business
2 Membership There is no limit. Since It is owned by two or more persons
membership keeps on changing subject to the limit of 10 in banking
depending upon the birth and business and 20 in case of other
deaths in that Joint family business
3 Formation JHF firm formed is by the It is formed through an agreement
operation of Hindu law which may be oral or in writing.
4 Liability of In HUF, liability of each The liability of all the partners is
members member, except the Karta, unlimited. Every partner is jointly
is limited to the extent of his and severally liable to third parties
share in the property of the for the debts of the firm
family.
5 Regulating An HUF business is governed It is governed by the rules
law by Hindu Succession Act. contained under the Indian
Partnership Act, 1932.
6 Mode of The death or insolvency of a A partnership firm is dissolved on
dissolution coparcener does not affect an the insolvency or death of a
HUF. It continues to operate partner.
even after the death of
a coparcener.
7 Management Only ‘Karta’ is authorized to Every partner has the right to take
manage the business activities. active part in the management of the
affairs of the business.
8 Admission In joint Hindu family firm a In a partnership no new
of new new member is admitted just partner is admitted without the
members by birth. consent of all the partners
9 Quick As decision making lies in the Decisionmaking is comparatively
decision hands of Karta, quick delayed as the partners arrive at
making decisions can be taken. decision after consultation with one
another.
89
5.10 SUMMARY
The partnership is nothing but an agreement between two or more persons to share
the profits and losses among them. The formation of the partnership is very easy and the
capital contribution will also be from among the partners. The liability is unlimited and there is
no separate legal entity to this organization. The control of the partnership is a joint effort by all
the members. There are various kinds of partners. They are the active partners and sleeping
partners. The partnership form of business has to be registered under the Partnership Act of
1932 and there are more advantages in this business form. Apart from .registration there is an
agreement between these partners regarding their capital contribution, profit sharing and other
terms and conditions. In this unit, apart from main advantages and disadvantages of partnership
firm, the key differences between partnership firm and sole proprietorship and Joint Hindu
Family business were also presented.
5.11 CHECK YOUR PROGRESS: MODEL ANSWERS
1. The key elements of partnership are;
• Plurality of Persons
• Contractual Relationship
• Profit Sharing
• Existence of Business
• Principal-Agent Relationship
2. The important features of partnership are;
• Simple Procedure of Formation
• Capital
• Control
• Management
• Duration of partnership
• Unlimited liability
• No separate legal entity
• Restriction on transfer of shares
3. Partnership deed is a document containing the terms and conditions of a partnership.
It is an agreement in writing signed by all partners duly stamped and registered.
Partnership deed defines certain rights, duties and obligations of partners and governs
relations among them in the conduct of business affairs of the firm.
90
5.12 MODEL EXAMINATION QUESTIONS
I. Short Answer Questions
1. What is Partnership Deed?
2. What do you mean by Partner by Estoppel?
3. What do you mean by Limited Liability Partnerships (LLP)?
4. Explain the effects of nonregistration of Partnership firm.
II. Long Answer Questions
1. Define partnership? Explain the features of partnership form of organization.
2. Discuss the advantages and disadvantages of partnership form of organization.
3. Explain the rights, obligations and powers of partners.
4. Discuss the different types of partners
5. Distinguish between sole proprietorship and partnership?
6. Explain the differences between Partnership and Joint Hindu Family business.
III. Objective Type Questions
A. Multiple Choice Questions
i) A partner who invests in the business but does not take active part is called
(a) Secret Partner
(b) Sleeping Partner
(c) Active Partner
(d) Nominal Partner
ii) In the absence of an agreement, interest on loan advanced by the partner to the firm
is allowed at the rate of
a) 5 %
b) 8%
c) 6%
d) 7%
91
iii) There exists a special form of partnership called a Limited Partnership. Which ONE
of the following statements concerning limited partnerships is NOT true?
a) Limited partners do not have power to bind the firm
b) A limited partnership must have at least one general partner.
c) Limited partnerships are formed by registering documents with the Registrar
of Companies.
d) Limited partners have limited liability while taking part in the management of
the firm.
iv) Which statement is most accurate with respect to partnerships?
(a) A Partnership is a separate legal entity
(b) General partners have unlimited liability
(c) Partners are not agents for the firm
(d) Partnership liability requires that one intend to be a partner
v) A partner who is not actually involved in the partnership but lends his name for
public relations purpose is called as:
a) Silent partner.
b) General partner.
c) Nominal partner
d) Dominant partner.
Answers: (i) b (ii) c (iii) d (iv) d (v) c
B. Fill in the blanks
i) The Partnership Act, 1932 came into force on ______________.
ii) The written agreement of partnership is called ______________ .
iii) Liability of partners in a partnership business is _____________ .
iv) The death of partner has effect of ________________________.
v) Liability of a new partner generally commences from _____________ .
Answers: (i) 01-10-1932 (ii) Partnership Deed (iii) Unlimited
92 (iv) Dissolving the firm (v) Date of admission
C. Match the following
i) A minor partner will have a) Partnership deed
ii) A person actually not a partner, but behaves b) Limited liability
as a partner
iii) Written agreement between the partners c) Partner by Estoppel
iv) An ordinary partnership firm can have d) Implied Authority
v) A Partner selling the goods on behalf of firm e) Not more than 20 members
Answers: i) – (b) ii) – (c) iii) - (a) iv) - (e) v) – (d)
5.13 GLOSSARY
Partnership : The relation between persons who have agreed to
share the profits of a business carried on by all or
any of them acting for all.
Limited Liability Partnership : A Limited Liability Partnership (LLP) is a partner
ship in which some or all partners (depending on the
jurisdiction) have limited liabilities. It therefore exhibits
elements of partnerships. In an LLP, one partner is
not responsible or liable for another partner’s
misconduct or negligence.
Partnership Deed : An agreement entered into by partners. It specifies
the rules and regulations of the partnership. It defines
certain rights, duties and obligations of partners
and governs relations among them in the conduct of
business affairs of the firm.
5.14 FURTHER READINGS
Bhushan Y.K. : Fundamentals of Business Organizations and
Management, Sultan Chand and Sons, New Delhi
Krishna Swami O.R : Essentials of Commerce,
Eagle Press Publication Division, Madras.
Reddy P.N. and Gulshan : Principles of Business Organization and
Management.
Himalalya Publishing House, Mumbai400004
93
Rao VSP : Business Organisation and Management
Himalalya Publishing House, Mumbai400004
Sherlekar, Khushpat Jain : Business Organisation,
and Apexa Jani Himalalya Publishing House, Mumbai400004
94
UNIT-6 : CO-OPERATIVES
Contents
6.0 Aims and Objectives
6.1 Introduction
6.2 Definition of Cooperatives
6.3 Principles of Cooperatives
6.4 Formation of a Cooperatives
6.5 Management of Cooperatives
6.6 Types of Cooperatives
6.7 Structure of Cooperatives
6.8 Merits and Demerits of Cooperatives
6.9 Cooperatives Vs. Partnership
6.10 Summary
6.11 Check Your Progress: Model Answers
6.12 Model Examination Questions
6.13 Glossary
6.14 Further Readings
6.0 AIMS AND OBJECTIVES
The aim of this unit is to explain various aspects of cooperative form of organisation.
After studying the unit, you should be able to:
• define a cooperative society;
• explain the principles of cooperatives;
• describe the procedure for forming a cooperative society;
• analyse how a cooperative society is managed;
• describe the different types of cooperatives; and
• discuss the merits and demerits of cooperative form of organisation.
95
6.1 INTRODUCTION
Cooperative form is another form of business organisation. Cooperative organisation
has emerged as a means of protecting the interests of relatively weaker sections of the society.
The basic philosophy of co-operatives is “All for each and each for all”. It is a
voluntary and democratic association of human beings based on equality of control and
opportunity, equity of distribution and mutually for the promotion of their common interests as
producers or consumers. It directly serves its members interests, by meeting their needs, but
does not earn profit for itself as an independent economic unit, at their cost. It is organised for
the benefit of its members. Therefore, cooperative business is different from other concerns
which render service to others but are owned by and run for the personal profit of their
owners.
Cooperation serves as an organisational instrument for economically weaker
producers like farmers, artisans, workers and consumers. It helps them to strengthen and
protect themselves against exploitation by the stronger sections. When these economically
weak persons act individually, they are exploited by the stronger ones. For example, farmers
are exploited by money lenders and merchants; workers by employers and consumers by
traders. Cooperation helps such people of the weaker sections to escape exploitation by
enabling them to become their own financiers, merchants, employers or traders. It helps them
“to gain the advantages of large scale operation, while maintaining their independence”.
Cooperation thus enables them to fulfil their needs economically and honourably.
6.2 DEFINITION OF COOPERATIVE
As a form of ownership, a cooperative society is a voluntary association of persons
who join together based on certain high values for the purpose of fulfilling their economic
interests. Many authors have given their own definitions for cooperatives.
Among the available definitions, that of H.C. Calvert is the most acceptable one.
According to Calvert, a cooperative society is “a form of organisation wherein persons
voluntarily associate together as human beings on the basis of equality for the
promotion of the economic interests of themselves”.
H.N. Kunzeen defined cooperatives as “co-operation is self-help as well as
mutual help. It is a joint enterprise of those who are not financially strong and cannot
stand on their legs and, therefore, come together not with a view to get profits but to
overcome disability arising out of the want of adequate financial resources”.
According to V.L. Mehta, “co-operation is one aspect of a vast movement
promoting voluntary associations of individuals having common needs who combine
96 towards the achievement of common economic ends”.
The Indian Cooperative Societies Act, 1912 defines cooperative organisation as
“a society which has its objectives the promotion of economic interests of its members
in accordance with the co-operative principles”.
From these definitions, it is clear that co-operatives are (i) voluntary organisations
(ii) carry on business for their mutual benefits (iii) promote economic interests of the
members (iv) work with service motive; and (v) are based on certain principles.
6.3 PRINCIPLES OF CO- OPERATIVES
The cooperative organisations function in accordance with certain principles. These
are also regarded as distinctive features or characteristics of cooperatives.
(i) Voluntary and open membership
The membership of a cooperative society is neither restricted nor limited, because
the object of the association is the common good and those who join it must exhibit
no selfish spirit. The only qualification to become a member of a Cooperative is the
attainment of the age of majority. There cannot be any restriction to membership
based on caste, creed, sex, religion or party politics.
There is however, some kind of restriction based on two grounds. One is common
economic need. The members joining a society should have a common goal. This is
mostly based on the occupation of the members. For instance, in a Cooperative
Credit Society the agriculturist members need credit at low rates of interest; in co
operative stores, the members need supply of goods at low prices and in a Weavers
Cooperative Society the weavers have the common economic need of getting
continuous employment. Persons who are considered to be exploiters will not be
admitted in the Cooperative Society. Village money lenders, traders are not to be
admitted to a Cooperative Credit Society. This restriction is based on the assumption
that such people, if admitted, will exploit the Cooperative Society also.
The movement is absolutely voluntary and there is no compulsion or force on anybody
to join a Society. After joining it, they are at liberty to leave the organisation, if they
wish to do so. The Cooperative Society can develop, only when it has persons who
can understand and follow the spirit of cooperation and mutual help. This is possible
only in voluntary membership. Compulsion of any kind would make the members
disloyal and would prove to be dangerous for the Cooperative Society. Hence,
voluntary membership is an important principle of Cooperation.
(ii) Democratic Management
Cooperative Societies are managed purely on democratic principles. The democratic
management of the societies is based on the following aspects: 97
The general body consisting of all the members is the all powerful supreme body.
This general body elects a smaller body to manage the affairs of the society. This
smaller body is called Board Managing Committee. The responsibility of managing
daytoday affairs of the society rests with another body, namely the Executive
Committee.
In all the elections, the principle of ‘oneman onevote’ is followed irrespective of the
number of shares held by the member. The spirit, democratic management in Co
operative Societies can be understood when we compare it with that of the existing
Joint Stock Companies. In companies, each share is given a vote and hence, the
largest shareholder can dominate the affairs of the company. In all the bodies in
Cooperative Society, decisions are taken on the basis of majority though the interest
of the minority is also kept in mind. In annual general meetings, proxy is not allowed
either for attendance or for voting. This is one of the essential principles of democracy
followed in cooperatives. This is not present in other type of organisation.
(iii) Limited interest on capital
In cooperative justice is done in the distribution of the surplus. The distribution of
profit in a Cooperative Society is equitable. Equity demands that only a fair return
should be paid to capital for its service and that capital should not hold dominant
positions in the affairs of the Cooperative as in other organisations. Thus, equitable
distribution of profit implies a limited interest on capital. For instance in the Co—
operative Societies in India, there is a ceiling on dividend on share capital at 9 percent.
(iv) Patronage Dividend
Profit is used for creating reserves, for general as well as specific purposes like co
operative development fund, Common Good Fund and Education Fund.
Any further surplus is distributed among the members after giving a small share to
labour as bonus. Generally the members of the Cooperative Society are its
customers. Therefore, it is the memberpatrons who actually contribute to the profits
of the Cooperative Society. As Cooperatives aim at promoting members’ interest
they are not expected to earn profits from them and to render service at cost.
Therefore, the profits earned out of the transactions with the memberpatrons are
returned to them after meeting the limited interest on capital and the reserve
requirements. While returning the amount, the extent of individual contribution is also
taken into consideration. This dividend is distributed according to the volume of
transactions each member had their share with the society. Thus, the dividend is paid
to the members in proportion to the purchases made by the members in the case of a
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consumers’ cooperative store, or in proportion to the goods delivered for sale to the
society in the case of a producers’ cooperative society. In the words of C.R. Fray
“the members of the Co-operative Society share its rewards in proportion to
the degree in which they make use of the association”. Therefore, this dividend
is called Patronage dividend. This patronage dividend is “the essence of co-
operation as the operation of the equity principle reduces the distance between
the rich and the poor without denying opportunities for individual initiative
and creative activity”.
(v) Co-operation among Co-operatives
A Cooperative association is not an association of selfish individuals. No one can try
to gain his own objective at the cost of others. There prevails a cooperative instead
of competitive spirit. The members are united in a Cooperative Society to undertake
common action for common welfare and for that reason Cooperative Societies, in
turn federate themselves into Cooperative Unions and Federations for common action
instead of competing with each other.
(vi) Co-operative Education, Training and Information
A Cooperative Society is a voluntary organisation and members cannot be kept
together by compulsion. Educating the members in cooperative principles is the
only alternative. The movement is meant only for the poor illiterate people who know
very little about the principles and practices of cooperation. Therefore, a continuous
system of education should be evolved and the members should be kept informed of
the decisions and activities of the society. Such a system should not confine itself to
teaching principles of cooperation alone. It should have the broader aim of inculcating
in the members, the good habits of thrift, saving, hard work, etc. Its object should
also be to make them better consumers, honest workers, better social beings, trained
electors, useful citizens and more disciplined and responsible human beings.
Besides the above principles, the following practices have also been
conventionally accepted as principles of Co-operatives.
(vii) Self-help through Mutual help
Selfhelp through mutual help is the guiding principle of cooperatives. The members
are for the Society and Society is for helping them. This principle envisages that the
members try to draw advantage out of the bigger pool of resources created by the
common efforts of all concerned. The individual member derives help from others by
extending his help to others. “Each for all and all for each” is the motto of Co
99
operation. “Cooperation is the act of persons voluntarily united for utilising reciprocally
their own forces, resources of both under their mutual arrangement to their common
profit or loss” Herrick.
(viii)Service Motive
A Cooperative Society is meant not to earn profit but to enable its members improve
their economic condition by helping them in their pursuits. Again, it is not only a
movement for economic betterment. An unselfish spirit and honest dealing are very
essential to practice “selfhelp through mutual help”. The service motive of Co
operatives, however, does not mean that they are against profit. An efficiently managed
Society must, of necessity, run in profit. The profit is meant to meet unforeseen
losses, if any, at a later stage. They are also utilised to strengthen the funds of the
Society, so that it may be able to render better and cheaper service to its members
and make its footing strong. Any surplus left over again goes to members in the form
of dividend or bonus. The main objective is to avoid the profit motive, and not profit
for itself which would result from good management of the cooperatives.
(ix) Principle of Thrift
A cooperative society is in its essence a thrift institution, a body inculcating thrift in
the members. Cooperation does not seek to do away with capital which is as much
necessary in a cooperative society as in any other business concern. Thrift combined
with cooperation can transform the economic status of a country and with co
operation, thrift is given an added momentum. Hence, the idea of thrift as the basis of
selfhelp is kept in the forefront in organising and conducting cooperative societies.
(x) Principle of Equality
Cooperation recognises human individuality. In cooperative societies, all the members
are equal. There can be no discrimination on the basis of caste, creed, sex, religion,
politics or wealth. This is reflected in the principle of ‘one man one vote’ system of
decision making. Besides this, cooperation aims at giving equal opportunity to all its
members to become leaders and share in the management.
(xi) State Control
The activities of cooperatives societies are regulated by the Government through
Cooperative Societies Act. The Government frames the rules and regulations to
safeguard the interests of the members of cooperatives. It conducts periodic
inspections on the affairs of the society and the audit of accounts. The cooperative
societies have to submit their annual reports and accounts to the Registrar of Co
100 operatives.
(xii) Cash Trading
Another distinctive feature of cooperative Societies is “trading on cash basis”. This
eliminates collection charges and bad debts. This also avoids misunderstanding among
the members in the matters of extending credit facility. However, the societies may
make exception to this principle for helping needy members. But generally trading
takes place on cash basis.
Check Your Progress - 1
What do you mean by patronage dividend?
Check Your Progress - 2
What is the principle of equality?
Check Your Progress -3
How does the Government control cooperatives?
6.4 FORMATION OF CO- OPERATIVES
A cooperative society is formed by registering either under the Cooperative Societies
Act, 1912 or the Cooperative Societies Act of a State Government. Such registration is
compulsory.
Procedure
Any group of persons having some common need like credit supply, marketing or
distribution can organise themselves into a Cooperative Society in order to eliminate
exploitation by middlemen. The procedure followed in the formation of a Cooperative is
discussed below:
101
The persons desirous of starting a Cooperative Society approach or write to the
Deputy Registrar or Assistant Registrar of Cooperation in the area. The officer then refers
the proposal to an Administrative Inspector of the Department. The Inspector visits the place
and explores the scope of organising the society. He submits his report. The officer, after
examining the report, directs the Inspector to organise the society. The Inspector visits the
place and convenes a preliminary meeting with the promoters.
At the meeting, the application is prepared in the prescribed form furnishing details
such as the name of the Society, headquarters, area of operation, postal address, population
covered, names and addresses of the promoters. It is to be signed by at least 10 persons,
who are eligible to enter into contract (above the age of 18 years). Then the byelaws of the
Society are prepared based on the model byelaws. The byelaws should be in accordance
with the provisions of the Act and the Rules. The various clauses of the byelaws are to be
read and approved at the meeting. The promoters present at the meeting sign two copies of
the byelaws and the application.
A separate schedule of particulars regarding the addresses, assets and liabilities of the
promoters is prepared in duplicate and signed by them. A chief promoter is elected at the
meeting. Members of an Interim Committee are also elected. A resolution is passed at the
meeting requesting the Deputy Registrar to register the Society at an early date. The initial
share amount which should not be less than the minimum amount prescribed by the Act is
collected from the promoters. The amount collected is remitted into the District Central Co
operative Bank. The Inspector submits his report to the Deputy Registrar along with the
promoter’s application for registration, copies of byelaws, the schedule of particulars of the
promoters, copies of resolutions passed at the meeting, the names of Interim Committee
members and the amount of initial share capital paid into the bank with details. He scrutinizes
all these papers so as to satisfy himself.
i) that the application and the byelaws are in conformity with the Cooperative Societies
Act and Rules; and
ii) that the proposed Society has reasonable chances of success.
Then he consults the Central Bank and the Federal Society concerned, if any. After
all these formalities are over, the Deputy Registrar registers the Society with its byelaws and
issues a Registration Certificate. On getting this certificate, the society becomes a body
corporate having a separate legal entity of its own like a company.
After the registration the first general meeting is convened to transact the following business:
i) to read and record the Registration Certificate, the byelaws and the names of members
of the Interim Committee;
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ii) to admit the promoters as members of the Society;
iii) to get affiliation to the Central Bank and the Federal Society concerned; and
iv) to elect delegates to the above Federal organisations
Then a current account is opened with the Central Bank through a resolution passed
at the meeting of the Interim Committee. Two persons among them are authorised to operate
the account. Then, shares are taken in the Central Bank and in the Federal Society concerned.
This completes the process of formation of the Society.
Check Your Progress-4
List out the steps involved in the registration of cooperatives.
6.5 MANAGEMENT OF A CO-OPERATIVES
After registration the society’s affairs are to be managed as per the approved bye
laws. A Cooperative Society is democratically managed by the members. It has two organs
of management: the General Body and the Board of Directors.
General Body
This is the supreme body in a Cooperative Society. The ultimate authority in all
matters relating to the administration of the Society rests with it. It makes or amends the bye
laws of the Society. It elects the Board of Directors. It approves the annual report and
decides the disposal of net surplus. It operates through general meetings and makes decisions
by passing resolutions by majority votes. In elections and also in making decisions, one
member has only one vote.
Board of Directors
The authorisation of a Cooperative Society is vested in the hands of the Board of
Directors, subject to the resolutions passed in the general meetings from time to time. The
directors are elected by the members of the general body from among themselves as prescribed
in the byelaws. It exercises such powers as are prescribed in the byelaws. It is ultimately
responsible to the general body for all its actions. It discharges its duty by periodical meetings.
Decisions are made on the basis of majority vote. Each member has only one vote.
The Board of Directors elects officebearers such as the President and VicePresident,
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Secretary, Treasurer from among the directors and entrusts them with the management of the
Society’s affairs. It is subject to the budget allotment. The Board appoints the chief executive
who is assisted by paid staff and entrusts the daytoday administration to him. A sound and
favourable relationship between the Board and the Chief Executive is essential for the success
of a Cooperative Society. In order to promote efficiency without impairing members’
democratic control, the Board should confine itself to the formulation of policies, appointment
of executives to implement those policies and the supervision and evaluation of their
performance.
The Board has the responsibility of managing the Society in the best interest of all the
members of the Society. In the election to the Board or in decision making, one member has
only one vote. Proxy is not allowed as in Joint Stock Companies. For reasons cited above,
generally an official of the Cooperative department of the State Government is deputed to
run a Cooperative Society. Though this is very useful for the directors in formulating policies
in tune with the provisions of the Act and Rules, these deputationists are not independent.
Hence the status of the Cooperative society becomes subservient to Government. That is
the reason why most people consider Cooperative Societies as Government agencies rather
than their own organisations.
The success of a Cooperative depends very much upon the members’ awareness
and solidarity. Hence, the Board should take steps for educating the members and improving
their skills and latent talents. It should aim at instilling faith in Cooperation in the minds of the
members. The resources available in a Cooperative Society are limited. Therefore, the
Board should make every effort to optimise the utilisation of the available resources. It should
undertake long range planning for stability and growth in the context of changes in the market,
technology and environment.
The Board is also expected to be a vigilance committee: i) for safeguarding the funds
and assets of the Cooperative Society; and ii) for ensuring the effective performance of the
Cooperative Society by (a) establishing suitable management systems; (b) providing in built
checks and balances; and (c) comparing the results with the standard set. However, the
Board should not interfere in daytoday management of the Society which is the responsibility
of the Chief Executive and his team. The Board should frame policies and allow the Chief
Executive to implement them.
Functions of the Board of a Co-operative Society
The Board of Directors of a Cooperative Society has the following functions:
• selection of the Chief Executive;
• determining the terms of service of the Chief Executive;
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• formulating General Policies regarding prices, dividends and reserves;
• deciding on the bonus and rebate to members;
• approving budgets;
• formulating a plan of development for the future;
• reviewing trade and other trends to give information to members and employees;
• maintaining continuous liaison with members, customers and outsiders;
• establishing standards for performance;
• evaluating performance visavis standards; and
• Recommending appropriate action for the future based on performance evaluation.
President of the Society
The Chairman of the Board is called the President. The President has a special role
to play in a cooperative Society. He acts as the liaison between the Board, the Executive
and the society. He ensures proper implementation of such policies. He enables the Board to
formulate policies in accordance with the member’s views. He also communicates the policies
formulated by the Board to the members and convinces them about their effectiveness.
The President acts as a liaison between the Cooperative Society and the public. He provides
an image to Society. His views and actions reflect on the Society. He provides inspiration to
the other directors, members and employees of the Cooperative Society.
Functions of the President
In order to play the above roles, the President performs the following functions.
• Presides over the meeting of the Board and the General Body.
• Initiates discussions in the meetings.
• Answers questions and queries raised by its members.
• Represents the Cooperative Society to the Government and the Central organisation.
• Examines the proposals of the Chief Executive and places them before the Board for
discussion and decision.
• Examines proposals for the long range planning and development of the Society and
places them before the Board for decisions.
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Check Your Progress-5
What is the responsibility of Board of Directors of a Cooperative Society?
6.6 TYPES OF CO-OPERATIVES
Cooperative Societies are started in different fields to fulfil the needs of different
sections of people and to promote their economic and social wellbeing. The needs of different
sections of people vary; accordingly there are different types of Cooperative Societies. Co
operative Societies can be broadly dividend into two major categories viz., Credit and Non
Credit. Each category in turn can be divided into Agricultural and Nonagricultural.
Types of Co- Operatives
1. Co-operative Credit Societies
Credit Societies are started by persons who are in need of credit. These Societies
provide credit to their members at a reasonable rate of interest. They collect the savings of
the members in the form of share capital and deposits. They also borrow from outside sources
and their Apex Societies. The resources so raised will be used to grant loans to their members
at a fair rate of interest. These societies can be classified into agricultural and nonagricultural
societies.
(i) Agricultural Credit Societies
The State Cooperative Bank is an Apex organisation at the State level. It is a
Federation of Central Cooperative Banks. It coordinates the activities of District
Central Cooperative Banks. These banks grant loans to the primary agricultural
Cooperative Credit Societies. The Primary Credit Societies are classified into two
types: the Agricultural Credit Societies and the Nonagricultural Credit Societies.
Agricultural Credit Cooperatives are started to provide shortterm and medium
term finance to the farmers to meet expenses in cultivation. The shortterm loans
issued by these Societies are called crop loans. The duration of the loans is one crop
season ranging from 4 to 8 months. These loans are sanctioned against sureties.
Loans are disbursed both in cash and in kind in the form of seeds, fertilisers and
pesticides. Besides lending, these Societies also supply essential goods and make
available improved agricultural implements. They promote thrift among the local
people by accepting deposits from members.
106
The purpose of these societies is to remove rural indebtedness and exploitation
of villagers by the money lenders. They also provide short-term loans to
rural artisans and allied agricultural activities like sheep breeding, weaving
etc.
In the State of Telangana, the longterm credit structure is merged with shortterm
credit structure under the single window cooperative credit delivery system. As
such, now we do not find land development banks in our state. The long term credit
needs of the agriculturists are also met by the primary agriculture cooperative credit
societies.
(ii) Non-Agricultural Credit Societies
Employees of industrial units, small traders, artisans and people of low income groups
in towns and cities start Credit Societies. A few examples are: Cooperative Urban
Banks, Thrift Societies, Employees Credit Societies, Industrial Cooperative Banks
and House Mortgage Banks.
Urban Banks
These banks are started for providing shortterm credit to small traders and people of
low income groups. They also undertake all the functions of commercial banks.
Though the bulk of the loans issued by them are jewel loans, they also lend against
bills and hypothecation. They also accept safe custody deposits. They promote
thrift and savings by collecting the small savings of people of low income. They raise
funds through share capital, public deposits and borrowings from Apex Banks.
Thrift Societies
These societies are started with the objective of inculcating a sense of thrift and saving
in people of low income by collecting their small savings. Such collections may be
made daily, weekly, fortnightly or monthly. These Societies repay such deposits with
interest after the stipulated period. The members are also permitted to avail credit
facilities against such deposits.
Employees’ Credit Societies
Employees in industrial and other undertakings in towns and cities are victims in the
hands of money lenders. These Societies are started in order to protect employees
from the exploitation by the latter. Membership of these Societies is confined to the
employees of a particular organisation. These Societies provide shortterm loans to
their members and collect deposits from their members and nonmembers. The
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members also subscribe to the share capital of their societies. These Societies also
depend on borrowings from the District Central Cooperative Banks. Loans are
issued on guarantees and they are recovered through deductions from the monthly
earnings of the employeemembers. These Credit Societies also involve themselves
in activities promoting the welfare of the members.
Industrial Co-operative Banks
Small scale and cottage industries play a pivotal role in developing the economy of the
underdeveloped countries. Hence, the development of the Small Scale and Cottage
industries is very essential. Industrial Cooperative Banks are started with the objective
of providing shortterm, mediumterm and longterm finance to SmallScale and
Cottage industries. They also lend money to and promote thrift among the members.
They raise finance through share capital, deposits from members and public borrowings
from the Government.
Co-operative Housing Societies
Cooperative Housing Societies are formed in order to provide housing or
accommodation to the members. Most of these Societies operate in urban areas.
There are different types of Housing Societies. Some of them provide loans to their
members and leave the selection of the site and the construction of houses to them.
Loans are repayable in easy instalments. These Societies are also called House
Mortgage Banks. Some of Societies acquire land, plan the layout and construct houses
and later allot the houses to the members. The cost of house is collected in instalments.
Some Societies sell the houses on hiresale basis. Housing Cooperatives raise finance
through share capital, reserves borrowings from Central Government, State
Government, State Cooperative Housing Societies, Life Insurance Corporation,
Urban Development Corporation and the National Cooperative Housing Federation.
They subsidise the cost of the house besides lending money for the purpose.
2. Co-operative Non-credit Societies
Cooperation has branched out in many fields. There are many NonCredit Co
operative Societies to promote the varied interests of human life. A few examples are Consumer
Cooperative Stores, Producers’ Cooperatives, Marketing Cooperatives and Cooperative
Farming Societies.
i) Consumer Co-operative Stores
Consumer Cooperative Stores are started for selling household goods to the members
108 at reasonable prices. Their objective is to protect the members from the evils of
unfair trade and steep rise in prices. These stores buy their requirements from the
producers through the Apex Societies so as to avoid the profiteering and adulteration
of goods by middlemen. Hence, the members of the stores are able to get better
quality goods at low prices. Thus Consumer Cooperative stores are retail trading
units.
The consumer Cooperative Stores purchase goods from the District Central Co
operative Stores which, in turn, buy from the State Consumer Cooperative Federation.
The State Federation purchases a few goods directly from the producers and a few
others from the National Cooperative Consumer Federation. As these Apex Societies
buy on behalf of several Primary Stores, they place bulk orders and enjoy the
advantages of largescale buying. A few Apex Societies themselves produce some
goods through their own processing units.
Cooperative Supermarkets are popular in India. They are largescale departmental
stores. They deal in various kinds of consumer goods.
ii) Producers’ Co-operative Societies
Producers’ Cooperative Societies are called Industrial Cooperatives. Small
producers and artisans are members of these Societies. These Societies are formed
in order to protect the small producers and workers from the exploitation of powerful
capitalists. The objectives of these Societies are to provide credit facility to supply
raw materials and to market the products produced by them and to help the members
to buy machinery on a hire purchase basis. There are two types of Industrial Co
operatives. In the first, the Society procures raw materials and distributes them to the
members. The members work in their houses and sell the finished goods through the
Society. Weavers’ cooperative societies, artists cooperative societies are the
examples for this type of cooperatives. The Society gets a better price for the
products from the members. In addition, the Society provides the finance, tools,
equipment and machinery required by the members. In the second type the Society
maintains a work shed with the necessary equipment, machinery and raw materials.
The members are expected to go and work in the society work shed. They get
wages for the work they do. At the end of the year the profit is distributed as bonus
in proportion to the wages earned by members.
Industrial Societies raise through share capital, and loans from Industrial Cooperative
Bank, Government and other financial institutions. Longterm financial requirements
are met by borrowings from the State Directorate of Industries, State Finance
Corporation, National Small Scale Industries Corporation, Khadi and Village 109
Industries Commission and other bodies. There are Industrial Cooperatives in
weaving, tanning, pottery, oil processing, spinning, handicrafts, chemical engineering
etc. There are also cooperative workshops to attend to serving functions.
iii) Co-operative Marketing Societies
Agricultural producers are exploited when they market their products. Middlemen
take away a larger portion of the price paid by the consumers. The Marketing’
Societies are started in order to protect such producers. These societies arrange for
marketing the members’ products at favourable price. These societies provide storage,
processing, grading and standardisation facilities. They grant advances against the
pledge of goods. There are Federation of Marketing Cooperatives at the district,
state and national levels.
iv) Co-operative Farming Societies
Subdivisions and fragmentation have affected the land holdings of farmers. Economies
of large scale operations cannot be derived by small holders. Farming Societies are
formed to promote the welfare of small holders.
There are various types of Cooperative farming societies and they are discussed hereunder:
v) Co-operative Better Farming Society
The members own their land and cultivate their lands individually. The Society
undertakes supply of inputs such as seeds, fertilisers and implements and some of the
modern machinery which can be used commonly by all the members. The Society
provides facilities for processing, grading and storing. Later, the Society arranges to
sell the produce.
vi) Co-operative Joint Farming Society
This type of Society pools the members’ land and other resources and arranges for
joint cultivation. The land ownership rests with the individual members. Members
get rent for the land and wages for the work done. The profit of the society is
distributed among the members on the basis of their wage earnings. The members
are free to withdraw their land from the common pool whenever they wish to do so.
vii) Co-operative Tenant Farming Society
This type of Society owns land or takes land on lease from an organisation. The land
is divided into economic holdings and distributed among members for cultivation on
lease. The membertenants buy seeds and fertilisers, etc., through the Society and
market their produce through the Society. The profit of the Society is distributed in
110 proportion to the members’ patronage.
viii) Co-operative Collective Farming Society
In this type of Cooperative, the ownership of the land rests with the Society, and
cultivation is done jointly. The members are paid wages and patronage dividend out
of the surplus in proportion to the wages earned by them. The Cooperative Farming
Societies are most helpful to small and marginal farmers and enable them to get the
advantages of largescale operations.
ix) Other types of co-operative societies
In addition to the above types of Societies, there are various other types of Societies
such as Transport Cooperatives, like Autorikshaw Cooperatives, Motor Transport
Cooperatives, Washer man Cooperatives, Fishery Cooperatives, Dairy Co
operatives and Poultry Cooperatives. All these Societies aim at promoting the welfare
of their members.
Check Your Progress - 6
(i) List out the objectives of Consumer Cooperative Societies?
Check Your Progress - 7
(ii) What are the types of Producers’ Cooperative Societies?
6.7 STRUCTURE OF CO-OPERATIVES
The Cooperative Credit Institutions in India have a threetier structure. They are as
follows:
(i) Primary Agricultural Credit Societies (PACS) at the bottom level
(ii) District Central Cooperative Bank (DCCB) at the middle level
(iii) State Cooperative Bank (SCB) at the top level (TSCAB).
111
That is, the primary societies are functioning in the various towns and villages, the
Central Banks at the district headquarters and the State Cooperative Banks at the state
capitals forming the apex of the system.
The Reserve Bank of India assist the cooperative structure by providing concessional
finance through NABARD in the form of General Lines of Credit for lending to agricultural
activities. Thus, the whole system is integrated with the Banking structure of the country.
6.8 MERITS AND DEMERITS OF CO-OPERATIVES
Like other forms of organisation, cooperatives also have their own merits and demerits.
Some of them are explained below:
Merits
i) Open Membership: The membership of cooperatives is open to each and
everyone. Anybody having the common interest can join the society. There will not
be any discrimination based on the status, caste, creed, etc.
ii) Democratic Management: The cooperatives are managed on the basis of
democratic principles. The office bearers of cooperatives are elected by the members.
Each member will have one vote irrespective of the number of shares held.
iii) Service Motive: The primary object of cooperatives is not to make profit but to
promote the interest of members. They provide better services to the members. The
members get goods and services at cheaper rates.
iv) Limited Liability: The liability of members is limited to the extent of capital contributed
by them.
v) Stability: The Cooperative Societies are registered organisations. They have separate
legal entity and enjoy a perpetual existence. It is not affected by the death, insolvency,
retirement, etc. of the members.
vi) Low Operating Costs: Since these are managed ‘by the members (elected) only,
they take keen interest in each and every aspect. They provide honorary services.
As the members only are the customers there is no need to spend any amount on the
advertisement. There will not be any loss on account of bad debts as they generally
sell on cash basis.
vii) Internal Financing: The cooperative societies depend on internal financing. Due
to statutory limitation on the rate of dividend and compulsory transfer of some part of
profit to different reserves the profits are ploughed back. Thus, they mostly depend
112 on their own funds.
viii) Tax Advantage: The cooperatives enjoy the tax advantages granted by the
Government. For instance, they are exempted from payment of income tax.
ix) State Patronage: The cooperatives enjoy the state patronage. The Government
provide so many grants and assurances. They are also given certain tax concessions.
The Government encourage the cooperatives as they serve as an instrument of socio
economic development of the weaker sections.
x) Social benefits: They promote cooperation among members. They develop
brotherhood, unity and spirit of service among members. They also take up the
education of members on aspects of democracy, selfgovernment, selfhelp and mutual
help. They inculcate the habit of saving among the members.
Demerits
i) Limited Financial Resources: The capital which a cooperative society can raise
is very limited. They cannot approach the public at large as the companies do. They
are started by economically weaker sections. As such the societies are not in a
position to the raise required funds for the purpose of taking up expansion and large
scale operations. The inadequacy of capital and various other limitations make co
operative societies dependent on the Govt. for support and patronage in terms of
grants, loans subsidies, etc.
ii) Excessive State Regulation: The cooperatives do not enjoy complete freedom to
manage the business affairs. They have to follow many procedures and formalities
imposed by the Government. They may result in delay in decision making.
iii) Political interference: Political interference adversely affects the functioning of co
operatives. The Government nominates the party members on the managing
committees. Political parties also take cooperative elections on party basis. As
such the societies are managed on political considerations.
iv) Lack of unity: Most of the members are illiterate. They are easily influenced by
other members. The members are divided into different groups and there will be lack
of harmony. They lead to delay in taking decisions and malfunctioning of the society.
v) Inefficient management: The societies cannot afford to employ expert and efficient
staff. They depend on honorary managerial service by the members. As a result,
they are not properly managed.
vi) Lack of motivation: Every cooperative society is formed to render service to its
members rather than to earn profit. This does not provide enough motivation to the
members to put in their best efforts and manage the society efficiently.
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This foregoing discussion reveals that cooperative form is suitable for small and medium
scale business operations and service organisations.
6.9 COOPERATIVES VS. PARTNERSHIP
The basic differences between Cooperatives and Partnership are as follows:
Sl No. Cooperatives Partnership
1 Determining factor is union of persons Mutual understanding and trust
2 Creation based on Mutual Association Agreement
3 It has legal entity No legal entity
4 There exists continued existence There is no continued existence
5 Objective is promotion of members Objective is profit
welfare
6 Ownership memberusers Owners are partners
7 Number of members 10 and above Not exceeding 10 (20 in case of banking)
8 Limited liability Unlimited liability
9 Registration is compulsory Not compulsory
10 Managed by Board of Directors Managed by partners
(elected by members)
11 Distribution of profit in proportion As per agreement
to patronage
6.10 SUMMARY
Cooperatives are voluntary and democratic associations of persons based on common
interest. They have certain distinctive features which are called the principles of cooperatives.
The main objective of cooperatives is to promote the economic interest of the members.
These societies are formed by registering them under the cooperative Societies Act. On
registration it becomes body corporate and it is managed by the elected representatives of the
members. The president of the society plays a key role in the affairs of the society. Based on
the purpose for which the cooperatives are started, they can be broadly divided into two
types, i.e., credit societies and noncredit societies. Again these societies are divided into
agricultural and nonagricultural. The group of credit societies consists of the land development
banks, urban banks, employees’ credit societies, Industrial credit societies, housing societies
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etc. The noncredit societies consist of consumer cooperative societies. They are very
important. They do both wholesale and retail trade. Different consumer stores are started
namely rural stores, urban stores, Women’s stores, Student’s ‘stores, employee stores and
supermarkets. Among these, the super markets are very popular in India. Like any other
form of organisation, cooperatives do have their own merits and demerits. The cooperative
form business organization is quite different from partnership.
6.11 CHECK YOUR PROGRESS : MODEL ANSWERS
1. The profits of the cooperative societies are earned out of the transactions with the
members. The surplus is not distributed according to the capital contributions. It is
distributed according to the business made by the members with the society. This
dividend is called patronage dividend.
2. All the members are treated equally. There is no discrimination based on religion,
caste or creed. All the members will have equal chances in taking part in the affairs of
the society.
3. The cooperative societies have to follow certain rules and regulations framed by the
Government. They are regulated by the Government through the administration of
Cooperative Societies Act. Their accounts are to be audited by the departmental
auditors and audited accounts and other reports are to be submitted to the Registrar
of Cooperatives.
4. The registration of cooperative societies is compulsory. Any of the members having
common interest have to make an application to the Registrar of cooperatives. Then,
the Inspector of cooperatives visits the place and explores the possibility of starting
a society. The byelaws of the society are to be prepared and submitted. Members
of an interim committee are elected. The initial share capital is to be collected and
deposited into the bank. On the submission of the report by the Inspector along with
all the required documents, the society is registered.
5. The Board is responsible for the administration of the society. They elect the office
bearers. The board appoints the Chief Executive. It has the responsibility of managing
the society in the best interest of all the members.
6.(i) To eliminate the middlemen and make available goods for the daily requirements of
the members at cheaper prices and to supply qualitative products.
(ii) These are started for the benefit of the small producers. There are two types of societies.
The first one procures and distributes the raw materials to the members and the
second one maintains the work shed with all equipment and machinery. 115
6.12 MODEL EXAMINATION QUESTIONS
I. Short Answer Questions
1. Define a Cooperative Society.
2. Explain “patronage dividend.”
3. Explain three important features of cooperatives.
4. What are the functions of the Board of a cooperative society?
5. What are the functions of the president of a cooperative society?
6. What are the objectives of the consumer cooperatives?
7. What is the need for producers’ cooperatives?
8. Explain the agricultural credit cooperatives.
9. What are the objectives of employees’ cooperative credit society?
10. Explain any four types of consumer cooperatives.
11. What are the objectives of cooperative marketing societies?
12. Describe the structure of Cooperatives.
13. Distinguish between a cooperative and partnership.
II. Long Answer Questions
1. What do you mean by a cooperative society? Explain its features.
2. Describe the principles of cooperatives.
3. Explain the different types of cooperatives.
4. Describe the merits and demerits of cooperative form of organisation.
5. Explain the procedure followed in the formation of a cooperative society.
6. Explain the management of cooperatives.
III. Objective Type Questions
A. Multiple Choice Questions
i) The supreme body for managing a Cooperative Society.
a) General body b) Board of Directors
c) President d) The Secretary
ii) The activities of Cooperative Societies are regulated by
(a) State Government
(b) Central Government
(c) Board of Directors
116 (d) Registrar of Cooperatives
iii) From the following, which is not a Cooperative Noncredit Societies?
(a) Consumer Cooperative Stores
(b) Producers’ Cooperative Societies
(c) Cooperative Marketing Societies
(d) Industrial Cooperative Banks
iv) From the following, which is not a principle of Cooperatives?
(a) Voluntary association
(b) Democratic Management
(c) Cooperation among the Cooperatives
(d) Profit sharing
v) Which is not a limitations of the Cooperatives
(a) Limited financial resources
(b) Limited liability
(c) Political interference
(d) Lack of unity
Answers: i) a ii) a iii) d iv) d v) b
B. Fill in the Blanks
i) The cooperative society is a _____________association of persons.
ii) These cooperative societies can be classified into _____ and _______ societies.
iii) The basic philosophy of cooperatives is ______________________________.
iv) The Cooperative Society is democratically managed by_________________ .
v) _______________(factor) adversely affects the functioning of cooperatives.
Answers: i) Voluntary ii) Agricultural, non-agricultural
iii) Each for all and all for each iv) Members v) Political interference
C. Match the Following
i) Cooperatives (a) Elimination of bad debts
ii) Cash trading (b) Democratic management
iii) Primary agricultural credit society (c) Nonagricultural credit
iv) Cooperative urban banks (d) Retail trading units
v) Consumer cooperative stores (e) Village level cooperative
society
Answers: i) - b ii) - a iii) - e iv) - c v) - d 117
6.13 GLOSSARY
Bye-laws : The rules and regulations governing the
Management of cooperative society
Co-operative Society : Society registered under the Cooperative
Societies Act.
Crop Loan : Loan granted by a cooperative credit
Society for raising a crop.
Equality : Equal opportunity to all the members – one
man one vote.
General Body : Consisting of all the members of a co
operative society.
Interim Committee : Committee elected at the preliminary
meeting to arrange for the registration of a
society.
Member Patron : The member of a cooperative society is
both its customer and patron.
Multipurpose : Cooperative society which combines the
Co-operative Society supply and marketing functions with those
of credit.
Voluntarism : Not resorting to compulsion in enrolling
the members and their continuance.
6.14 FURTHER READINGS
Hajela T.N : Principles, Problems and Practice of Co-operation
Krishnaswami O.R : Fundamentals of Co-operation
Mathur B.S : Co-operation in India
Reddy P.N. and : Principles of Business organisation and
Gulshan S.S Management
Rao VSP : Business Organisation and Management
Himalalya Publishing House, Mumbai400004
Sherlekar, Khushpat : Business Organisation, Himalalya Publishing
Jain and Apexa Jain House, Mumbai400004
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BLOCK – III : FORMS BUSINESS
ORGANIZATION - II
UNIT – 7 : JOINT STOCK COMPANY
UNIT – 8 : INCORPORATION OF COMPANY
UNIT – 9 : DOCUMENTS FOR REGISTRATION OF
COMPANY
119
120
BLOCK – III :SOURCES OF FINANCING
UNIT – 7 : JOINT STOCK COMPANY
Contents
7.0 Aims and Objectives
7.1 Introduction
7.2 Concept of Joint Stock Company
7.3 Features of Joint Stock Company
7.4 Types of Companies
7.5 Formation of Joint Stock Company
7.6 Advantages and Disadvantages
7.7 Summary
7.8 Check Your Progress: Model Answers
7.9 Model Examination Questions
7.10 Glossary
7.11 Further Readings
7.0 AIMS AND OBJECTIVES
This unit acquaints you with the formation of Joint Stock Company. After studying this
unit, you should be able to:
• understand the concept of Joint Stock Company (JSC);
• identify the features of a Joint Stock Company;
• explain the types of companies and procedure for formation of JSC; and
• evaluate the merits and demerits of the JSC.
7.1 INTRODUCTION
The previous unit presented the Proprietary Joint Hindu Family and the Partnership
forms of organisation at length. The present unit describes the company form of organisation
i.e., Joint Stock Company. It includes the concept and features of Joint Stock Company,
types of companies, the procedure for formation of Joint Stock Company and advantages
and disadvantages.
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7.2 CONCEPT OF JOINT STOCK COMPANY
Sole-proprietorship and partnership form of organisations could not meet the needs
of modern industry and commerce because of their limitations like limited resources, unlimited
liability etc. The need for another form of organisation free from the above mentioned limitations
was felt and thus Joint Stock type of organisation came into existence. It can raise large
resources without the risk of unlimited liability. It is suitable for undertakings requiring large
capital.
Meaning
The word ‘company’ has strictly technical or legal meaning. It may be described to
imply an association of persons for same common object or objects. The purposes for which
people may associate themselves are multifarious and include economic as well as non-
economic objectives. But in common parlance, the word ‘company’ is normally reserved for
those associated with economic purposes i.e., to carry on business for gain or profit.
‘Company’ in simple terms may be described to mean a voluntary association of
persons who have come together for carrying on some business and sharing profits arising
therefrom.
Definitions
In order to understand the meaning of a company let us analyse some of the definition.
According to L.H. Haney: “a Joint Stock Company is a voluntary association of
individuals for profit, having a capital divided into transferable shares, the ownership of which
is the condition of membership.”
Lord Justice of England has defined Joint Stock Company as ‘an association of
many persons, who contribute money or money’s worth to a common stock and employ it for
a common purpose. The common stock so contributed is denoted in money and is the capital
of the company. The persons who contribute to it are called members. The proportion of
capital to which each member is entitled to his share’.
According to Justice John Marshall of USA ‘a Corporation (Company) is an artificial
being, invisible, intangible and existing only in the contemplation of the law. Being a mere
creature of the law, it possesses only those properties which the charter of its creations confers
on it, either expressly or as incidental to its very existence’.
Companies Act 2013 of India defines Joint Stock Company ‘as a company limited
by shares having a permanent paid up or nominal share capital of fixed amount divided into
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shares, also of fixed amount held, transferable as stock and formed on the principles of having
in its members only the holders of those shares or stocks and no other persons’.
A more comprehensive definition will, however, be one that indicates all the essential
features of a company. Thus we may define a company “as an artificial creature created by
law, with a distinctive name, a common seal and perpetual succession”.
The above definitions reveal many distinctive characteristics of a Joint Stock Company.
They are:
i) it is created by law;
ii) it has a separate legal entity;
iii) it is an artificial being but invisible and intangible;
iv) it is an association of many persons;
v) it has a distinctive name;
vi) it has common seal as a substitute for signature;
vii) its liability may be limited; and
viii) it has perpetual succession.
7.3 FEATURES OF JOINT STOCK COMPANY
A Joint Stock Company is voluntary association in which people contributes with
capital in the forms of shares to carry on a certain type of business for earning profit”. Company
operates in its own name under a common seal. It has separate body from its members. Some
of the distinctive features of a joint stock company are as follows:
i) Incorporated Association: A company comes into existence only after registration
under the Companies Act whereas registration is not compulsory for other forms of
business organisations like sole-proprietorship and partnership.
ii) Artificial Legal Person: A company is a corporate body, it is an artificial person
created by law. It enjoys all the legal rights of a natural person like the making of
contracts, owning of property, etc.
iii) Distinct Legal Entity: A company is regarded as an entity separate from its members.
A shareholder of a company can enter into contract with the company and can sue
the company and be sued by it. The life of the company is independent of the life of
its members.
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iv) Common Seal as a Substitute for Signature: As the company is not a natural
person, it cannot sign documents. The common seal with the name of the company
engraved on it is, therefore used in place of signature. It acts as its official signature.
Generally, the secretary of the company is authorised to keep the seal under his
custody.
v) Perpetual Succession: A company has perpetual existence unlike a partnership or a
sole trading concern. Once a company is formed, it continues for an unlimited period
until it is legally dissolved. In other words, a company has an unending life and the
death or insolvency of a shareholder does not affect its existence. It states that ‘men
may come and men may go out but I go on forever’ applies to the company. The life
of a company is not measured by the life of any member, as it has a separate entity of
its own.
vi) Limited Liability: The liability of the members of a company is normally limited by
guarantee or by the shares. If a member has already paid the full amount due on his
shares, he is not further liable towards the debts of the company and his personal
properties are not liable to be attached for the payment of the company’s debts. It
may be stated here that in the case of sole-proprietorship and partnership the liability
is unlimited.
vii) Number of Members: The maximum number of members in the case of a public
limited company is unlimited, the minimum being seven, while in the case of a private
limited company, the maximum is fifty excluding the employee members of the company
and the minimum is two. However section 3 of the Companies Act allows formation
of “One Person Company (OPC)”
viii) Separation of Ownership and Management: A company is owned by the share
holders, but it is managed by a separate body, called ‘Board of Directors’ elected by
the shareholders. We have seen in the case of partnership that every partner is an
agent of the firm and also of the other members. But in the case of a company, a
shareholder is not an agent of the company and he cannot bind them by his acts.
ix) Rigidity of Objects: The scope of the business of a company cannot be changed
and it cannot do any business that is not already included in the ‘objects clause’ of its
Memorandum of Association. A change in the ‘objects clause’ can be effected after
complying with the provisions of the Companies Act and only then any alteration in
the scope of business can be made.
x) Transferability of Shares: The shareholder of a Public Limited Company is at liberty
to transfer his shares to others without the consent of other shareholders. For
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transferring the shares the only thing he has to do is to follow the procedure laid down
in the Companies Act. In a Private Company, however, some restrictions are imposed
for transferring shares.
xi) Financial Resources: In the case of a company, there is a great scope for mobilising
a large capital because of the principles of limited liability and diffusion of ownership.
xii) Statutory Regulations: A company has to comply with the numerous and varied
statutory requirements. A company is governed by the Companies Act and it has to
follow the various provisions of the Act. It has to submit a number of returns to the
Government and also its accounts have to be audited by a Chartered Accountant.
Check Your Progress - 1
Explain the features of Joint Stock Company.
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7.4 TYPES OF COMPANIES
The Companies Act, 2013 broadly classifies the companies into private and public
limited companies. However, with the growth of the Indian economy and increasing complexity
of business operations, the forms of business organizations keep on changing.
The Companies Act, 2013 broadly classified companies as detailed below:
1. Classification on the basis of Incorporation
2. Classification on the basis of Liability
3. Classification on the basis of Public Interest
4. Classification on the basis of Nationality.
Classification on the basis of Incorporation
i) Chartered Company
If a company is incorporated under a special Royal Charter granted by the Monarch,
it is called a ‘Chartered Company’ and it is regulated by the provisions of that Charter.
For example, the East India Company, the Chartered Bank of Australia, India and
China were incorporated by the grant of a special Royal Charter. In India, this form
of organisation does not exist now because there is no monarchy. 125
ii) Statutory Corporation
A corporate body which is established by a special Act of the Parliament is called a
‘Statutory Corporation’ and it is governed by the provisions of such an Act. This is
done only in special cases where it is required to regulate the functioning of the company
for some specific purposes. Examples of such corporations in India are the Life
Insurance Corporation of India, Air India Corporation, Industrial Finance Corporation,
the State Bank of India, State Trading Corporation, Food Corporation of India, etc.
iii) Registered Company
A company which is established through registration with the Registrar of Companies
under the Companies Act is called a ‘Registered Company’. Most of the companies
in India belong to this category.
Classification on the basis of Liability
With reference to liability, companies may be classified as (i) companies with liability
limited by guarantee; (ii) companies with liability limited by shares and (iii) unlimited Liability
Company,
i) Companies with Liability Limited by Guarantee
In this case, each member gives guarantee for the debts of the Company upto a
certain extent in addition to the amount of shares held by him. The additional amount
payable by the member is laid down in the Memorandum or Articles of Association.
This type of company is formed mostly when the business is of a non-profit making
nature and has the object of promoting social and cultural activities. Chambers of
Commerce, Trade association, Clubs, Societies and Charitable organisations can be
registered as this type of company. The Hyderabad Stock Exchange can be cited as
an example in this context. It is to be noted that the members are called upon to pay
only when the company is wound up and the assets are inadequate to pay the claims
of the outsiders in full.
ii) Companies with Liability Limited by Shares
In this case, the liability of members is limited only to the amount of the shares held by
them. It means that a member can be called upon to pay only the unpaid amount on
shares purchased by him. For example, a shareholder, who has paid Rs.5/- on a
Rs.10/- share, can be called upon to pay the balance of Rs.5/- and nothing more.
Most of the companies in India are of this type.
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iii) Unlimited Liability Company
A company having no limit on the liability of its members is an unlimited company.
Section 3(2) of the Companies Act, 2013 allows a company to be formed as an
unlimited company. Thus, in the case of an unlimited liability company, the liability of
each member extends to the whole amount of the company’s debts and liabilities. It
may be seen that the liability of members of an unlimited company is similar to that of
the partners but unlike the liability of partners, the members of the company cannot
be directly proceeded against. Company being a separate legal entity, the claims can
be enforced only against the company. Thus, creditors shall have to institute
proceedings for winding-up of the company for their claims. But, the Official Liquidator
may call upon the members to discharge the debts and liabilities without limit.
An unlimited company may or may not have share capital.
An unlimited company is not subjected to any restrictions regarding purchase of its
own shares [Sec.67]. Accordingly, such a company may purchase its own shares or advance
monies to any person to purchase its shares. Under section 18, a company registered as an
unlimited company may subsequently convert itself into a limited liability company, subject to
the provision that any debt, liabilities, applications or contracts in regard to or entered into, by
or on behalf of the unlimited liability company before such conversion are not affected by such
conversion.
Further, section 65 of the Companies Act, 2013 provides that an unlimited company
having a share capital may, by a resolution for registration as a limited company under this Act,
do either or both of the following things, namely-
(a) Increase the nominal amount of its share capital by increasing the nominal amount of
each of its shares, subject to the condition that no part of the increased capital shall
be capable of being called up except in the event and for the purposes of the company
being wound up;
(b) Provide that a specified portion of its uncalled share capital shall not be capable of
being called up except in the event and for the purposes of the company being wound
up.
You may more here that whereas, the concept of ‘Reserve Capital’ has been
done away with regarding limited liability companies; it still finds a place with
respect to unlimited companies.
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Classification on the basis of Public Interest
From this point of view, the companies may be classified as: (i) Private Company (ii)
Public Company (iii) Government Company (iv) One Person Company (OPC) and (v) Small
Company.
(i) Private Company
A Private Company is a company which requires a minimum number of two
persons for registration and which by its articles a) limits the maximum number of its
members to 50 excluding its employees, b) restricts the transfer of its shares from one
shareholder to another, and c) prohibits invitation to the public to subscribe to its
shares and debentures. The Private Company suits such persons who wish to have
the advantages of limited liability, while at the same time keeping the business as
private as possible. Even though there are certain similarities between Private Company
and Partnership, many businessmen prefer the Private Company form of organisation
because of its advantages of limited liability, corporate entity, and legal privileges.
Privileges of a Private Company: Private companies enjoy certain privileges
which are not allowed to a public company. The various privileges of a private company are:
(a) two members are sufficient to form a private company;
(b) it is not necessary to file with the Registrar either a prospectus or a statement-in-lieu
of prospectus;
(c) it is allowed to start business immediately after registration and there is no need to
secure a certificate to commence business;
(d) it need not hold the statutory meeting and need not file statutory report with the
Registrar
(e) two Directors are sufficient though more can be appointed if the company is so
inclined;
(f) the approval of the Government for granting loans to Directors is needed.
(g) many of the restrictions laid down on the allotment of shares by the public companies
are not applicable to the private companies;
(h) just two members can make a quorum for its meetings;
(i) there is no restriction regarding the term of appointment of managerial personnel;
(j) there is no restriction on the remuneration payable to directors and managerial personnel;
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(k) there is no need to keep an index of its members;
(l) restrictions on the issue of shares with disproportionate voting rights are not applicable
to private companies;
(m) provision regarding the issue of further shares, first to the existing equity shareholders,
does not apply to a private companies;
(n) restrictions on investment in other companies under the same management do not
apply to private companies;
(o) no person other than a shareholder of the private company is entitled to inspect or
obtain copies of the ‘Profit and Loss Account” and the Balance Sheet filed with the
Registrar and
(p) provisions regarding the Central Government’s power to prevent changes in the board
which are likely to affect the companies prejudicially are not applicable to a private
company.
Limitations of a Private Company: The law as pointed out places three restrictions
on a private company namely, restriction on the maximum number of members which it could
have; restriction on transfer of shares and prohibition of an invitation to the Public to subscribe
to its shares and debentures. These restrictions impose certain constraints on the growth and
expansion of its business. In that case the remedy lies in converting itself into a public company
(ii) Public Company
According to section 2(71) of the Companies Act, 2013, A public company means a
company which is not a private company and has a minimum paid-up share capital as
may be presented”. The minimum number of members required to start it is seven
and there is no maximum limit. It can invite the public to subscribe to its shares which
are transferable. It must have at least 3 directors to commence its business and must
also obtain a certificate to commence business from the Registrar of Companies.
(iii) Government Company
A “Government Company” is defined under Section 2(45) of the Companies Act,
2013 as “any company in which not less than 51% of the paid-up share capital is held
by the Central Government, or by any State Government or Governments, or partly
by the Central Government and partly by one or more State Governments, and includes
a company which is a subsidiary company of such a Government company”.
(iv) One Person Company
The concept of One Person Company in India was introduced through the Companies
Act, 2013 to support entrepreneurs who on their own are capable of starting a venture
129
by allowing them to create a single person economic entity. One of the biggest
advantages of a One Person Company (OPC) is that there can be only one member
in a OPC, while a minimum of two members are required for incorporating and
maintaining a Private Limited Company or a Limited Liability Partnership (LLP).
Similar to a Company, a One Person Company is a separate legal entity from its
promoter, offering limited liability protection to its sole shareholder, while having
continuity of business and being easy to incorporate. The introduction of OPC in the
legal system is a move that would encourage corporatisation of micro businesses and
entrepreneurship.
In India, in the year 2005, the JJ Irani Expert Committee recommended the formation
of OPC. As per section 2(62) of the Companies Act, 2013, “One Person Company” means
a company which has only one person as a member. The memorandum of One Person Company
is required to indicate the name of the other person, with his prior written consent in the
prescribed form, who shall, in the event of the subscriber’s death or his incapacity to contract
become the member of the company and the written consent of such person shall be filed with
the Registrar at the time of incorporation of the OPC along with its memorandum and articles.
Such nomination shall be filed in Form No INC.2 along with consent of such nominee obtained
in Form No INC.3 and fee as provided in the Companies (Registration offices and fees)
Rules, 2014. The member of One Person Company may at any time change the name of such
other person by giving notice, change the name of the person nominated by him at any time for
any reason including in case of death or incapacity to contract of nominee and nominate
another person after obtaining the prior consent of such another person in Form No INC.3.
Similarly, the other person may withdraw his consent by giving a notice in writing to
such sole member and to the One Person Company. The sole member shall nominate another
person as nominee within fifteen days of the receipt of the notice of withdrawal and shall send
an intimation of such nomination in writing to the Company, along with the written consent of
such other person so nominated in Form No. INC. 3. The company shall within thirty days of
receipt of the notice of withdrawal of consent under sub-rule (3) file with the Registrar, a
notice of such withdrawal of consent and the intimation of the name of another person nominated
by the sole member in Form No INC.4.
Privileges available to OPC
One person company is a new concept introduced by the Companies Act, 2013. As
the name suggests, such a company is formed only with one person as its member with effect
from 01.04.2014. Now let us discuss the privileges available to a One Person Company
as hereunder.
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• Mandatory rotation of auditor after expiry of maximum term is not applicable.
• The annual return of a OPC shall be signed by the company secretary, or where there
is no company secretary, by the director of the company.
• The provisions of Section 98 and Sections 100 to 111 (both inclusive), relating to
holding of general meetings, shall not apply to a One Person Company.
• An OPC needs to have minimum of one director. It can have directors up to a maximum
of 15 which can also be increased by passing a special resolution as in case of any
other company.
• For the purposes of holding Board Meetings, in case of a OPC which has only one
director, it shall be sufficient compliance if all resolutions required to be passed by
such a Company at a Board meeting, are entered in the minutes-book, signed and
dated by the member and such date shall be deemed to be the date of the Board
Meeting for all the purposes under this Act. For other OPC, at least one Board
Meeting must be held in each half of the calendar year and the gap between the two
meetings should not be less than 90 days.
• The financial statements of a one person company can be signed by one director
alone. Cash Flow Statement is not a mandatory part of financial statements for a
OPC. Financial statements of a one person company needs to be filed with the
Registrar, after they are duly adopted by the member, within 180 days of closure of
financial year along with all necessary documents.
• Board’s report to be annexed to financial statements may only contain explanations
or comments by the Board on every qualification, reservation or adverse remark or
disclaimer made by the auditor in his report.
(v) Small Company
The concept of Small Company has also been introduced for the first time in the
Companies Act, 2013. According to section 2(85) of the Companies Act, 2013,
“small company” means a company, other than a public company-
(i) Paid-up share capital of which does not exceed fifty lakh rupees; and
(ii) Turnover of which as per its last profit and loss account does not exceed two crore
rupees;
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However, the expression ‘small company’ shall not include:
(a) A holding company or a subsidiary company;
(b) Non-profit association (i.e., companies registered under section 8 of the Companies
Act, 2013;
(c) A company or body corporate governed by any special Act.
You should note that ‘one person company’ or ‘small company’ cannot be formed for
non-economic objectives, i.e., as a non-profit association.
Classification on the basis of Nationality
(i) Indian Company
It is also known as Private Limited Company is the most prevalent and popular type
of corporate registered and having place of business in India is called Indian Company.
Private limited company registration is governed by the Indian Companies Act, 2013
and the Companies Incorporation Rules, 2014. To register a private limited company,
a minimum of two shareholders and two directors are required. A natural person can
be both a director and shareholder, while a corporate legal entity can only be a
shareholder.
(ii) Foreign Company
A company registered outside India and having its place of business located in foreign
country may be called as foreign company. Further, foreign nationals, foreign corporate
entities or NRIs are allowed to be Directors and/or Shareholders of a Company with
Foreign Direct Investment, making it the preferred choice of entity for foreign
promoters.
Check Your Progress - 2
What are the different bases for the classification of companies?
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7.5 FORMATION OF JOINT STOCK COMPANY
It is very easy to establish a sole proprietorship business or a partnership firm as there
are a few regulations to meet. But for the establishment of a company, a lot of formalities are
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to be complied with. The registration of the company is mandatory before starting its operation.
The formation of a company, right from the origin of idea to establish a company goes through
four different stages, like:
• Promotion Stage
• Incorporation Stage
• Raising of Capital Stage
• Commencement of Business Stage.
Let us now learn about these stages in detail.
(i) Promotion Stage
Promotion being the first stage of a business simply refers to all those activities that
are required to be undertaken to establish a new business unit for manufacturing or
distribution of any product or provide any service to the people. It starts with conceiving
an idea of business or discovers an opportunity for doing a business, assess its
feasibility and then take the necessary steps to launch the business unit. This involves
ascertaining as to whether all the basic requirements such as land, building, raw material,
machine, equipments etc. are available or not. If they are available one can assemble
them, arrange the necessary funds and set up the business unit to give shape to the
initial idea of establishing the business. The whole process is called business
‘promotion’ and the person who does it is called the ‘promoter’.
(ii) Incorporation Stage
A sole proprietorship or partnership firm can be formed to carry out its business even
without any registration. But a company cannot be formed or permitted to run its
business without registration. In fact, a company comes into existence only when it is
registered with the Registrar of Companies.
(iii) Raising of Capital Stage
After the company is incorporated, the next stage is to raise the necessary capital. In
case of a private limited company, funds are raised from the members or through
arrangement from banks and other sources. In case of a public limited company the
share capital has to be raised from the public.
(iv) Commencement of Business Stage
In case of a private limited company, it can immediately start its business as soon as
it is registered. However, in case of public limited company a certificate, known as
‘certificate of commencement of business ‘must be obtained from the Registrar of
Companies before starting its operations. 133
Check Your Progress – 3
Describe the stages in the formation of JSC.
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7.6 ADVANTAGES AND DISADVANAGES
The Company form of organisation has become very popular throughout the world.
This is due to many advantages which the company organisation enjoys over the other forms
of organisation.
Advantages: The main advantages of the company form of organisation are as follows:
i) Financial Strength: A company can raise large amounts of capital by issuing shares
and debentures to the public, spread throughout the length and breadth of the country
and sometimes even to the people living in other countries.
ii) Limited Liability: A company can adopt the principle of limited liability. According
to this principle, a shareholder’s liability is limited to the extent of the face value of the
shares held by him or guarantee given by him and his personal properties are not
affected even if the company goes into liquidation. This is a great attraction to investors.
iii) Benefits of Large Scale Organisation: A company can organise a large enterprise
and can offer goods and services to the public at low prices as a result of the economies
of large scale operation.
iv) Scope for Expansion: As there is no limit to the maximum number of members
which a public company can have, there is a great scope for increasing the resources
of the company for the expansion of the business. A prosperous company can build
up sources for financing its expansion or modernisation.
v) Diffused Risk: The risk of each member is reduced because it is diffused and spread
over several members of the company. This is an advantage for the individual investor.
vi) Transferability of Shares: The shares of a public company are freely transferable
from one person to another for which the consent of other shareholders is not necessary.
Unlike partnerships, where the relationship is essentially personal, the relationship
between the members and the company is impersonal. Hence the shares of a company
can be sold at any time in the Stock Exchange and this is an added attraction to the
134 investors.
vii) Stability: A company enjoys perpetual succession, as the retirement or death of a
shareholder does not affect the company.
viii) Efficient Management: In a company organisation, there is considerable scope for
efficient management. Efficient persons may be elected as directors and, if found
inefficient they may be changed in the next meeting. Normally, the directors have a
great stake in the business. Hence, they have to be efficient. Further, the company is
in a position to get the services of the most talented persons and specialists. This also
helps the company in managing its business efficiently as professional competent
managers can be recruited by the Company.
ix) Tax Relief: Companies get tax advantages when profits are large because the system
of corporate taxation is ‘flat’ and not progressive.
Disadvantages: Nevertheless, the company form of organisation suffers from some drawbacks
and limitations. They are as follows:
i) Formation is Difficult: The promotion of a company is a long-drawn out process.
Various legal formalities have to be carried out, involving heavy expenses. Because
of these difficulties, many people are dissuaded from starting companies.
ii) Lack of Personal Interest: A company is managed by paid executives and not by
shareholders. Hence, the paid executives may not have a personal interest in the
management of the company, as they have no financial stake in it. This may result in
inefficiency.
iii) Excessive Government Control: The company form of organisation is subject to
considerable Government regulation and it has to spend considerable time and effort
in complying with the various legal requirements, under a plethora of legal enactments.
iv) Delay in Decision Making: The major policies have to be decided by the Board
which may consist of diverse interests which may lead to disagreement, etc. Hence,
prompt decisions are not possible in the company form of organisation.
v) Absence of Secrecy: The details of operations, transactions and results have to be
furnished to the shareholders and filed with the Registrar of Companies. Hence, it is
not possible to maintain business secrecy.
From this discussion of the advantages and disadvantages of the company form of
organisation, it may be concluded that the advantages considerably outweigh the disadvantages.
Now the company form of organisation has become universally popular and well-established
in the business world. It is best suited to those lines of business activity which require a huge
capital outlay and maximum stability.
135
Check Your Progress -4
What is a diffused risk?
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7.7 SUMMARY
In the process of analysing the different forms of organisations it is found that the joint
stock companies would play a very important role in the economy of any country. In this unit,
a description of Joint Stock Company is given. The features of Joint Stock Company are
analysed in the beginning. The Joint Stock Company is an association and it is an artificial
legal person. It has continuous existence with limited liability and it has more financial resources.
After this, different kinds of companies based on different characteristics are given, finally, it
has been explained that the companies are divided into two types: (i) Public Company and (ii)
Private Company. The idea of One Person Company is a new form of business, introduced
by the Companies Act, 2013 thereby enabling entrepreneurs carry on the business and has
been provided with concessional requirements under Act. There are both advantages and
disadvantages of public and private companies. Depending on the need and nature of the
situation, these companies are formed into private or public companies. In the present day
circumstances, many people are going to public companies because of many advantages in
this form of organisation. Thus the company form of organisation is universally popular and
has gained the public confidence in the business world.
7.8 CHECK YOUR PROGRESS: MODEL ANSWERS
1. The features of a joint stock company are:
i) Incorporated Association
ii) Artificial Legal Person
iii) Distinct Legal Entity
iv) Common Seal as a Substitute for Signature
v) Perpetual Suceession
vi) Limited Liability
vii) Number of Members
136
viii) Separation of Ownership and Management
ix) Transferability of Shares, etc.
1. Types of companies are:
• Classification on the basis of Incorporation
• Classification on the basis of Liability
• Classification on the basis of Public Interest
• Classification on the basis of Nationality.
Procedure formation of a JSC are:
(i) Promotional stage;
(ii) Registration or incorporation stage;
(iii) Raising capital stage; and
(iv) Obtaining certificate or commencement of business stage.
3. The risk of each member is reduced because it is diffused and spread over several
members of the company. It is an advantage for the individual investor.
7.9 MODEL EXAMINATION QUESTIONS
I. Short Answer Questions
1. Define ‘Joint Stock Company’
2. What is a Private Company? How it is different from Government Company?
3. What is the meaning of ‘Companies with liability limited by shares’?
4. What is the meaning of ‘Companies with liability limited by guarantee’?
5. What is a Chartered Company? How it is different from a Statutory Company?
6. Explain: (i) One Person Company (OPC) (ii) Small Company
II. Long Answer Questions
1. Explain the features of ‘Joint Stock Company’.
2. What are the different bases for the classification of companies?
3 Explain the advantages and disadvantages of the Joint Stock Company.
4. What is private company? What are the various privileges enjoyed by it?
5. Discuss the procedure for formation of a Joint Stock Company? 137
III. Objective Type Questions
A. Multiple Choice Questions
i) The maximum number of members in case of a public limited company
(a) Unlimited
(b) Limited
(c) Fifty
(d) Seven
ii) Single person economic entity known as
(a) Limited company
(b) Limited liability partnership
(c) One Person Company
(d) Sole trading
iii) The minimum number of members required to start a public limited company
(a) Two
(b) Seven
(c) Fifty
(d) Unlimited
iv) To register a private limited company, the minimum number of members required
(a) Two shareholders & Two Directors
(b) Five shareholders & Two Directors
(c) Seven shareholders & Two Directors
(d) Fifty shareholders & Two Directors
v) For commencement of business, registration is not compulsory.
(a) Joint Stock Company
(b) One Person Company
(c) Foreign company
(d) Partnership
Answers: i) b ii) c iii) a iv) a v) d
138
B. Fill in the Blanks
i) Joint Stock Company can raise large resources without the risk of __________
ii) Joint Stock Company is owned by__________but it is managed by__________
iii) A Corporate Company established by a special Act is called________________
iv) Transfer of shares from one shareholder to another is restricted in _____company.
v) A Company is registered outside India but place of business in India known as__
Answers: i) Unlimited liability ii) Shareholders, Board of Directors
iii) Statutory company iv) Private v) Foreign company
C. Match the Following
i) Joint stock company requires (a) J.J.Irani Committee
ii) One Person Company (b) Large capital
iii) A company granted by Monarch (c) Private company
iv) Sharing of risks (d) Diffused risk
v) Company enjoys special privileges (e) Chartered company
Answers: i) b ii) a iii) e iv) d v) c
7.10 GLOSSARY
Board of Directors : The Directors of a company are collectively known as
the Board of Directors.
Government Company : A company in which not less than 51% of the paid-up
share capital is held by the Central Government and/
or by State Government or Governments or jointly by
the Central and State Governments.
Joint Stock Company : An artificial person, created by law, with a perpectual
succession and a common seal.
One Person Company : One person company of sole-proprietor and company
form of business has been provided with concessional
requirements under the Companies act, 2013. With
this a single person can constitute a company.
139
Limited Liability : The liability of the members as regards the debts of
their company is limited to the face value of the
shares subscribed by each of them or to the guarantee
given by them.
Registered Company : A Company which is formed and registered under
the Companies Act,2013, including the companies
which are earlier registered under any of the previous
company, are called as the Incorporated or Registered
Company.
7.11 FURTHER READINGS
Krishnaswamy O.R. : Essentials of Commerce,
Eagle Publication Division, Madras
Pattanshetti C.C. and Reddy P.N. : Company Secretariat Practice, Mc.Graw
Hill Publishing Co. Ltd., New Delhi
Reddy P.N. and Gulshan S.S. : Principles of Business Organisation and
Management, S.Chand Co. Ltd.,
New Delhi
Bhushan Y.K. : Fundamentals of Business Organisation
and Management, Sultan Chand & Co.
Ltd., New Delhi
Rao VSP : Business Organisation and Management
Himalalya Publishing House, Mumbai-
400004.
Sherlekar, Khushpat Jain and : Business Organisation,
Apexa Jain Himalalya Publishing House, Mumbai-
400004.
140
UNIT – 8: REGISTRATION OF COMPANY
Contents
8.0 Aims and Objectives
8.1 Introduction
8.2 Memorandum of Association
8.3 Articles of Association
8.4 Differences between Memorandum and Articles of Association
8.5 Summary
8.6 Check Your Progress: Model Answers
8.7 Model Examinations Questions
8.8 Glossary
8.9 Further Readings
8.0 AIMS AND OBJECTIVES
In this unit, you will be acquainted with the important documents required for the
registration of a company such as—(i) Memorandum of Association; (ii) Articles of Association;
and also with the differences between Memorandum and Articles of Association.
After studying this unit, you should be able to:
• explain the meaning and contents of Memorandum of Association;
• describe the contents of Articles of Association; and
• distinguish between Memorandum and Articles of Association.
8.1 INTRODUCTION
For the purpose of incorporation of a company, various documents are required to
be submitted to the Registrar of Companies for registration of a company, as per the section
2 (56) of the Companies Act, 2013. These documents include Memorandum of Association
and Articles of Association. Memorandum of Association is the charter of the company and
defines the scope of its activities whereas Articles of Association is another important document
of the company which regulates the internal management. This unit is devoted to present the
concepts and contents of Memorandum of Association and Articles of Association and the
141
procedure for alteration of these clauses within the scope of the provisions available in the
Companies Act, 2013 including Entrenchment. Let us discuss these documents in detail.
8.2 MEMORANDUM OF ASSOCIATION
The Memorandum of Association (MoA) is the most important document of the
company. It is its charter. It lays down the objectives of the company, defines the scope of its
operation and its relation with the investors and the outside world. The company has to work
within the limits laid down in the memorandum. MoA defines the relationship with the rights of
the members of the company and also establishes the relationship of the company with the
members.
Definition
As per the section 2 (56) of the Companies Act, 2013 “memorandum” means the
memorandum of association of a company as originally framed or as altered from time to time
in pursuance of any previous company law or of this Act. One of the first steps in the formation
of a company is to prepare a document called Memorandum of Association. It contains the
fundamental conditions upon which alone the company has been incorporated.
The memorandum has to be divided into paragraphs and consecutively numbered
and printed. It must be signed by everyone of the seven subscribers with their full addresses.
Contents of the Memorandum: Section 4(6) of the Companies Act, 2013 deals with
Memorandum of Association shall contain the following clauses:
1. Name Clause: It contains the name of the company. The name selected should not
be similar to or identical with that of any other existing company. Further, the name
should not be one which is considered undesirable by the Central Government. The
name of the company should end with the words, ‘Limited’. If it is a private company,
it should end with the words ‘Private Limited’. However, an “association not for
profit” and incorporated as a company and licensed by the Central Government, may
not use the word “limited” or “private limited” as part of its name.
2. Situation Clause: In the clause, the name of the State in which the registered office
of the company is to be situated is stated.
3. Objects Clause: This clause specifies the objects for which the company is formed.
As it is difficult to alter the objects clause later on, it is necessary that the promoters
should draft this clause carefully and include in this clause, all possible types of business
in which a company may engage in future. The object clause must contain:
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(a) the main objects of the company and objects incidental or ancillary to the
attainment of the main objects; and
(b) other objects of the company not included in (a)
4. Liability Clause: This clause states that the liability of members is limited to the
unpaid amount of the face value of the shares held respectively by them. In case of a
company limited by guarantee, the amount up to which each member undertakes to
contribute- (a) to the assets of the company in the event of its being wound-up while
he is a member; and (b) to the costs, charges and expenses of being wound-up and
for adjustment of the rights among the members.
5. Capital Clause: This clause mentions the total amount of capital called ‘authorised
capital’ with which the company is to be registered. The type of shares, their number
and denominations are also mentioned.
6. Association or Subscription Clause: This clause contains a declaration by the
subscriber to the Memorandum and reads as follows: “We the several members,
whose names and addresses are subscribed, are desirous of being formed into a
company in pursuance of this Memorandum of Association and we respectively agree
to take the number of shares in the capital of the company mentioned opposite our
respective names”.
Alteration of the Memorandum of Association: The following clause of Memorandum
can be altered by following the procedure prescribed by Section 13 (1) of the Companies
Act, 2013:
1) Alteration of name clause: Name clause can be altered by passing a special resolution
and obtaining the approval of the Central Government. However, if registered
inadvertently under a name identical with that of an existing company, the alteration
requires and ordinary resolution and the consent of the Central Government.
2) Alteration of domicile clause: This can be changed in the following manner:
(a) By a special resolution and the sanction of the court for shifting the Registered
Office from one State to another;
(b) By only a special resolution for shifting the office within the State; and
(c) By an ordinary resolution for shifting the office from one locality to another in
the same town.
3) Alteration of objects clause: This can be done by passing a special resolution and
securing the sanction of the Company Law Board. 143
4) Alteration of capital clause: This can be effected by passing an ordinary or special
resolution as provided in the Articles of the Company except with regard to reduction
of capital, in which case the company must pass a special resolution and obtain
confirmation by the court.
Check Your Progress – 1
List out the clauses in the Memorandum of Association.
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8.3 ARTICLES OF ASSOCIATION
An Articles of Association is a document which prescribes the rules and bye-laws for
the general management of the company and for the attainment of its object as given in the
Memorandum of Association of the company. The Articles are the internal regulations of the
company on the basis of which its internal affairs are managed. It lays down the powers of the
directors, shareholders and officers of the company. It also contains rules and regulations.
Articles should not contain anything which goes against the Memorandum and if it does contain
any such, it will not have any effect as the Articles are subordinate to the Memorandum.
Memorandum of Association formulates objectives of the company and the Articles devise
ways to achieve them. Articles should be printed and divided into paragraphs and signed by
each subscriber to the Memorandum and filed with the Registrar.
Definition
According to Article 5 of Section 2 of the Companies Act, 2013, “Article means the
articles of association of a company as originally framed or as altered from time to time in
pursuance of any previous Company Law or this Act”.
The Articles of Association are a subsidiary to the Memorandum of Association of the
company. They define the rights, duties, powers of the management of a company as between
themselves and the company at large. Further, they also prescribe the mode and form in which
changes in the internal regulation of a company may be made from time to time. The Articles
of Association of a company must always be in consonance with the Memorandum of that
company and be subordinate to the memorandum; they cannot extend the objects of a company
as specified in the Memorandum of the company.
144
The following companies must have their own Articles of Association:
1. Unlimited Companies
2. Companies Limited by Guarantee
3. Private Companies limited by shares.
Contents of Articles of Association
Section 5(1) and Section 5(2) of the Companies Act, 2013 provide for the contents of
the Articles of Association. The Articles must contain the regulations for the management of
the company alongwith the matters prescribed by the Central Government. Further, the Articles
of Association must also contain the following:
1. Share capital including sub-division, rights of various shareholders, the relationship
of these rights, payment of commission, share certificates.
2. Lien of shares: Lien of shares means to retain possession of shares in case the
member is unable to pay his debt to the company.
3. Calls on shares: Calls on shares include the whole or part remaining unpaid on each
share which has to be paid by the shareholders on the company’s demand.
4. Transfer of shares: The Articles of Association include the procedure for the transfer
of shares by the shareholder to the transferee.
5. Transmission of shares: Transmission includes devolution of title by death,
succession, marriage, insolvency, etc. It is not voluntary but is, in fact, brought about
by operation of law.
6. Forfeiture of shares: The Articles of Association provide for the forfeiture of shares
if the purchase requirements such as paying any allotment or call money, are not met
with.
7. Surrender of shares: Surrender of shares is when the shareholders voluntarily return
the shares they own to the company.
8. Conversion of shares in stock: In consonance with the Articles of Association, the
company can convert the shares into stock by an ordinary resolution in a general
meeting.
9. Share warrant: A share warrant is a bearer document relating to the title of shares
and cannot be issued by private companies; only public limited companies can issue
a share warrant.
145
10. Alteration of capital: Increase, decrease or rearrangement of capital must be done
as the articles of association provide.
11. General meetings and proceedings: All the provisions relating to the general meetings
and the manner in which they are to be conducted are to be contained in the Articles
of Association.
12. Voting rights of members, voting by poll, proxies: The members’ right to vote on
certain company matters and the manner in which voting can be done is provided in
the Articles of Association.
13. Directors, their appointment, remuneration, qualifications, powers and
proceedings of the boards of directors meetings.
14. Dividends and reserves: The Articles of Association of a company also provide for
the distribution of dividend to the shareholders.
15. Accounts and Audits: The auditing of a company shall be done subject to the
provisions of the Articles of Association of the company.
16. Borrowing powers: Every company has powers to borrow. However, this must be
done according to the Articles of Association of the company.
17. Winding up: Provisions relating to the winding up of the company find mention in
Articles of Association of the company and must be done accordingly.
Alteration of Articles
Articles can be altered by a special resolution. However, if any alteration is unfair or
inequitable between the members or contains something illegal, the court can disallow such
alteration. Further, the alteration should not exceed the powers of the company as given by
the Memorandum. Further, the change should not be violating the provisions of the Section
14 (1) Companies Act, 2013.
ENTRENCHMENT
The word ‘entrenchment’ in the newly incorporated entrenchment provisions in the
Companies Act 2013 has not been defined therein. These provisions have been added in the
Act to give voice and strength to the vulnerable and inferior party so as to not allow discretionary
decisions in the company in various areas until the consent of such members if prescribed in
the entrenchment clauses of the AOA, is taken. It makes certain amendments either more
difficult or impossible, i.e., inadmissible. It may require a form of a supermajority,
a referendum submitted to the people, or the consent of another party.
146
According to Section 5 of the Companies Act, 2013 the Articles may contain
provisions for entrenchment to the effect that specified provisions of the articles may be
altered only if conditions or procedures as that are more restrictive than those applicable in
the case of a special resolution, are met or complied.
A Company is a group of persons that comes together to create their wealth by
making joint and mutual decisions for the benefit of each other, but it is likely that
majority shareholders will try to impose their decisions on the others in the working of
company, thereby affecting the mutual decision-making power of the shareholders and
violating their rights to have a say on matters especially relevant and crucial for them.
Considering such problems, the Companies Act, 2013 incorporated entrenchment
provisions under Section 5(3) to give a helping hand to the minority from the dangers of
majoritarianism and to prevent the creation of legal dictatorship (this provision was not there
under the Companies Act, 1956).
In the view of these provisions, it is not binding on the company to incorporate such a
clause as it is discretionary. However, if such entrenchment provisions are incorporated in the
Articles of Association of the company, then the company can’t exercise particular power,
without the restrictive conditions for decisions are complied with.
Entrenchment Provisions
The Government inserted a new section, i.e., Section 58(2) in the Companies Act,
2013 which gave the companies the discretionary power to incorporate in their AOA
entrenchment provisions so as to make it cumbersome and more regulatory for the majority
and the people at the helm of the company, restricting their power to control the company at
their own whims and fancies.
Legal dictatorship that was previously available under the former Companies Act has
been restricted by this section and now minority members can insist on the majority to take
their grievances into consideration and not make decisions unless minority views are put on
board. However, it is to be understood that these provisions are to be provided for in the AoA
at the discretion of the company, but once it is so provided, it is to be complied with at any
cost and any decision taken in violation of the entrenchment clause in the AOA would be
construed as abuse of majority power and violation of the Act.
Types of Entrenchment
Entrenchment can be either absolute or conditiona: (i) Absolute entrenchment implies
that certain provisions are unalterable and impossible to change unless there is a court/tribunal
order. This entrenchment is not provided for in the Companies Act, 2013. (ii) Conditional 147
entrenchment, on the other hand, implies that certain provisions can be altered, subject to
fulfilment of certain conditions or compliance with specific procedures (For example, approval
by more than 75% members instead of the usual special majority of 75%).
Effects of Memorandum and Articles of Association
The Memorandum and Articles, when registered, bind the company and members
thereof to the same extent as if they had been signed by each member. These two documents
are public documents and so are open to inspection by any person intending to deal with the
company. Hence, a person dealing with a company is considered to have full knowledge of
the Articles of that company.
Check Your Progress – 2
What do you mean by ‘entrenchment’?
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8.4 DIFFERENCE BETWEEN MEMORANDUM AND
ARTICLES OF ASSOCIATION
The Memorandum of Association and Articles of Association are the two charter
documents, for setting up of the company and its operations thereon. Memorandum of
Association is the root document of the company, which contains all the basic details about
the company. On the other hand, Articles of Association is a document containing all the
rules and regulations designed by the company.
While the MoA sets out the company’s constitution, and so it is the cornerstone on
which the company is built. Conversely, AoA comprises of bye-laws that govern the company’s
internal affairs, management, and conduct. Both, MoA and AoA, requires registration, with
the Registrar of Companies (RoC), when the company goes for incorporation.
The further differences are as follows:
1. The Memorandum is the fundamental charter of the company while the Articles
are subordin to the charter.
2. The Memorandum defines the objects and powers of the company whereas the Articles
are the bye laws of the company for the conduct of its internal administration. Further,
as Articles are subordinate to the Memorandum, it cannot provide anything contrary
to the powers and objects stated in the Memorandum.
148
3. Preparation and filing of Memorandum with the Registrar are compulsory for getting
the company incorporated whereas the preparation of Articles is not compulsory. If
any company does not prepare Articles, the Table-A of Companies Act is applicable
to such a company.
4. The Memorandum cannot be altered easily. It requires a special resolution and the
sanction of the court or the Central Government or the Company Law Board, as the
case may be, whereas the Articles can be altered by a special resolution and without
any such sanction.
5. Memorandum defines the relationship between the company and outsiders, whereas
the Articles define the relationship between the members and the management of the
company. It mainly provides rules and regulations for the internal working of the
company.
Check Your Progress – 3
Distinguish between Memorandum and Articles of Association.
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8.5 SUMMARY
Memorandum and Articles are the two very important documents of the company,
which are to be maintained by them as they guide the company on various matters. They also
help in the proper management and functioning of the company throughout its life. That is why
every company is required to have its own Memorandum and Articles. For any company
MoA is a must whereas AoA is not so, in case of companies limited by shares. Alteration of
MoA is restricted while AoA can be altered through a special resolution. The government by
incorporating the entrenchment provisions in the Companies Act, 2013 gave the breath to live
to the minority and vulnerable people and power to negotiate fearlessly with the majority in
their interest, although these provisions are discretionary on the part of the company.
8.6 CHECK YOUR PROGRESS:MODEL ANSWERS
1. Contents of the Memorandum of Association are:
(i) Name Clause
(ii) Situation Clause 149
(iii) Objects Clause
(iv) Liability Clause
(v) Capital Clause
(vi) Subscription Clause.
2. The Government inserted a new section, i.e., Section 58(2) in the Companies Act
which gave the companies the discretionary power to incorporate in their AoA
entrenchment provisions so as to make it cumbersome and more regulatory for the
majority and the people at the helm of the company, restricting their power to control
the company at their own whims and fancies.
3. Differences between Memorandum and Articles of Association are as follows:
All the companies have their own Memorandum of Association and Articles of
Association, many people got puzzled between these two.
‘Memorandum of Association is the root document of the company, which contains
all the basic details about the company. ‘Articles of Association is also a major
document which contains all the rules and regulations designed by the company. For
its internal functioning.
8.7 MODEL EXAMINATION QUESTIONS
I. Short Answer Questions
1. What are the documents required for the registration of company?
2. Define ‘Memorandum of Association’.
3. What do you mean by ‘Articles of Association’?
4. What type of companies must have their own Articles of Association?
5. Distinguish between Memorandum and Articles of Association.
II. Long Answer Questions
1. Explain the contents of Memorandum of Association and also describe the alteration
procedure.
2. Define Articles of Association and discuss its contents.
III. Objective Type Questions
A. Multiple Choice Questions
i) From the following which clause cannot be altered-
(a) Name Clause (b) Domicile Clause
(c) Objects Clause (d) Liability Clause
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ii) Which company may not have their own Articles of Association-
a) One person company
b) Unlimited Companies
c) Companies limited by guarantee
d) Private Companies limited by shares
iii) From the following which is not a public document-
(a) Memorandum of Association
(b) Articles of Association
(c) Prospectus
(d) Minutes of the meeting
iv) Memorandum of Association can be altered by-
(a) Special resolution
(b) Court
(c) Company Law Board
(d) All of these
v) Articles of Association can be altered by-
(a) Court
(b) Company Law Board
(c) Special Resolution
(d) Central Govt.
Answers: i) d ii) a iii) d iv) d v) c
B. Fill in the blanks
i) The essential two documents required for registration of a company _______ .
ii) Memorandum of Association is also known as _________________ .
iii) Name clause of the company contains ___________________.
iv) Articles of Association contains ___________________.
v) The very purpose of entrenchment is _____________________ .
151
Answers: i) Memorandum of Association & Articles of Association
ii) Charter iii) Name of the company
iv) Rules and Regulations v) Helping hand to the minority
C. Match the following
i) Memorandum of Association (a) Rules and Regulations
ii) Articles of Association (b) Charter
iii) Capital Clause (c) Bearer document
iv) Share warrant (d) Under Companies Act, 2013
v) Entrenchment provisions (e) Authorised Capital
Answers: i) b ii) a iii) e iv) c v) d
8.8 GLOSSARY
Memorandum of Association : MoA is a legal document prepared in the
formation and registration process of a limited
liability company to define its relationship with
shareholders.
Articles of Association : AoA is a document that contains the purpose
of the company as well as the duties and
responsibilities of its members defined and
recorded clearly.
Forfeiture of Shares : A forfeited share is a share in a company that
the owner loses (forfeits) by failing to meet
the purchase requirements.
Share Warrant : A share warrant is a bearer document of title
to shares and can be issued only by public
limited companies and that too against fully
paid up shares only.
Entrenchment : Entrenchment provisions under Section
5(3) to give a helping hand to the minority
from the dangers of majoritarianism and to
prevent the creation of legal dictatorship.
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8.9 FURTHER READINGS
Reddy P.N. and Gulshan S.S. : Principles of Business Organisation and
Management, S.Chand Co. Ltd.,
New Delhi
Bhushan Y.K. : Fundamentals of Business Organisation
Sultan Chand & Co. Ltd.,New Delhi
Rao VSP : Business Organisation and
Management
Himalalya Publishing House,
Mumbai-400004
Sherlekar, Khushpat Jain and : Business Organisation
Apexa Jani Himalaya Publishing House,
Mumbai-400004.
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UNIT – 9 : COMPANY IN CORPORATION
Contents
9.0 Aims and Objectives
9.1 Introduction
9.2 Incorporation of a Company
9.3 Prospectus
9.4 Commencement of Business
9.5 Summary
9.6 Check Your Progress: Model Answers
9.7 Model Examinations Questions
9.8 Glossary
9.9 Further Readings
9.0 AIMS AND OBJECTIVES
The present unit introduces you to the procedure for the incorporation of a company,
documents needed for registration of company and how the company starts its business.
After studying this unit, you should be able to:
• state the steps involved in promotion of the company;
• explain the different aspects involved in the issue of prospectus and understand the
application and allotment of shares; and
• discuss the procedure involved in getting the certificate of commencement of business.
9.1 INTRODUCTION
This unit is a comprehensive account of a company’s incorporation and commencement
of business. In this unit, the documents required for registration of company such as
Memorandum of Association, Articles Association in brief and prospectus is discussed. Further,
the procedure for allotment of shares and how the certificate of commencement of business is
obtained are also explained.
154
9.2 INCORPORATION OF COMPANY
The idea of forming a company is conceived either by a person or by a group of
persons known as promoters. The investors are so widely scattered that somebody has to
take the initiative of bringing them together for participating in an industrial venture. The
promoters take a lead for bringing men, money, materials and machinery together for establishing
an industrial enterprise. Guthmann and Dougal consider that ‘promotion starts with the
conception of the idea from which the business is fully ready to begin operation as a
going concern’. Promotion work to be done by the promoters involves discovery of specific
business opportunities, study of their feasibility, establishment of a form of organisation,
mobilisation of resources etc.
The work of promotion of a company involves four stages. They are:
1. Discovery of a business: This is also called as idea generation. Discovery of a
business proposition and making a preliminary study to find out whether it is worthwhile
to make a detailed investigation.
2. Investigation study: Making a detailed investigation of the proposition with the
assistance of experts like Engineers, Financial experts etc., to determine its technical
feasibility, economic viability and profitability.
3. Preparation of project report: After investigation study, a detailed report has to be
prepared including financial planning.
4. Mobilisation of resources: It is also known as preparatory work. Actual work
begins and this involves selection of site, securing the approval of building plan, licence,
mobilisation of resources, etc.
Check Your Progress – 1
Describe the steps involved in promotion of a company.
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Documents Required for Registration of Company
After completing the various stages of promotion, the promoters have to take steps to
get the company incorporated. For this purpose, the following documents have to be prepared
and filed with the Registrar of companies of the State in which the Registered Office of the
Company is to be situated:
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1. The Memorandum of Association: At least seven persons, each promising to take
up at least one share must subscribe their names to the Memorandum.
2. The Articles of Association: Section 5(1) and section 5(2) of the Companies Act,
2013 provide for the contents of the articles of association. The articles must contain
the regulations for the management of the company along with the matters prescribed
by the Central Government.
3. A list of proposed Directors with particulars of their names, addresses, occupation
and age.
4. Consent in writing of the proposed Directors to act as Directors.
5. An undertaking by the Directors stating that they have agreed to purchase and pay for
the prescribed qualification shares.
6. A statutory declaration by an advocate or by a Chartered Accountant or by a person
named as Director or any person who has taken part in the formation of the company
stating that all the provisions of the Companies Act with regard to registration have
been complied with.
7. Proof of payment of the prescribed registration fee.
If the Registrar is satisfied with these documents, he will issue a Certificate of
Incorporation. The certificate of incorporation which is dated and signed by the
Registrar is a proof of the fact that the company has been incorporated under the
Companies Act.
In this unit, we will discuss the prospectus before inviting public subscription but after
the incorporation of the company.
9.3 PROSPECTUS
Meaning
After the incorporation of the company, if the promoters want to invite the public to
subscribe to its shares or debentures, they have to prepare and issue a document known as
‘prospectus’ with the necessary information. Clause 70 of Section 2 of the Companies Act,
2013 defines ‘prospectus’ as ‘any document described or issued as a prospectus and
includes any notice, circular advertisement or other document inviting deposits from
the public or inviting offers from the public for the subscription or purchase of any
shares in or debentures of a body corporate’.
156
Objectives of Prospectus
The main objects of the Prospectus are:
(a) to inform the public about the new company that is being formed;
(b) to induce investors to invest their funds in the company;
(c) to preserve an authentic record of the terms on which the investors have been
invited; and
(d) to make the Directors responsible for the statements in the Prospectus.
Statement-in-lieu of prospectus
If the Company manages to get capital without public subscription, there is no need
for it to issue a prospectus and instead, it can prepare a statement in lieu of Prospectus
containing almost similar information and file it with the Registrar.
Legal provisions regarding the issue of prospectus
The Prospectus must be prepared carefully and it should not contain any untrue
statement or mislead the public. If any person has purchased shares or debentures
from a company on the basis of untrue statements in the Prospectus, he can cancel
the contract and also claim damages from the promoters, Directors or any other
person who has authorised the issue of the Prospectus.
Consequences of false and misleading in Prospectus
The persons, responsible for preparing false and misleading prospectus will face civil
and criminal liabilities.
1. Civil liability: In case, misleading prospectus amounts to misrepresentation,
the aggrieved persons can repudiate the contract. They can claim refund of
their money. Damages can also be claimed from the persons found guilty.
2. Criminal liability: In case any deliberate concealment is made, directors will
be punished with a fine of Rs. 5,000 or imprisonment upto two years or both.
If it is fraud the fine will extend to Rs. 10,000 or 5 years imprisonment or
both.
However, several defences are open to the person who authorises the issue of
prospectus with untrue statements. Some of the defences are as follows:
(a) that he has a reasonable ground to believe that the statements are true;
157
(b) that it was issued without his knowledge or consent and that on becoming aware of it,
he gave public notice;
(c) that he withdrew his consent to become a director; and
(d) that after becoming aware of the false statement, he withdrew his consent to the issue
and gave public notice thereof.
Contents of prospectus: The important contents of prospectus are as follows:
1. Contents of Memorandum;
2. Nature of the business of the company;
3. Details regarding the persons who have signed Memorandum and number of shares
subscribed by them;
4. Classes of shares into which the share capital is divided together with their totals;
5. Rights attached to each class of shares;
6. If debentures are issued, details regarding their issue;
7. Particulars about the Directors, Managing Director and their remuneration, powers
etc;
8. Particulars relating to preliminary expenses;
9. The minimum subscription;
10. Time of the opening of the subscription list;
11. The amount of premium or discount on shares;
12. Property of vendors to be sold to the company;
13. The amount payable as consideration the promoters for floating the company;
14. Particulars regarding capitalisation of reserves or profits;
15. The amount payable along with application and on allotment on each class of share;
16. Names of the underwriters and the opinion of the Directors that the resources of the
underwriters are sufficient to discharge their obligations;
17. Names and addresses of auditors, bankers and solicitors;
18. Share qualification, if any, of a Director;
19. In the case of an existing company, a report of the auditors about its performance;
and
158 20. A statement regarding the filing of the Prospectus with the Registrar.
Points to be considered by a Prospective Investor
Since the Prospectus is issued to the public with the intention of persuading investors
to invest their funds in the Company. The following are the points to be considered by a
prospective investor for arriving at a decision to invest his funds in the company;
(a) nature of business and its prospects;
(b) objectives of the company: He has to know whether they are too ambitious and
whether they can be achieved under the existing conditions;
(c) standing and reputation of promoters and Directors of the Company;
(d) nature of contracts entered into by the Company;
(e) Capital structure: He should find out whether the capital proposed to be raised is
adequate and whether the proportion between various classes of shares and their
voting rights is acceptable;
(f) past history of the concern, if any;
(g) purchase consideration for properties acquired for the Company;
(h) terms of underwriting and the reputation of underwriters; and
(i) standing of the company, bankers, legal advisers and auditors of the Company.
After considering the above mentioned points if the prospective investor is satisfied,
he may take a decision to apply for the shares.
Check Your Progress – 2
Write a note on Statement-in-lieu of prospectus.
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Application and Allotment of Shares
The Companies Act provides that all application forms should be issued along with
the Prospectus and usually the public is requested to send the application to the Company’s
bankers. After the closure on the last day for the receipt of applications, the banker forwards
the applications to the company. An allotment to be valid must fulfil the following conditions.
(a) It should be supported by a resolution at the Board of Directors meeting within a
reasonable time from the date of application.
159
(b) The Prospectus or a statement-in-lieu of prospectus must be filed with the Registrar.
(c) Subscriptions to the extent of minimum subscription must be made or applied for.
(d) At least 5 per cent of the nominal value of the shares must be received by the company
and the same must be deposited in a scheduled bank.
If the allotment is irregular, the applicant can avoid the allotment and can claim refund
of the money. If the allottees of the company suffer loss, because of irregular allotment, the
party concerned should be compensated by the person responsible for such irregular allotment.
Further, he is also liable to be fined up to Rs.5000/-
If the allotment cannot take place within 120 days of the date of issue of the Prospectus,
the applicant’s money must be refunded within the next 10 days, failing which the directors
become jointly and severally liable for the refund of the money with interest at 6% from the
expiry of the 130th day. The Secretary should file a return of allotment with the Registrar within
30 days of the date of allotment with complete particulars regarding the number, nominal
amount of shares allotted, the names and addresses of the allotters, etc.
Minimum Subscription
A company cannot allot shares unless the minimum subscription is received within
120 days from the date of issue of the Prospectus. Minimum subscription is the minimum
amount which, in the opinion of the Directors, is necessary to provide for the following:
i) purchase price for any property already purchased or agreed to be purchased;
ii) preliminary expenses;
iii) underwriting commission; if payable;
iv) repayment of the money if borrowed for any of the purposes mentioned above; and
v) working capital or any other expenditure.
If the minimum subscription amount is not received within 120 days from the date of
the issue of the Prospectus, whatever money is received from the applicants, must be returned
within the next 10 days (within 130 days after the issue of the Prospectus). If it is not done,
interest has to be paid. It may be mentioned here that the condition of minimum subscription
is meant to prevent companies from coming into existence with inadequate capital so that only
companies which can raise enough capital to meet this minimum requirement are allowed to
start their business.
9.4 COMMENCEMENT OF BUSINESS
A Private company can commence business immediately after getting the certificate
of incorporation from the Registrar. But a public company cannot commence business without
obtaining another certificate called ‘certificate to commencement business’ from the Registrar.
160 For obtaining this certificate, certain conditions are to be fulfilled. They are:
• that the prospectus or a statement-in-lieu of prospectus has been filed with the Registrar
of Companies (a statement-in-lieu of the Prospectus has to be filed by those companies
which do not issue Prospectus to the public for the issue of their shares);
• that the number of shares allotted is not less than the minimum subscription mentioned
in the prospectus;
• that the Directors of the company have paid for their qualification shares in the same
proportion as the members from the public have been required to pay on application
and allotment; and
• that the declaration by a Director or the Secretary of the company to the effect that all
the conditions regarding the commencement of business have been complied with.
If the Registrar is satisfied that all these conditions have been fulfilled, he issues a
certificate to commence business.
The company has to get this certificate within one year of its incorporation. If it fails
to get this certificate within this period, the court may order it to be wound up. It may be
stated here that all contracts entered into from the date of incorporation till the date of the
commencement of business are provisional and would become binding on the company only
after it is issued the certificate to commence business.
CERTIFICATE OF COMMENCEMENT OF BUSINESS
(SPECIMEN)
I hereby certify that--------------------- Ltd., of--------------------- which was
incorporated under the companies Act,2013, on the day of --------------------2013
and which has this day filed a statutory declaration in the prescribed form that the conditions
of Section,24 (2) have been complied with, is entitled to commence business. Given
under my hand at------------------------- this day of----------------------- two
thousand ---------------------.
SEAL
REGISTRAR JOINT STOCK COMPANIES
------------------- (State)
161
9.5 SUMMARY
After the selection of the form of organisation comes the formation of the company.
In this process, there are three stages in the bringing up of the company. They are: (i)
Incorporation of a company; (ii) Prospectus –issue and subscription; and (iii) Commencement
of business.
After the completion of the promotion in industry, the next step is incorporation of the
company. For the purpose of incorporation of company various documents have to be filed
with Registrar of Companies. With this, the incorporation of the companies is over. Once this
job is completed the company will come into existence. After this, the company has to issue
the prospectus to get finance from various sources. In this prospectus, the company has to
give more details regarding the subscription of shares. The third aspect in this unit is the
commencement of business. Though the company is incorporated and the prospectus is
being issued, the company has to necessarily get the certificate of commencement of business.
Unless this is done, the company cannot start its business. Normally it will take one year from
the date of incorporation, to get the certificate of commencement of business.
9.6 CHECK YOUR PROGRESS : MODEL ANSWERS
1. The work of promotion of a company involves four stages. They are:
(a) Discovery of a business proposition and making a preliminary study to find
out whether it is worthwhile to make a detailed investigation.
(b) Making a detailed investigation of the proposition with the assistance of experts
like Engineers, Financial experts etc., to determine its technical feasibility,
economic viability and profitability.
(c) Preparation of project report including financial planning.
(d) Preparatory work.
2. If the company manages to get the capital without public subscription, there is no
need for it to issue a prospectus and instead, it can prepare a statement-in-lieu of a
Prospectus containing almost similar information and file it with the Registrar.
9.7 MODEL EXAMINATION QUESTIONS
I. Short Answer Questions
1. What is meant by promotion of a company?
162 2. What is Minimum Subscription?
3. What is Prospectus?
4. What is a Certificate of Incorporation?
5. What is a Certificate of Commencement of business?
6. What is Statement-in-lieu of prospectus?
II. Long Answer Questions
1. Explain the steps involved in promotion of a company.
2. What is a Prospectus of a Joint Stock Company? What are its contents?
III. Objective Type Questions
A. Multiple Choice Questions
i) Which is the basic document required for incorporation of a company-
(a) Memorandum of Association (b) Articles of Association
(c) Prospectus (d) Certificate of registration
ii) Which is the latest Companies Act-
(a) 1956 (b) 1986
(c) 1991 (d) 2013
iii) First step in the incorporation of a company is-
(a) Discovery of a business (b) Investigation study
(c) Project report (d) Mobilisation of resources
iv) Purpose of issuing company prospectus for-
(a) Inviting public fund (b) Promoters
(c) shareholders (d) None of these
v) Under Companies Act, 2013, maximum duration for transfer of shares in a private
company would be-
(a) 120 days (b) 90 days (c) 60 days (d) None of these
Answers: i) a ii) d iii) a iv) a v) c
B. Fill in the Blanks
i) The idea of forming a company is conceived either by a person or by a group of
Persons known as ____________
ii) Certificate of incorporation is issued by _________________
iii) Document used for inviting public issue known as__________________
iv) Maximum duration for allotment of shares_____________
v) A __________company can commence business immediately after getting the
certificate of incorporation from the Registrar. 163
Answers: i) Promoters ii) Registrar of the Company iii) Prospectus
iv) 120 days v) Private
C. Match the Following
i) Company formation by (a) After discovery of business
ii) Investigation study (b) Promoters
iii) Statement-in-lieu of Prospectus (c) Registrar of the companies
iv) Refund of money (d) within 10 days
v) Certificate of Incorporation issued by (e) Substitute document for Prospectus
Answers: i) b ii) a iii) e iv) d v) c
9.8 GLOSSARY
Certificate of Incorporation : Issued by the Registrar of Companies as proof
of birth of a company legally.
Certificate of Commencement : Issued by the Registrar of Companies after
of Business the prescribed conditions are satisfied. This
certificate must be obtained by a Public
Company for commencing its business.
Memorandum of Association : A document which sets out the constitution
of the company defining its relations with the
outside world and the scope of its activities.
9.9 FURTHER READINGS
Krishnaswami O.R. : Essentials of Commerce,
Eagle Publication Division, Madras
Pattanashetti C.C : Company and Secretarial Practice, Mc. Graw Hill
and Reddy PN Mc. Graw Hill Publishing Co.Ltd., New Delhi
Reddy P.N and Gulshan S.S. : Principles of Business Organisation and
Management,
S.Chand Co. Ltd., New Delhi
Rao VSP : Business Organisation and Management
Himalaya Publishing House, Mumbai-400004
Sherlekar, Khushpat Jain : Business Organisation,
and Apexa Jain Himalaya Publishing House, Mumbai-400004
164
BLOCK – IV : SOURCES OF FINANCE
UNIT – 10 : INTRODUCTION TO BUSINESS FINANCE
UNIT – 11 : SOURCES OF FINANCE - TRADITIONAL
UNIT – 12 : SOURCES OF FINANCE - MODERN
165
166
BLOCK – IV SOURCES OF FINANCE
UNIT – 10 : INTRODUCTION TO BUSINESS FINANCE
Contents
10.0 Aims and Objectives
10.1 Introduction
10.2 Definition of Finance
10.3 Types of Finance
10.4 Nature of Finance
10.5 Importance of Finance
10.6 Factors Determining the Need for Funds
10.7 Meaning of Working Capital
10.8 Concept of Working Capital
10.9 Importance of Working Capital Finance
10.10 Factors determining Working capital requirements
10.10.1 Internal Factors
10.10.2 External Factors
10.11 Summary
10.12 Check your Progress: Model Answers
10.13 Model Examination Questions
10.14 Glossary
10.15 Further Readings
10.0 AIMS AND OBJECTIVES
After studying through this Unit, you should be able to-
• define the term business finance;
• nature and scope of Business Finance;
• identify the importance of business finance; 167
• explain the scope of business finance;
• factors that determine the need for business finance;
• define the term Working Capital;
• various concepts of working capital;
• explain how operating cycle helps plan for working capital requirements; and analyse
the factors that determine working capital requirements.
10.1 INTRODUCTION
One cannot imagine starting a business without finance. It is one of the vital requirements
to start any business or an enterprise. The quantum of finance will determine the size and
nature of business that an entrepreneur intends to start. One of the biggest challenges that an
enterprise faces is to identify the sources of finance for the acquisition of assets. While mobilising
the finances the entrepreneur will have to take into consideration the legal environment. Covering
the developments in the money and capital markets, fiscal and monetary policies.
10.2 DEFINITION OF FINANCE
The term finance may be defined as the “Science of Money”. George Christy and
Peter Roden state that “to finance means to arrange payment for it”. They further
observe that finance may be generally defined as the study of money, its nature, creation,
behaviour, regulation and problems. Finance is a study of money management and deals with
the ways in which investors, governments, businessmen, financial institutions and families handle
their money. An understanding of what money is and does is the foundation of financial
knowledge.
The definitions presented hereunder enable us to comprehend the true nature of finance
“Business finance can be broadly defined as the activity concerned with planning, raising,
controlling and administering of funds used in the business”.
- Guthman and Dougall
“The Finance function is the process of acquiring and utilising funds by a business”
- R C Osborn
“The issuance of, distribution of and purchase of liability and equity claims issued for
the purpose of generating revenue producing assets”
- Ray G. Jones and Dean Dudley
168
“Finance is the management of monetary affairs of a company”.
- Paul G.Hastings
It is evident from the above that the term “finance” is understood in many ways.
Irrespective of the discussions and definitions, finance function primarily focuses on the
mobilisation and utilisation of funds by a business enterprise.
The definition does not distinguish between the finances for individuals and businesses.
However, the students of commerce need to understand that the discussion is towards the
finances for business and finance function of a business enterprise.
10.3 TYPES OF FINANCE
There are three broad categories of finance, namely:
i. Personal Finance;
ii. Public Finance; and
iii. Business Finance;
It is very important that we distinguish the above three;
i. Personal Finance:
Deals with finances relating to the individuals and the issues relating to the savings and
investments.
ii. Public Finance:
The governments have the responsibility of running the states and the country. In the
process governments invest in development of infrastructure and also spend on the
welfare of the people. All the government programs require huge amounts of money
which it collects by imposing taxes. The amount so collected is not sufficient to invest
in different projects. Hence, governments borrow from the domestic and international
agencies, institutions and markets. The discussion of such is described as “Public
Finance”.
iii. Business Finance
Various types of businesses evolved over a period also have to fund the establishment
and expansion of business activities. Business finance is a very broad concept and
relates to all the financial activities of a business enterprise.
The scope of the business finance is broad. The firms operating in the economy are
classifiable on the basis of ownership to understand the financial requirements of various types
169
of businesses. All business units need finances to acquire fixed assets and the needs of working
capital for the successful and smooth operation. A small Kirana and General Stores requires
fixed assets like racks, shelves and storing units to keep the materials for sales. Whereas the
large firms manufacturing products require assets like plant and machinery, land and building
for the machinery, warehouse to store raw materials and finished products demanding huge
amount of finances. On the other hand small scale industries supporting the large enterprises
require finances more than small kirana and general stores and less than the large manufacturing
unit. The requirement of finances for the purpose of acquisition of capital assets is for a long
term known as fixed capital and the requirement of finances for the purchase of raw materials
and conversion into finished products is generally for a short period of time, hence known as
working capital requirements of the business.
10.4 NATURE OF FINANCE
All types of capital needs for a business whether it is fixed capital for a long term or
working capital for short term used for the business. Business finance is required for any size
and type of business – may it be large or small, manufacturing, trading or processing. It is a
very wide term and involves estimation of requirement of funds for the business, sources of
finance, investment of funds mobilised, management of cash, planning for earnings and control
of funds. The requirement of funds for business finance depends on the nature and business
model of the firm. (Cookers is a product – it can be manufactured by the firm to sell or
outsourced to another unit to sell; both firms require different amounts of finance); Depending
on the availability of finances – the business determines on the scale of operations;
10.5 IMPORTANCE OF FINANCE
Finance is the life blood of business. Without finances starting a business and running
it is unimaginable. Business units cannot carry on the operations smoothly and effectively
without the accessibility of required amount of funds at the right cost on time. To start the
business finances are required to buy the non-current (long term) assets like land, building,
plant and machinery and current (short term) assets like inventory, etc. Finances are also
required to / (for) ——
• Acquire the non-current (fixed) assets and current assets to operate the business;
• Modernize the business;
• Expansion of the business;
• Scale up the operations of business;
• Acquisition of another business;
• Diversification of the business (vertical or horizontal / backward or forward);
170
Check Your Progress - 1
What are the causes for which the businesses require long term finances?
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10.6 FACTORS DETERMINING THE NEED FOR FUNDS
Every firm needs funds to establish and operate. Funds are also required, apart from
carrying on business activities, to expand its operations, grow and diversify. The availability of
finances is necessary for profitable working and sound health of business. Sufficient funds
empower the business and allow the enterprise to purchase necessary assets and meet its
current and long term debts. Finances will also help business avail the opportunities arising in
the due course for which the business needs to plan for.
a. Objectives: The financial plans of a business should be aimed to attain the objectives
of the business particularly the financial objectives. Financial objectives of a business
include the procurement of funds at the lowest cost possible and put to the best utility
of such mobilised funds;
b. Nature of Industry: Financial needs and investments of a business are dependent
on the nature, characteristics of the particular industry. The capital intensive industry
like iron and steel, petrochemicals, etc. require huge amount of funds to build and
operate successfully and smoothly whereas the labour intensive industry will require
funds for payment of wages, raw materials, etc. for the growth and expansion. Industry
also requires funds for the purpose of research and development and technology
upgradation and modernization.
c. Size of the Firm: Larger the firm higher will be the requirement of funds for building
of assets and investment into working capital. The performance record of the past,
credit standing and reputation of the firm, management’s attitude and the degree of
risk the business is willing to assume affects financial planning and requirement of
funds.
d. Capital Market Conditions: Well developed capital markets enable firms access
funds as and when required at an effective or optimal cost. Innovative financial
instruments or alternatives along with liquidity in the secondary market for such
instruments improve the conditions of capital markets enabling firms’ access cheaper
funds. 171
e. Regulations: The agencies of government like Securities Exchange Board of India
help the confidence of the investors. Interest rate deregulation enables the supply and
demand for funds to determine the interest rates. The firms should also be able to
generate cash inflows to meet the interest obligations at least.
f. Financing Cost: The cost of debt is generally lower than that of the cost of equity.
The cost of finances is dependent upon the interest rates prevailing in the debt market,
cost of floating the issue and issue administrative expenses. High Tax rates generally
make the debt financing attractive.
g. Period and Purpose: Funds that are required to be invested permanently generally
are mobilized by selling equity shares. For long and medium term financing requirements
the firms tend to sell debentures and redeemable preference shares.
h. Investor Sentiments: During the boom in the market with rising index of the stock
exchange, firms tend to capitalize the conditions and sell securities in the market.
Particularly the firms are able to sell equity shares at a higher share premium and
realize better price. On the other hand the bearish markets force the firms postpone
the sale of shares in the market in general. In such instances, the firms tend to sell debt
securities with the interest rates fixed or floating.
i. Statutory Requirements: The government of India has laid down norms and ceiling
for fixed deposits that can be mobilised by any company. The Companies Act and
SEBI have laid down the norms for issuing an Initial Public Offering (IPO) or Further
Public Offering. The regulations will have a bearing and impact on the firms in terms
of mobilising resources from the market and particularly from the public at large.
j. Needs of Investors: Investors’ attitudes and requirements regarding income and
risk is an important consideration in designing the capital structure (financing
proportions of debt and equity) of the firm. Enterprising investors preferring to take
risk and earn capital appreciation prefer buying shares and those who desire regular
return with lesser risk invest in debentures. Therefore, the firms have to design the
securities as per the needs of investors and still plan for their financing needs.
Check Your Progress - 2
What are the factors determining the need for long term funds for a business?
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10.7 MEANING OF WORKING CAPITAL
Every business needs funds broadly for two different purposes – firstly to establish
the business with fixed assets like Land and Building, Plant and Machinery, etc. which require
fixed capital and secondly to run the business on a day-to-day basis i.e., purchase of raw
material, payment of wages, extending credit to the buyers, etc. The funds required for the
latter reason are known as Working Capital.
10.8 CONCEPT OF WORKING CAPITAL
There are two concepts of Working Capital. They are: i) Gross Working Capital
Concept and ii) Net working capital concept. The gross working capital also known as
current capital or circulating capital. It is represented by the sum total of all current assets
of the enterprise. The current assets comprise items that can be converted into cash in the
short period, say, within a year, or within the normal operating cycle of the business. These
items are stock of raw-materials and supplies, finished goods, semi-processed items or
components, sundry debtors, short term investments, cash and bank balances. These items
are also known as components or elements of current assets or gross working capital.
On the other hand, the net working capital is the difference between current assets and
current liabilities. Current liabilities are those claims of outsiders which are expected to fall due
in a short-period, say within a year. They represent short term sources of funds which include
creditors, bills payable, bank overdraft or cash credit facilities and outstanding expenses of
different types. These are called as components of current liabilities.
The two concepts of working capital should not be regarded as mutually exclusive.
Each has its relevance in specific situation. They represent two distinct and important facets of
working capital management. The emphasis on grow working capital involves focussed attention
on two aspects of current assets management. They are:
i. It has to be ensured that the investment in current assets is optimal; and
ii. It has to be ensured that the investment in current assets is obtained through the
lowest cost of sources of finance.
Excessive investment in current assets should be avoided as it adversely affects the
profitability of the firm. However, whenever additional investment is needed, funds should be
made available promptly. For this, a good knowledge of the available avenues of investment
for short periods is very essential.
The concept of net working capital represents a qualitative definition and highlights
the long term sources of funds which have been obtained to finance the net working capital.
173
The net working capital will be positive when the current assets exceed the current liabilities.
If they exceed by a wide margin, the company’s liquidity or solvency position is said to be
sound. On the other hand, if the current liabilities exceed current assets, a situation of negative
working capital arises indicating a precarious financial position. A part of the working capital
has to be provided by the proprietors in the form of share capital and a part has to be obtained
from the external sources in the form of long term borrowings. Internal sources such as ploughing
back of profits can also be used to finance a portion of working capital.
The finance manager has to strive hard to maintain a sound working capital position.
While excessive working capital leads to non-remunerative use of scarce funds, inadequate
working capital interrupts the smooth functioning of the business activity and impairs profitability.
Check Your Progress - 3
What is the difference between Gross Working Capital and Net working Capital?
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10.9 IMPORTANCE OF WORKING CAPITAL
The other way to look at the importance of finance is that we look at it with the
perspective of business undertakings and from the perspective of the society.
For the business undertakings - Adequate finance enables the business to:
• Continue its operations efficiently without any interruptions;
• Meet its liabilities on time – payment of debts on time helps business earn credit
worthiness and in turn the firm can easily borrow finances as and when required;
• Take the advantage of opportunities in the market like buying the inventory when
prices are lower;
• Replace or modernize the fixed assets like plant and machinery in time to improve the
efficiency of its operations; and
Face the challenges like business cycles, macro-economic issues and any other crises
(Asian Crises, Global Financial Crises) impacting the business with confidence;
174
10.10 FACTORS DETERMINING WORKING CAPITAL
REQUIREMENTS
There are no specific rules to determine the working capital requirements of the firm.
A wide variety of factors influence the total investment in the working capital of an enterprise.
In order to determine the amount of working capital needed by a firm a number of factors are
to be considered by the manager – finance. These factors can be categorised into two groups,
viz. internal factors and external factors.
10.10.1 Internal Factors
a. Promotional and Formative Phase
The starting of a new project and the early years of its working constitutes the most
crucial phase for planning for working capital funds. In practice, however, this fact is
generally overlooked and, as a result, many new ventures run into financial difficulties
in their early operating years.
The general tendency is to estimate the hurdles that may arise in the formative years of
the company’s operations. Facile assumptions are made in regard to ready availability
of raw materials, availability of operative skills, adherence to norms and manufacturing
cycle, overall competence to manufacture quality products, ready marketability and
prompt settlement of dues by customers. Working capital needs are computed in
broad terms. When the assumptions miss the mark, and when the operational pace
and efficiency lag behind expectations, the funds plans go away and severe shortage
of working capital funds is experienced. And the period of operations following the
commissioning of the plant is marked by avoidable struggle to find funds to match
needs and repeated threats to the company’s solvency.
Generally, the working capital requirements for a newly established company are
initially conceived in a very general and casual terms. They form the basis for funds
projections in early years of the company. The inadequacy in planning gets exposed
only when succession of funds problems arise because of the wide gap between
sweeping assumptions and stark realities.
b. Nature of Business
The nature of business has an important bearing on its working capital needs. Working
capital requirements of a firm are basically influenced by the nature of its business.
For some ventures, such as, retail stores, tobacco manufacture and construction
companies, the fixed assets become nominal or incidental and they require an
abundance of working capital. At the other extreme, there are some public utilities
175
such as electricity generation and supply, where the fixed assets constitute the dominant
segment, the current assets playing a minor and secondary role. Most of the
manufacturing organizations have to finance substantial investment in current assets to
support their operations.
c. Size of Business
The size of the business also has an important impact on its working capital needs.
Size may be measured in terms of the scale of operations. A small firm may employ
additional current assets as a cushion against cash flow interruptions. Small firms
having cash inflows from relatively fewer services are more affected by the defaults
on the part of customers to pay in time. On the other hand, larger firms with many
sources of funds may require less working capital relation to total assets of sales.
d. The Manufacturing Cycle
The manufacturing cycle starts with the purchase and use of raw materials and completes
with the production of finished goods. An extended time interval between the raw
material purchase and the completion of the manufacturing process yielding the finished
product, will obviously mean a larger tie-up of funds in the form of enhanced working
capital needs. Certain policy steps concerning terms of credit for raw-materials and
other supplies procured can help reduce working capital requirements.
e. Credit Terms to Customers
The credit terms granted to customers influence the working capital level by determining
the level of investment in book debts. Conventions and practices relating to specific
industries very often dictate the nature, extent and duration of credit to customers.
But in most cases, management has the discretion to decide on suitable credit rating
of prospective or existing customers, in respect of both the duration of credit and the
amounts involved. Slack collection procedures or permissive attitude in the matter of
collection of the outstanding can also lock up funds which would otherwise be available
for operating needs. Hence, the firm should follow rationalized credit policies based
on the credit standing of customers and other relevant factors. The firm should evaluate
the credit standing of new customers and periodically review credit worthiness of the
existing customers.
f. Production Policies
While noting that companies which experience strong seasonal movements have special
working capital problems, a strategy for maintaining a steady rate of production
176 throughout the year as against a pronounced seasonal demand for manufactured goods
has to be considered. As such the fluctuating or seasonal pattern of demand for some
of its products need not necessarily lead to major working capital problems. On the
other hand, some companies may have the facility of curtailing activity during the lean
periods by diversion of labour force to agriculture or related areas. In some cases,
accumulation of inventories may create special risks and costs because of the inherent
character of the products.
g. Growth and Expansion Programmes
As business grows, additional working capital has to be found. There is no simple
formula for establishing the link between growth in sales and growth in working capital.
Although, there is no definite relationship between the volume of a company’s business
and growth in its working capital, it is usually found in actual practice that a growing
firm requires additional funds to acquire additional fixed assets so as to sustain its
growing production and sales. Besides, additional current assets will be needed to
support increased scale of operations. Thus, the growing firm needs funds continuously.
h. Profit Levels and Dividend Policy
The magnitude of working capital in a firm is dependent upon its profit margin and
dividend policy. As a matter of fact, a high net profit margin reduces the working
capital requirements of the firm as it contributes towards the working capital pool. To
the extent net profit has been earned in cash, it becomes a source of working capital.
However, whole of the profit earned is not available for working capital purposes.
The availability of net profits for working capital purposes depends upon the dividend
policy pursued by the company. Distribution of larger sums of profits in the form of
cash dividend results in a drain on cash resources and reduces company’s working
capital to that extent. If the management follows a conservative dividend policy, it can
retain larger portion of net profits. As such, it can improve its working capital position
to that extent.
i. Reserve Policy
One of the cherished goals of enterprise is to build up adequate reserves out of profits.
Besides cash or funds position, the urge to retain or ploughing back of profits often
acts as a major constraint on the dividend policy. In concerns that function well, the
built up reserves constitute a strong base on which the corporate growth and expansion
can be sustained. Wherever the desire to build up reserves is dominant, the working
capital or funds position receives priority of consideration and dividends a residual
treatment.
177
j. Depreciation Policy
Depreciation policy centers around the determination of the amount to be provided
as depreciation charge to make up the ultimate resource for replacement of worn out
or obsolete assets. These variations in approach are often justified in terms of them
impact on working capital position. The depreciation charges do not involve any cash
outflow. Enhanced rates of depreciation have the effect of reducing profits
correspondingly, which in turn helps in holding back distribution of dividends. By this
process, cash is conserved. Thus, the effect of depreciation policy on working capital
is indirect.
k. Operating Efficiency
The operating efficiency of the management is also an important determinant of the
level of working capital. The management can contribute to a sound working capital
position through operating efficiency. There is an obvious relationship between the
operating efficiency of a company and its working capital position. Aggressive
management loses no time in finding ways to off-set the adverse effects of raw material
price increases, increased labour rates and other factors outside the purview of
corporate control, waste elimination, improved coordination to cut delays, higher
efficiency in operations and fuller utilisation of resources. These measures have the
effect of getting more out of a given volume of working capital or obtaining the current
levels of output with a reduced volume of working capital.
Thus, the level of working capital is determined by wide variety of factors which are
partly internal to the firm and partly external to it. Efficient working capital management requires
efficient planning and constant review of the needs for an appropriate working capital.
Check your Progress - 4
Discuss four important internal factors that determine the need for working capital of a firm.
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10.10.2 External Factors
a. Business Cycles
Movements of the business cycle bring about change in working capital position. In
the event of economic prosperity, to cope with increased demand and subsequently
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increased production, the firm requires additional working capital. On the other hand,
if the economy is experiencing recession, there will be decline in sales. As such
production requirements decline and therefore less working capital is needed.
However, the firm needs additional cash to meet operating expenses as the funds are
locked in inventories. Thus, a business depression may give a misleading appearance
of the financial position of the enterprise. With recovery, the cash position may decline
and a shortage of working capital may develop.
b. Technological Development
Technological developments in the area of production bring about changes in working
capital requirements. If a firm switches over to new manufacturing process and installs
new equipment, it may cut short the period involved in converting raw materials into
finished goods. As such, the permanent working capital requirements of the firm may
decrease considerably. Further, if the new machine utilises less expensive raw materials,
the inventory needs in terms of amount may also be reduced.
c. Change in Demand for Products
Some manufactured products are subject to seasonal fluctuations in sales. There are
obvious difficulties in ensuring that production tempo matches the ebb and flow of the
seasonal demand pattern.
In the interest of full utilisation of resources, steady production will have to be maintained
independent of change in demand for the finished products. This will result in progressive
accumulation of finished goods inventories during the off season and their quick disposal
during the peak season. The rising stock levels during the periods of production in
excess of demand will require increasing amounts of working capital to be provided
and these funds will remain tied up in inventories for some months. The financial
planning will have to incorporate this pattern of funds requirements associated with
steady production and seasonal sales.
d. Taxation
Tax liability is an inescapable element and it is to be an integral part of working capital
planning. Dividend can be curtailed or postponed but not tax commitments. Periods
of high taxation impose additional strain on working capital.
e. Price-Level Changes
The changes in the price levels over the year have always created problems for the
finance manager. The financial experts, all over the world, are still endeavouring to
spell out right way to resolve the enigma of changing price levels. 179
Rapid rising prices create the need for obtaining more funds to maintain the present
volume of activity. For the same levels of inventories, higher cash outlays are needed.
In an inflationary set up, even operating expenses will grow for a given level of activity.
Wage increases have to be financed and for current levels of services higher costs
have to be incurred. Replacement of fixed assets at enhanced prices requires higher
cash outlay than what has been contemplated by depreciation charges.
f. Vagaries in Supply of Raw Materials
Certain raw-materials pose problems in the matter of procurement and holding. Their
sources may be few and irregular. They may, therefore, be less amenable to the
discipline of planned inventory management. The enterprise may feel compelled to
purchase and carry large reserves of these items to sustain smooth flow of production.
Inventory levels rise, as a consequence, using up more funds.
Another problem, often confronting the enterprise, pertains to the sporadic supplies
of some essential raw materials such as steel in scarcity conditions. Where controlled
commodities are involved, the buyer has very limited option as to the quantum and
the timing of the purchase. At a time when the company’s funds position is not too
happy a bulk assignment may arrive and the finance manager may have to struggle to
scrap up the required money and arrange for early clearance of the goods and save
mounting demurrage charges. This element of unpredictability of the amount and timing
of these surprise arrivals of some materials unsettles the financial plans of the enterprise
and causes much confusion. The cautious manager finds it necessary to carry a
relatively, high level of cash and near-cash assets.
Some raw materials may be available on in certain seasons so that these have to be
obtained and stored in advance for the lean months. The working capital requirements
in such circumstances may register seasonal fluctuations.
g. Competitive Conditions
A company which enjoys a dominant hold on its market feels little obliged to strain
beyond a measure in satisfying customer’s requirements. It can afford to restrict the
variety of its products and thus reduce the aggregate levels of inventories. It can with
equal facility, lighten up its credit standards and save on investments in book-debts. If
conditions favour, it can dispense with the policy of extending credit facilities and
obtain ready cash for its sales, or it can even raise funds in advance of sale by insisting
on advance payments along with the purchase orders of customers.
A company which operates in a highly competitive market has to attempt to win and
retain the customer’s satisfaction on a continuing basis. This involves extra cost and
180
creates a variety of working capital problems. To offer the customers the benefit of
choice, varied lines of products will have to be manufactured and stocked. The
consequence is high levels of inventories at raw materials, work-in-process and finished
goods stages and corresponding need for additional working capital funds. To win
and retain the confidence of customers, it is necessary to extend generous credit
terms in keeping with competitor’s practices with very limited direction in formulating
its own credit policies. The investment in book debts, thus may need additional funds.
Thus, the degree of competition is an important factor that influences the working
capital requirements.
h. Transport and Communication Developments
In a country, where the means of transport and communication are not well developed,
industries may need additional funds to maintain large quantities of inventory of raw-
materials and other accessories.
10.11 SUMMARY
Finance is a study of money and it deals with the way in which the businessmen,
investors, governments, financial institutions and families invest in building and establishing a
business. In business finance is invested for the purpose of making profits, the other types of
finance being personal finance and public finance. To establish and run the business the funds
are invested to fund long term fixed assets and also funds are required for the purpose of
running the business on a day-to-day basis i.e. working capital. A wide variety of factors
influence the total investments in the fixed assets and as well as working capital of a business.
The factors that determine working capital requirements are categorised into internal and
external factors.
10.12 CHECK YOUR PROGRESS: MODEL ANSWERS
1. The business requires long term finances for establishment of business with the need
for funds to be invested in long term assets, i.e. land and building, plant and machinery,
equipment, etc. The business also requires huge amount of funds for modernization of
the business; expansion of the business; scale up the operations of business; acquisition
of another business; and diversification of the business
2. The factors that determine the need for long term finances for a business could be - a)
Nature of Business; b) Size of the Business; c) Nature of Business; d) Capital Markets;
e) Cost of Capital, f) Investor Sentiments, g) Regulations of the Markets; and h)
Statutory Requirements. 181
3. The total of investments in the current assets is gross working capital and when we
deduct the current liabilities from the gross working capital will be equal to net working
capital.
4. The four vital factors that determine the need for working capital of a business are:
Nature of Business, Manufacturing Process; Operating Efficiency; Depreciation Policy;
Reserve policy, Profits and Dividend policy; Credit Terms to Customers: etc.
10.13 MODEL EXAMINATION QUESTIONS
I. Short Answer Questions
1. Define the term “Finance”.
2. Explain the importance of Finance
3. Discuss the concepts of Gross and Net Working Capital
4. What are the stages in an operating cycle of a manufacturing firm?
5. Discuss the importance of working capital in business.
6. Define the three broad categories of finance.
II. Long Answer Questions
1. Discuss the types of finance.
2. What are the factors that affect the need for funds in a business?
3. Define working capital and discuss the importance of working capital management in
the present day context.
4. Explain the internal factors that determine the working capital needs of a manufacturing
firm.
5. Explain the external factors that determine the working capital needs of a manufacturing
firm.
III. Objective Type Questions
A. Multiple Choice Questions
i) The discussion of finances relating to the individuals and the issues relating to the
savings and investments is related to:
a. Public Finance
b. Business Finance
c. Personal Finance
182 d. Governmental Finance
ii) Mobilisation of funds by the government and utilisation of the same for the welfare
and development of the state is a study of:
a. Business Finance
b. Personal Finance
c. Public Finance
d. None of the above
iii) The ……………. is not the external factor that determines the working capital
requirements of firm:
a. Business cycle
b. Technological Development
c. Change in Demand for Products
d. Size of Business
iv) The ……………….. is not an internal factor that determines the working capital
requirements of firm:
a. Nature of Business
b. Price Level Changes
c. Production Policies
d. Operational Efficiency
v) The funds required for the long term finances of a firm does not include:
a. Acquire the non-current (fixed) assets and current assets to operate the
business;
b. Finances required to improve and modernize the business;
c. Finances for increased quantity of raw material in the process of expansion of
the business;
d. Finances required to scale up the operations of business;
Answers: i) c ii) c iii) d iv) b v) c
183
B. Fill in the Blanks
i) The funds needed for the day-to-day functioning of a business is known as
………………………….
ii) The finance needed to establish a business is known as ………………………….
iii) There are two types of capital required for a business. The first one being fixed capital
and the second is ……………………………..
iv) The total current assets is known as Gross Working Capital and the Net Working
Capital is defined as Gross working capital minus …………………………. &
……………….............
v) The term finance may be defined as the “………………………......……”
vi) The Finance function is the process of ………….. and ………………… funds by a
business.
vii) The discussion of finances relating to the individuals and the issues relating to the
savings and investments is related to …… ……………….
viii) All the government programs require huge amounts of money which it collects by
imposing and collecting ………………….. from the public.
ix) …………………………… is required for any size and type of business – may it be
large or small, manufacturing, trading or processing.
Answers: i) Working Capital ii) Fixed Capital or Long Term Funds
iii) Working Capital iv) Current Liabilities and Provisions
v) Science of Money vi) Acquiring and utilising
vii) Personal finance viii) Taxes ix) Finance
C. Match the Following
i) Personal Finance a) External Factor
ii) Public Finance b) Internal Factor
iii) Gross Working Capital c) Current Assests – Current Liabilities
iv) Net Working Capital d) Total of Current Assests
v) Size of the Business is a ......... e) Finances of an Individual
determining working capital
vi) Business Cycle is ............... f) Finances of Government
in determining working capital
184
vii) Life Blood of a Business g) money management
viii) Finance is a study of h) Finance
Answers: i – e ii – f iii – d iv – c v- b
vi – a vii – h viii - g
10.14 GLOSSARY
1. Business Finance : The management of monetary affairs of a
Company
2. Capital Market : Market for medium and long term finances
3. Development Financial : Institutions established for the purpose of
Institutional Finance extending credit to the firms eg. IFCI, IDBI,
ICICI, etc.
4. Public Finance : Mobilisation and utilisation of public funds
by the Government
5. Debenture : A document acknowledging debt by the
company issued to the investor (holder)
6. Shares : The capital of a company is divided into small
units called shares.
7. Working Capital : The amount of investment needed to finance
the short term or day-to-day operations.
8. Gross Working Capital : The sum of money invested in all the current
assets;
9. Net Working Capital : Difference between the current assets and
current liabilities;
10. Operating Cycle : The length of time which is required to convert
Cash into resources, resources into final
product,the final product into receivables and
receivables into cash;
185
10.15. FURTHER READINGS
Pandey, I.M. : Financial Management;
Vikas Publishing House Pvt. Ltd., New Delhi.
Kulkarni, P. V. : Financial Management – A Conceptual
Approach
Himalaya Publishing House, Bombay.
Rustagi, R. P. : Financial Management
Galgotia Publishing Co., New Delhi.
Chandra, P. : Financial Management: Theory and Practice
McGraw Hill Education, New Delhi.
Khan, M. Y. and : Financial Management: Text, Problems
Jain, P. K. and Cases
McGraw Hill Education, New Delhi.
186
UNIT – 11: SOURCES OF FINANCE - TRADITIONAL
Contents
11.0 Aims and Objectives
11.1 Introduction
11.2 Finances for the Sole Proprietary Business
11.3 Partnership and Sources of Finance
11.4 Hindu Undivided Family and Sources of Finance
11.5 Finances for Joint Stock Company
11.6 Sources of Finance
11.7 Equity Shares
11.7.1 Features of Equity Shares
11.7.2 Advantages of Issue of Equity – Company’s Point of View
11.7.3 Disadvantages of Equity Share Issue
11.8 Preference Shares
11.8.1 Types of Preference Shares
11.8.2 Advantages of Preference Equity
11.9 Debentures and Types of Debentures
11.10 Public Deposits
11.11 Borrowings from Banks
11.12 Retained Earnings
11.13 Trade Credit
11.14 Foreign Capital – External Commercial Borrowings (ECBs)
11.15 Summary
11.16 Check Your Progress: Model Answers
11.17 Model Examination Questions
11.18 Glossary
11.19 Further Readings 187
11.0 AIMS AND OBJECTIVES
One needs to understand that the larger the requirement of finances greater will be the
number of people or participants into the business for finances. The businesses have mobilised
the funds as per the financial system and financial infrastructure existing at that point of time.
After studying this Unit, you should be able to understand and appreciate-
• the sources of for various types of firms;
• the participation of owners in the form of equity or ownership;
• the participation of lenders in the form of extension of debt;
• the participation of lenders (institutional / commercial banks) to fund the various needs
of a business like expansion, modernization, diversification, acquisition, etc.
• the sources of finance that a firm could mobilise for the working capital requirements;
• the internal sources used for the purpose of both long term needs and working capital
requirements of a business;
11.1 INTRODUCTION
The sources of finances required for various types of businesses will vary depending
on the scale of business operations, size and technology adopted by the business. The sole
owner of a business with a small scale of operations requires a small amount of money whereas
the funds required for the business to establish a large undertaking to manufacture steel are
huge and cannot be started by a single individual.
11.2 FINANCES FOR THE SOLE PROPRIETARY BUSINESS
A sole proprietory business is owned and funded by one single person and expects
the business to fetch him back a return on the capital that he/she employs in the business. This
type of business units exist across the country in almost all the nooks and corners of the
country. For example the Kirana and General Stores shop where one would go to buy some
biscuits or chocolates for the children or some tea powder or sugar for making tea at home.
The other sources of finance that the proprietor would be able to bring into business
is by borrowing funds from his family members i.e., uncle, maternal uncle or any other close
friend. In all these cases where the funds have been infused into the business will appear in the
liabilities side of business.
Short terms funds required for the operations of a business i.e. for the purpose of
working capital may be obtained from the commercial banks. The owner can also borrow
188
funds from the banks by assuring some security to the bank or without any security. The term
could be short, medium or long. (See detailed discussion in the heading secured borrowings,
unsecured borrowings).
The money may be invested by the spouse, relative, friends etc. as part owner of the
business i.e. the businessman is sharing the ownership in the business with another party. In
such case the businessman is selling share in the business and the investor is buying ownership
or share in the business. In the businesses where there are two or more owners is known as
partnership.
11.3 PARTNERSHIP AND SOURCES OF FINANCE
The sole proprietors when they invite others to participate by funding the business in
equity, the firm becomes partnership firm. The partnership firm and sole owner business have
access to very limited resources and the capital that can be invested into the business is not
too large.
For businesses like sole proprietor or partnership the sources of finance could be:
a. Own savings;
b. Parental savings;
c. Fixed assets earned by the parents or existing ancestral properties;
d. Borrowings from the relatives, friends, banks or any other financial institution;
e. Moneys borrowed in the form of chit bidding; (unorganized or organized)
11.4 HINDU UNDIVIDED FAMILY AND SOURCES OF FINANCE
There is another type of business known as Hindu Undivided Family as per the Acts
of Income Tax Act, 1961 and also as per the Hindu Law. These business units too can access
the sources of finance mentioned above.
Check Your Progress - 1
What are the sources of finance for a sole proprietorship firm and partnership firm?
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11.5 FINANCES FOR JOINT STOCK COMPANY
The next level of business units are the Companies registered as per “The Companies
Act, 1956” and this Act has been amended and improvised as “The Companies Act, 2013”.
This type of businesses requires huge amount of financial capital and generally mobilised by
issuing shares.
The Joint Stock Companies may mobilise finances from various sources on the basis
of the requirement of funds and for the period. If the fund requirement is for buying raw
materials and converting those to finished products to sell – the company requires short term
funds. But, if the firm requires finances for a long period like for the purchase of machinery,
construction of a building, etc. then the firm requires funds for a long period.
Depending on the quantum of funds required for the business and ability to generate
profits from the business the firm can plough back the profits and finance for the purpose of
growth of the business. The ploughing back of profits and retaining in the business is
known as internal sources. When, the internal sources are insufficient to fund the growth of
the business and the firm needs to mobilise funds from the outside – known as external
sources of finance.
The external sources of finance can be in the form of “shares” selling ownership in the
company to the existing shareholders or new shareholders or in the form of “debt” by selling
the loan papers. This debt can be borrowed from the financial institutions, banks or can be
borrowed from the public at large by selling “debt certificates” or otherwise known as “bonds”/
“debentures” etc.
11.6 SOURCES OF FINANCE
We can identify the following sources from which funds can be mobilised by a company:
a. Equity Share Capital
b. Preference Share Capital
c. Debentures
d. Public Deposits
e. Borrowings from Banks
f. Retained Earnings
g. Trade Credit – Suppliers’ Credit
h. Foreign Capital – External Commercial Borrowings (ECBs)
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11.7 EQUITY SHARES
The Joint Stock Companies’ major source of permanent capital is mobilised by issuing
issue ordinary equity shares and perpetual preference shares. Apart from that the companies
issue redeemable preference shares, debentures or bonds etc. to mobilise medium and long
term funds. “Financial Capital refers to a pool of funds used to create value through conversion
into other forms of capital. This capital is raised through financing (equity, debt), operations
and investments”. The companies are known as joint stock – because the shares or ownership
is widely disbursed and held by many people and institutions from across the country and in
some companies from across the globe.
Let us come back to discuss and understand the most vital source of finance to a
company of any size viz., “Equity Shares”. The Companies Act, 2013 in section 2, sub-
section 84 defines a share as “a share in the share capital of a company and includes stock”.
Also, a share is a movable property and is transferable according to the provisions laid down
in the Articles of Association of the company. Selling of shares is the most vital way of
channelizing funds for very long term or perpetually into the company. Company sells
ownership document as security to the investor representing the capital for business
known as share i.e., the investor has a share in the business depending upon the investment
made. Funds mobilised by this way of selling shares is a primary base to the firm.
Generally, the equity capital required is divided into a large number of equal parts and
sold in the market creating the marketability of shares. Thus, one needs to understand that
the term share means the interest of a shareholder in the company measured by a
sum of money.
11.7.1 Features of Equity Shares:
1. It represents a share in the share capital of a company;
2. It is one of the units into which the share capital of a company can be divided;
3. It indicates the interest of the holder in the assets and profits of a company;
4. The shareholder of the company enjoys the rights given by the Articles of Association
of that company;
5. The rights could be in form of voting to elect the body of management for the company
and right to dividend when declared by the company.
6. The share will have a face value printed on the share and generally it tends to be Rs.
10 in the contemporary periods. Earlier the face value of share used to be Rs. 100
and Rs. 1000 in some cases; 191
7. The market value of the share is dependent upon the demand and supply of the shares
and is traded in the stock exchange and does not represent the book value or face
value. ;
8. Shares of the Private Limited companies are not freely tradable and also not listed on
the stock exchanges;
9. Shares of the Public Limited companies are freely tradable and mandated to be listed
on the stock exchange for the purpose;
10. Ordinary equity shares do not carry any preferential rights – either for the dividend or
at the time of winding up of the company.
11. Dividend on the equity shares is payable at the will of the management and will be
declared in the Annual General Meeting conducted by the company yearly;
12. Dividend on ordinary equity shares is not allowed to be paid unless the company has
paid the dividend to the preference equity shareholders;
13. In the event of winding up of the company the equity shareholders will be paid after all
the other debts are cleared and paid, thus the risk borne by the equity shareholder is
maximum;
14. The ordinary equity shareholders are entitled to residual profits of the company;
15. Generally, ordinary equity shares of the firm are issued before issuing preference
shares and debentures;
11.7.2 Advantages of Issue of Equity – Company’s Point of View
1. The firm even in the case of not achieving profits or operating at break-even point –
need not worry about paying dividends to the equity shareholders;
2. Payment of dividend is at the discretion of the management, irrespective of profits
earned by the business and subject to the adequate availability of finances. Particularly
the firm is under no obligation to pay the dividends to the shareholders.
3. Once raised, share capital remains in the company perpetually. It is not refunded and
paid back to the shareholders only at the instance of winding up of the company.
Therefore, equity capital is said to be perpetual capital or permanent capital in the
firm it is presented on the liability side of the Balance Sheet.
4. Share capital of the company is the source of strength to the company and can command
prestige in the investment market. Its ability to borrow funds will be high.
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5. Ordinary equity shares have the face value at a very low value appealing to a large
number of people to invest and be part of the ownership of the company. The people
with low and medium income too can invest in the firm and in turn companies can
channelize savings of large sections of society.
6. The features of limited liability, transferability or negotiability and perpetual succession
make the equity share much more attractive.
7. Equity shareholders have the pre-emptive right to subscribe to new shares issued by
the company. Mispricing of equity shares due to any macro-economic factors for the
further public offering too will not harm the existing shareholder with the route of
rights shares issued by the company.
8. Equity shares enable the investors earn regular income by the way of dividends on a
regular basis apart from the dividends. The value gain of share in the market enables
holders to earn capital gains (when a share is sold at a higher price than the acquired
price – the difference of price of sale and acquisition is known as capital gain and this
could be a short term capital gain or long term capital gain as per the rules defined
and laid down in the Income Tax Act, 1961).
9. The central government in some instances to discourage the companies to pay dividend
and encourage them reinvest the earnings and levy tax on dividends payment apart
from the charge of income tax for the company. Otherwise the shareholder need not
pay the tax on dividends received – because the company is declaring and paying
dividend after paying the income tax to the government.
11.7.3 Disadvantages of Equity Share Issue
The issue of equity shares brings with it some disadvantages with the advantages
discussed above and that could be:
1. There could be some equity shareholders attempting to indulge in undesired practices
to gain control over the management of the company for their benefit;
2. The funds raised through equity shares cannot be refunded and in case the firm is not
having projects – it becomes over capitalized and this could also happen because of
errors in forecasting or estimations;
3. The above reason restrains the firms to mobilise total amount as “Equity” and forces
part of the capital employed into the business as debt with fixed commitment of
interest. This debt brings a risk of inability of the firm to meet the “Fixed Commitment”
i.e., interest payment. In case the firm has not earned profits, it will be forced to pay
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the money of the equity shareholders to meet the obligation known as “Trading on
Equity” or Financial Leverage
4. Cost of Equity is any day greater than the cost of preference shares and cost of debt
or borrowings from banks / Financial Institutions.
5. The company cannot issue shares beyond the authorised amount of share capital
specified in the Memorandum of Association of the company. However, the
Memorandum of Association can be amended and funds can be raised over the
period of time.
6. The equity shareholders though have the voting rights do not have the ability to go to
the Annual General Meeting in person and attend the same to elect the body of
management. Many a times the meeting is held in another distant city or it is on a
working day leaving the shareholder with inability to attend.
7. In the secondary market – the trading on shares is done by both the investors and
speculators. The proportion of speculators influence the price and lead to mispricing
of shares in some periods and particularly the price of share is overvalued in boom
times and under-priced during bearish market trends. In such cases the innocent and
ignorant investors suffer by reacting to the developments;
Equity Shares
S. No Advantages Disadvantages
1 Company need not worry about earnings There could be interference into the
management of company
2 The capital employed is permanent Over or under capitalisation
3 No charge on assets Trading on Equity – and that could
work in favour or against
4 Equity is a source of strength to the company It is a costlier source of finance over
debenture issued by a company
5 Risk and Return on Equity is high Risk could work out more and lead
to erode equity
6 Wide appeal Though the equity could appeal to
many – the risk frightens small
investors
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11.8 PREFERENCE SHARES
Another type of equity share is “Preference Equity”. This type of equity shareholders
has preference at two instances:
1. At the time of payment of dividend preference equity shareholders receive a fixed
percentage of dividend before equity shareholders i.e. the dividend is paid before the
payment of dividend to equity shareholders; (one needs to understand that the
preference equity shareholders get the fixed percentage of dividends as agreed at the
time of issue of such shares).
2. The second preference that the preference equity shareholders get is when the company
is going for winding up, all the assets are liquidated and debts are paid. From the
balance amount it is the preference equity shareholders who receive their full money
and after that if there is any money left equity shareholders will be in position to get.
11.8.1 Types of Preference Shares
The preference equity shares are described as hybrid security i.e. equity share with a
feature of debt. It has feature of fixed percentage payment like that of interest on
debenture and the feature of equity. In the case of preference equity shares the holders
do not have the voting rights. The companies can design such preference equity shares
with features of “Redemption”, “Convertibility”, “Cumulative” and “Participation”.
There could be multiple types of permutations and combinations of these four usable
as eight.
1. Cumulative Preference Shares
The company may issue a share with feature of accumulation of dividend fixed at the
time of issue. In cases or periods where the company has not earned sufficient profits
or incurred losses – the investor is promised that the same is paid back when the
profits are earned in future years or period. Therefore, the dividend of a year say
Financial Year 2016 company could not pay preference dividend and is committing
to pay the same in the FY 2017 or 2018 – such preference shares are known as
cumulative preference shares.
2. Non-Cumulative Preference Shares
In simple terms the dividend on these preference shares will not accumulate or will not
be paid in the year when the firm incurs losses. Generally, such preference shares are
issued by the companies operating successfully with positive earnings and are in a
position to pay dividends to the preference shareholders. 195
3. Convertible Preference Shares
This type of shares are issued by the companies where such shareholders are given
with an option to convert the preference shares into ordinary equity shares at an
agreed price on or after a specified date.
4. Non-Convertible Preference Shares
In contrast to the above i.e., the company issues a share where the preference
shareholder will not have any option to convert it into equity shares at a later date.
5. Redeemable Preference Shares
The holders of redeemable preference shares will get the refund of the principal along
with the agreed percentage of dividend on a regular basis on the agreed date or
expiry date. The company specifies the intention of repayment declaring the date of
repayment or date of redemption of such preference shares. Only a company limited
by shares can issue redeemable preference shares. However, the Companies
Act, 2013 laid down a condition that the redeemable preference shares cannot
be issued with a maturity more than twenty years;
6. Perpetual Preference Shares
The Capital raised from such preference shares will be in the company as permanent
capital with the necessity of repayment only at the time of winding up of the company.
The condition of maximum of 20 years prevents the companies to issue perpetual
preference share.
7. Participating Preference Shares
The holders of the participating preference shares are given a right to participate and
share profits after declaring and paying preference and equity dividend i.e., in the
surplus profits of the company in addition to the agreed customary fixed percentage
of dividend. In general the markets have not witnessed issue of such shares in the
market.
8. Non-participating Preference Shares
The opposite of the above preference equity where the preference shareholders are
not allowed to participate in the surplus profits of the company.
11.8.2 Advantages of Preference Equity
1. The company while issuing preference shares will attempt to appeal to the investors
looking for a reasonable safety of their capital along with a fixed but higher return
earnable over and above the rate of interest on debentures.
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2. Preference shares do not put a burden on the finances of the business, dividend on the
preference shares is paid out of profits only and the cost of financing using preference
is less than that of cost of equity and a little more than the cost of debenture.
3. One of the important benefits that a firm earns by issuing preference shares is that the
control and management of the organization is not affected because of voting rights
being not conferred on the shareholders of the firm. Preference shares do not carry
voting rights and control is not diluted in the firm at all.
4. In comparison to the debentures or debt borrowed from the commercial banks where
the lender creates a charge of mortgage on the fixed and tangible assets, preference
shares is a better way of raising the resources.
5. Preference shares allow the company raise the finances without creating a charge on
the assets of the company.
6. In case of resources mobilised as debt with an interest commitment the firm should be
able to earn at least the profits to meet the interest to be paid to lenders. In case, if it
is in an operating break even where the profits are not sufficient to pay the interest it
is the equity finances which need to be paid out as interest generally known as “Trading
on Equity”.
7. Preference shares do not allow such trading on equity and create a “probable loss”
because the dividend is paid out only from profits of the company. In the case of
cumulative preference shares the shareholders also need not worry that the income is
loss of the year in which the firm has not made profits.
8. In case the preference shares are issued with the option of redemption by the company
with a specific date the company can simply repay as and when the company does
not need the funds.
9. Convertible or participating preference shares may be issued by the company making
the investment attractive for the investors desiring to become part of the ownership or
to participate in the surplus generated in the business.
Check Your Progress - 2
What preferences will a preference shareholder have?
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11.9 DEBENTURES AND TYPES OF DEBENTURES
This is another major source of finance for companies. As against share capital,
debentures mostly have an assurance of the payment of a fixed rate of interest and return of
principal. The investors who do not want to take risk by investing in shares, prefer investment
in debentures. In debentures, there are various kinds, viz.,
i) On the basis of security
a. Secured; and
b. Unsecured
ii) On the basis of Redeemability
a. Redeemable; and
b. Irredeemable
iii) On the basis of convertibility
a. Convertible; and
b. Non-convertible
i) Secured and Unsecured Debentures
Secured debentures are those that are provided with security of assets by the company.
In other words, the debenture holders would have a charge on the assets of the
company. In the event of liquidation, they would be paid after the preferential creditors.
On the other hand, unsecured debentures do not carry any security with them. These
unsecured debentureholders would rank equal with other unsecured creditors.
ii) Irredeemable and Redeemable Debentures
On the basis of redemption, debentures are classified as such. If the debentures are
payable within the life time of the company or within a certain time period they are
called redeemable debentures. If they are not paid back within the life time of the
company, they are called irredeemable debentures;
iii) Convertible and Non-convertible Debentures
Convertible debentures are those that are convertible into specified number of equity
shares at an agreed price after sometime. Therefore, the holder of this debenture
would have an option to get part of his investment converted into equity shares of the
company as per the terms of the issue. On the contrary, non-convertible debentures
do not enjoy this facility.
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Check Your Progress - 3
What is a Debenture? State the types of Debentures.
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11.10 PUBLIC DEPOSITS
Public deposits are the traditional source of finance for many companies. Under this,
the companies advertise for the acceptance of deposits from shareholders, employees and
the public for duration of one to three years. This source has been used extensively by the
companies for various reasons like the lower interest rate, non-provision of security and non-
availability of bank credit.
11.11 BORROWINGS FROM BANKS
Banks have been one of the significant traditional suppliers of funds. Companies depend
largely on the banks for meeting their working capital requirements. Sometimes, they also
grant medium and long term loans to the companies. Banks provide the assistance in several
forms such as cash credits, overdrafts and discounting of bills. However, in the recent years,
the role of bank credit in financing industry has been declining due to shift in the priorities of
lending.
11.12 RETAINED EARNINGS
These are the funds that are retained out of the profits of the company. Generally,
companies do not declare all of their earnings in the form of dividends. They earmark a certain
portion for the future use in the company for meeting the expansion and modernisation
requirements. The company would always be free to utilise this source. The retained profits
enable a company to withstand seasonal reactions and business fluctuations. The large
accumulated savings facilitate a stable dividend policy and enhance the credit standing of the
company. However, the quantum of retained earnings depends on the volume of profits earned
by the company.
In order to meet the legal and other obligations, the firms create some provisions for
future use. These provisions include the provision for depreciation, taxation, dividends and for
various other current and non-current liabilities. The amount set apart in these forms would be
required to be paid only on certain dates. Till the time of payments of such in nature the firm
can use them for its own purpose. Therefore, though for a short period provisions would
serve as a good source of finance.
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11.13 TRADE CREDIT
It is common in business that enterprises sell and buy on credit basis. Normally, every
company gets its raw materials and other supplies on credit basis. This is what is known as
trade credit. This acts as an important source of financing. This form of financing is preferred
by many enterprises because of convenience and low cost.
Check Your Progress - 4
What is Trade Credit? How is it different from the other sources of finance?
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11.14 FOREIGN CAPITAL – EXTERNAL COMMERCIAL
BORROWINGS (ECBS)
Many companies draw funds not only from domestic sources but also from foreign
sources. In the most usual circumstances the collaborators of the project participate in the
equity of the company and also provide loans sometimes. Foreign Direct Investment (FDI) is
the most preferred source of foreign capital now. Foreign commercial borrowings can also be
availed. A company may directly approach the foreign capital markets for raising funds through
the use of Global Depository Receipts (GDRs) and American Depository Receipts (ADRs).
Sometimes the government may arrange for the transfer of funds from a foreign source to the
companies. The International Finance Corporations (IFC) and Asian Development Bank
(ADB) provide funds to companies directly.
11.15 SUMMARY
In general, the ability to raise the finances is limited when there is a single person as
owner of the business. When the owners of the business increase from one to two and then to
three, the ability to access finances will also increase.
Business Finance is the study of mobilising and utilising of resources by a commercial
organization. The businesses of different variety tap diverse sources and access for funds. The
mobilisation of finances seems to be simple – but the firms have to convince the investors and
lenders to invest in their ideas. There are various sources of finance that the businesses can
access. In the early stages of development of the country the successive governments have
established development financial institutions and specialised financial institutions and later
200 slowly and steadily guided the corporate to access funds directly from the financial institutions,
banks and markets. In the process the important sources like Equity Share Capital, Debentures,
Public Deposits, Borrowings from banks, Borrowings from Financial institutions have evolved
as extern and long term sources of finances for the firms. Whereas the profits earned by the
business, depreciation and provisions have enabled the firms to invest the money into the
business back for the expansion and other requirements for a shorter period of time. The
efficiency with which the finances are utilised will reflect in the prosperity of the organisation or
wealth maximisation of shareholders.
11.16 CHECK YOUR PROGRESS: MODEL ANSWERS
1 The sole proprietorship business and partnership business can access:
a. Own savings
b. Parental savings
c. Fixed assets earned by the parents or existing ancestral properties
d. Borrowings from the relatives, friends, banks or any other financial institution
e. Moneys borrowed in the form of chit bidding; (unorganized or organized).
2 A preference equity shareholder will have the preference at two times. The first: before
paying the equity dividend to the ordinary shareholders, the preference dividend has
to be paid by the company and the second one at the time of winding up or dissolution
of the company that the repayment of the principal should be made before the ordinary
equity shareholders.
3 A debenture is a debt certificate issued by a company to the investors and is negotiable
(freely tradable) in the market. The types of debentures that a company could be
redeemable, irredeemable, convertible, non-convertible, cumulative and non-
cumulative.
4 Every firm purchases goods from its suppliers or vendors and obtains some time to
pay known as trade credit. This is one of the sources of finance where the cost of
financing is zero(nil) for the firm explicitly. All other sources, either it could be bank
borrowings or any other borrowing the firm has to pay interest regularly.
11.17 MODEL EXAMINATION QUESTIONS
I. Short Answer Questions
1 What are the internal sources of finance for a company?
2 Distinguish between secured and unsecured debentures;
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3 Distinguish between cumulative and non-cumulative preference shares.
4 Explain the differences between convertible and non-convertible preference shares.
5 What is trade credit?
II. Long Answer Questions
1 Discuss the advantages and disadvantages of equity shares.
2 Explain the preferences that a preference share holder derives. Also discuss the various
types of preference shares.
3 Discuss the various types of debentures.
4 Discuss the internal sources and external sources of finance.
III. Objective Type Questions
a. Multiple Choice Questions
i) Sole proprietor or partnership business cannot access the finance through:
a. Own savings;
b. Parental savings;
c. Issue of Shares;
d. Borrowings from the relatives, friends, banks or any other financial institution;
ii) A Private Limited Company cannot raise finances from the:
a. Commercial Banks;
b. Development Financial Institutions;
c. Relatives;
d. Issue of Shares to the public.
iii) A Sole Proprietor can access to finances from:
a. Personal Savings of a Proprietor
b. Loans borrowed from the spouse
c. Loans from the commercial Banks;
d. All the above;
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iv) A unique type of business limited to India is:
a. Sole Proprietorship Business
b. Partnership Business
c. Joint Stock Company
d. Hindu Undivided Family
v) Identify the odd source out in the finances that a company can mobilise;
a. Debentures
b. Public Deposits
c. Borrowings from Banks
d. Retained Earnings
Answers: i) c ii) d iii) d iv) d v) d
b. Fill in the blanks
i) The sole owner of a business with a small scale of operations require ……………..
amount of finances in comparison with firms of large scale operations.
ii) Joint Stock Companies access to ……………… will be wider and more than a sole
proprietor or a partnership business.
iii) One of the important debt sources of finance for a sole proprietor business is
……………….. from relatives.
iv) The joint stock companies are of two types ………………………. and
……………………………
v) For the companies to fund the growth, the internal sources will be insufficient to fund
and hence the firm needs to mobilise funds from ………………………….. sources.
Answers: i) Lesser amount of Capital ii) Sources of finance
iii) Loans / Borrowings iv) Public Limited and Private Limited
v) External
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c) Match The Following
i) Public Deposits a) Sole Proprietor
ii) Convertible Debentures b) These shares are issued by the public limited
joint stock company with a right of dividend
and repayment of principal at the time of
winding up of company.
iii) Preference Equity c) Issue of debt certificates by The public
Limited Joint Stock Company with an
intention to convert the debt into ordinary
equity.
iv) Ordinary Equity Share d) Certificate of deposits (negotiable) issued by
a public limited joint stock company.
v) Loans from Relatives e) The shares issued to the public at large to be
part of the ownership of the firm;
Answers: i - d ii - c iii - b iv - e v - a
11.18 GLOSSARY
Corporate Securities : Securities issued by the joint stock companies to the
public
Debentures : A debt security issued by a company
Equity Share : A security acknowledging ownership in the company
to the holder
Sole Proprietor : Only one owner of the entire business
Partnership : There are two or more owners in a business;
partnership Act, 1932 restricts the partners to 20 in
case of other business and 10 in case of banking
business
Investor : The owner of securities issued by the companies –
one who bought them
Floatation : A company is incorporated by obtaining the certificate
from the Registrar of Companies; or it could be that
the company issued shares or debentures in the
market;
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Preference Share : An equity share with preference for fixed dividends in priority
over the equityholders and preference for repayment before
the ordinary equity shareholder is paid;
Redemption : Redeeming of debentures or repayment;
Rights Shares : The equity shareholders of the company will have the right of
getting new shares issued before they are offered to the public
at large;
11.19 FURTHER READINGS
1. Pandey, I. M. : Financial Management
Vikas Publishing House Pvt. Ltd. New Delhi.
2. Rustagi, R. P. : Financial Management
Galgotia Publishing Co., New Delhi
3. Chandra, P. : Financial Management: Theory and Practice
4. Khan, M. Y. and : Financial Management: Text, Problems and
Jain, P. K. Cases Tata McGraw Hill Education, New Delhi.
5. Maheshwari, S. N. : Financial Management: Principles and Practice
Sultan Chand Publications, New Delhi.
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UNIT – 12: SOURCES OF FINANCE – MODERN
Contents
12.0 Aims and Objectives
12.1 Leasing
12.2 Hire Purchase
12.3 Venture Capital
12.4 Private Equity
12.5 Forfaiting
12.6 Crowd Funding
12.7 Angle Investors
12.8 Bootstrapping
12.9 Private Equity (PE)Investments
12.10 Peer to Peer Lending (P2P)
12.11 Innovative Capital Market Instruments
12.12 Summary
12.13 Check Your Progress: Model Answers
12.14 Model Examination Questions
12.15 Glossary
12.16 Further Readings
12.0 AIMS AND OBJECTIVES
As size and operations of business houses are highly heterogeneous in nature,
requirements of funds differ from firm to firm, in terms of timing of funds, persons financing the
entity and their affiliation with the entities, their involvement in running operations, platforms
used for financing etc. Today technology emerged as one of the factors of production to every
entity. Technology is providing huge opportunities for the entrepreneurs to raise funds required
for the business in a unique way. As entrepreneurial culture and instinct are evolving on a
grand scale among the youngsters in the country, it is also providing opportunities for the
business to raise funds from entrepreneurs with a zeal to finance the modern ventures.
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The following are the modern sources of finance are discussed hereunder –
12.1 LEASING
Leasing is also one of the important ways of financing the fixed assets where the
companies obtaining the assets on lease not even need to present them in the assets side of
balance sheet like that of purchase. The lessor is the person who lends the money to buy the
asset to the company acquiring / purchasing the asset. Funding through leases is known as off-
balance sheet financing and a well-known method of financing the assets for the companies
when not in a position of raising debt from the financial institutions or markets.
12.2 HIRE PURCHASE
When a company purchases an asset with an agreement that the money will be paid
by the buyer as hire rental for certain number of years and at the end of the last rental paid the
Hire Vendor transfers the title of the asset to the Hire Vendee is known as Hire Purchase. In
this method too, it is like a borrowing and instead of borrowing from a financial institution or
a commercial bank, the company intending to buy the asset will acquire the asset by committing
to pay the finances as installments but will be treated as hire rental. After the payment of last
hire rental the asset will be transferred by the vendor.
12.3 VENTURE CAPITAL
For the development of Entrepreneurs in the country the specialized financial institutions
like industrial development corporations established by a separate statute in the state assembly
in the beginning have extended venture capital to the firms with new and innovative ideas.
Venture Capital (VC) is a type of equity form of financing provided by firms or funds to small,
early-stage, emerging firms that are deemed to have high growth potential, or which have
potential of high growth. Venture capital firms or funds invest in these early-stage companies
in exchange for equity or an ownership stake by taking the risk through equity financing. They
expect these start-ups to perform with high profits and growth and are usually based on an
innovative idea or a business model.
12.4 PRIVATE EQUITY
A private equity investment will generally be made by a private equity firm, a venture
capital firm or an angel investor. These are specialized financial investment firms with investment
to be made into a firm that is not publicly traded on a stock exchange. Private equity is a type
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of equity and one of the asset classes consisting of equity securities and debt in operating
companies that are not publicly traded on a stock exchange.
12.5 FORFAITING
The firms exporting goods get support from the commercial bank under export credit
facilities. In the case of exports an exporter can also sell the receivables directly to a specialized
financial services firm known as “Forfaiter”. The forfeiter will buy the exporters bill of lading
directly at a discount and the period of receivable can go up to five to seven years. All the
receivables are discounted at one go on a non-recourse basis by the forfaiter.
12.6 CROWD FUNDING
It is a modern way of raising finance based on various technology based platforms or
sites. It is a practice of raising funds from many different backers or crowd in the form of small
amounts or small portions of capital. All members providing funds to the ventures are unknown
parties. Best example for crowd funding is US based crowd funding platform Kickstarter
(2009). Interested entrepreneurs initially they will present and share their business ideas in
these platforms through a video. Business Entities need of funds can upload a video about
their venture and can convince the members for investment in the entity. Registered members
in the platforms can contribute to the capital of the entity and they can become the fractional
owners of the business. As a reward for their investment owners may receive either interest on
their capital or equity contribution. Among the two-popular method of receiving reward in the
form of interest. This mode of financing is popular among startup entities in the country.
Registered members can contribute to the capital through e-wallets. They can transfer
their portion of investment through e-wallets like pay pal, paytm, mobikwick etc., For every
transaction members need to pay transaction charges as well as commission to the platform
provider. In case of equity participation based platforms, members will transfer their capital
through bank and possibility to save the transaction charges. Equity based platforms are
suitable for startups with a need of lae equity base.
As crowd participating in the financing of the venture, normally each member in the crowd will
hold less than 1% stake in the business. Every member is interested about the growth of
venture in terms of idea popularization and success of the idea to get popular returns. The
biggest disadvantage is
12.7 ANGEL INVESTORS
An angel investor (also known as a business angel, informal investor, angel
funder, private investor, or seed investor) is an affluent individual who provides capital
208 for a business start-up, usually in exchange for convertible debt or ownership equity. A
small but increasing number of angel investors invest online through equity crowdfunding or
organize themselves into angel groups or angel networks to share research and pool
their investment capital, as well as to provide advice to their portfolio companies.
The application of the term “angel” to a kind of investor originally comes
from Broadway theater, where it was used to describe wealthy individuals who provided
money for theatrical productions that would otherwise have had to shut down. In 1978,
William Wetzel, then a professor at the University of New Hampshire and founder of its
Center for Venture Research, completed a pioneering study on how entrepreneurs raised
seed capital in the USA, and he began using the term “angel” to describe the investors that
supported them. A similar term is patron, commonly used in arts.
An angel network is a group of angel investors (HNI’s), collectively invest in early
stage businesses. Each angel network is a group of angel investors. This network operates on
a first come first serve basis. Angel Network receives variety of deals from the entrepreneurs
for funding support. Interesting deals will be funded by the interested angels and angels not
got an opportunity to invest in the deal can involve in the deal indirectly also. Angel can
participate in the follow-on round of investment in the successful deals. Typically, angel investors
participate in one round of financing only. Today, in the market in addition to angel investors,
venture capital firms and private equity firms are also in line for financing start-ups in a big
scale. With Ace investor Mr. Ratan Tata in collaboration with University of California established
a venture capital fund with a corpus of $100-$150 million to invest in start-ups.
Check Your Progress - 1
Who is an angel investor ?
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SEBI Guidelines on Angel Investors
SEBI -The capital market regulator recognized the angel investors and funds and
brought them under the ambit of Alternate Investment Funds (AIF) regulations. Angel Investors
are included in the definition of venture capital funds.
SEBI classified angel investors into two categories as Individual Angel Investors and
Corporate Angel Investors. As per SEBI, Individual Angel Investors are those investors,
need to have early-stage investment expertise or have experience as a serial entrepreneur or
be a senior management professional with 10 years’ experience with a net tangible asset of at
least Rs.2 crore. 209
Corporate Angel Investors need to have a net worth of Rs.10 crore or be a registered
AIF or venture capital fund with investment for at least three years . Angel funds also need to
have a corpus of at least Rs. 10 crores and the minimum investment by an investor would be
Rs. 25 lakhs, compared with Rs. 1 crore for other AIFs.
Recently, to boost start-up funding SEBI relaxed the angel investment norms like
minimum lock in investment requirement reduced from three years to one year for angel funds
and verge investment limit reduced from Rs.50 lakh to Rs.25 lakh and permitted them to
invest in ventures with a proven track record of five-year old entities.
SEBI (Alternative Investment Funds (AIF) Regulations, 2012 amended the definition
of start-ups for facilitating angel investors investment in start-ups, in line with the amendment
of Department of Industrial Policy & Promotion (DIPP). Angel Investors also permitted to
invest in overseas ventures and permitted to invest to an extent of 25% of their investable
corpus. Also increased the upper limit for number of angel investors in a scheme from 49 to
200 investors. Angel Fund, a sub-category of AIF, boosts young entrepreneurs to invest in
innovative start-ups in various stages such as initial stage (conceptualization and implementation
of the idea) of the venture, where they find it difficult to mobilize funds for the venture. Currently,
266 AIFs are registered with SEBI.
Angel Investors in India
In India, there are five major angel network companies are operating and investing in
various ventures in the country by mobilizing funds from domestic investors and overseas
investors. Domestic Investors includes domestic institutional investors (DII’s) like Small
Industries Development Bank of India (SIDBI), IIFL, Yes Bank, as well as investors from
renowned business families viz., Mr.Kris Gopalakrishnan, Mr.Sunil Munjal, Google India’s
Mr.RajanAnandan etc.,
The five-major angel investing companies are Indian Angel Network (currently invested
in 7 countries viz., USA, UK, and Israel), Chennai Angels, Calcutta Angels, Hyderabad
Angels, Mumbai Angels. Indian Angel Network (IAN) a big angel network (400 angel
investors) in India, invested in 17 (2016) start-ups like Sqaure Plums Technologies Pvt.Ltd.,
(Accommodation Start-up), Find My Stay (Hotel Booking Platform), Protinus Fashion
Networking Pvt. Ltd (Fashion Technology Venture), Little Black Book (Media-tech
Enterprise), Roast Media Pvt. Ltd., (Entertainment App).
Innoven Capital, a venture debt firm released a report on angel investments in India,
as per the report, in the year 2015, nearly INR 70 crores was invested in 47 deals, where as
in the year 2016 it stood at INR 113.6 crores, across 69 deals. Majority of the funds raised
210 by angel investors are rooted to start-up ventures. Start-up funding usually in the form of stage
wise financing. Based on the success rate of each stage, angel investors will pump the funds
into the ventures. Financial Feasibility of the start-ups will be assessed by the angel investors
at every stage, to understand their return on investment. Currently, angel investment turned
into an asset class as well as a viable investment opportunity to High-Net Worth Individuals
(HNIs) due to its high return on investment.
Angel Investors are investing in ventures like consumer internet and mobile, e-
commerce, food tech start-ups (example: Hyperlocal Delivery, Zomato, Pepper tap) and
they nearly secured 40% of the total angel investment in 2016.
12.8 BOOTSTRAPPING
Executives- turned -Entrepreneurs launching ventures with modest personal funds.
Most of these ventures are funded by the founder personal savings, credit cards, hand loans
and mortgages etc., Further funds required for the ventures are procured by the founders
from venture capital firms. To raise big money from the venture capital firms globally located,
founders will prepare plan of action for approaching the investors, negotiating a deal and to
design an optimal capital structure. Uniqueness of this method of financing is founders raise
money from venture capital firms, without launching any of their products in the market, just
simply based on their strong business plan and idea they will raise funds.
To raise money from venture capital firms, founders require a strong knowledge in the
areas of market research, concrete business plan with high amount of customization, funding
teams, sagacious boards, performance reviews at frequent intervals, complex financial
instruments etc.,,
Edureka, an online education company started by two IIT graduates, growing 15
times in a year. Founders Lovleen Bhatia and Kapil Tyagi had previous experience bootstrapping
a mobile app development company before they started Edureka in 2011. Nearly three years
on, Edureka has survived without external investments.
Indian Ventures Bootstrapped in the recent times reported by Business Standard
News Paper
Antilog Vacations
Online bookings and holiday packages, a Chandigarh-based startup claims to offer
the cheapest prices available for tours – offline or online. The company was founded
in 2010 by two former Infosys techies and friends, Mohit Singla and Abhishek Jaiswal.
Today it operates in 17 markets, the major ones being India, France, UK, US,
Germany and Japan.
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We Do Sky
A Delhi-based startup We Do Sky sends up drones to create virtual maps. Founded
by IT graduate Jaspreet Makkar in 2014, it is in high demand among construction
and mining companies
Zoho
Software products company Zoho Corporation was founded in 1996 by Sridhar
Vembu. Based in California and Chennai, it has a 3,000 strong workforce.The
company makes the popular Zoho Office Suite, a set of office productivity applications
that has 15 million users.
Fusion Charts
A data visualization company based in Kolkata and Bangalore, founded in 2002 by
Pallavi Nadhani. The company operates in the areas of data visualization like smart
charts with animation, designs and interactive elements etc., for companies. Company
had customer base of 24,000 customers with 50,000 developers and operates in
120 countries.
Check Your Progress - 2
Describe Bootstraping .
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12.9 PRIVATE EQUITY (PE) INVESTMENTS
Private Equity Investments are the investment fund houses investing in various ventures
with an aim to create alpha and producing returns, be the key driver for specialist in investments.
At the time of investment every PE invest firm considers the parameters like Return on
Investments (ROI), Core Strength of the Business, Possibility of Generating Extra Returns
(Alpha), Growth of Funds in next five years, investing in sectors as diverse as possible etc.,
In India, two types of PE investment funds are famous viz., Generalists and Specialists.
In the beginning every PE fund investment adopts a generalist approach and over a period of
time based on the experienced gained in the field of investments and their subject of interest
will transform into a specialist in the field of investments. Specialists keenly evaluates the
opportunities and focus on specific sectors for investments, understand the sector specific
opportunities in next five years and prepares clear growth path to ahead the sector.
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Mc Kinsey & Company, February 2017 report defined Private Markets as closed-
end funds (funds not traded publiclyowned) investing in private equity, real estate, private
debt, infrastructure and natural resources as well as secondaries and fund of funds. This
classification excludes hedged funds, publicly traded funds, and open-end funds.
1. Private Equity: Buyouts, Venture Capital and Growth Equity
2. Real Estate: Funds invested in listed real estate properties (REITs)
3. Private Debt: Closed end funds that invest in non-listed debt issues, including bonds,
notes or loans or structured debt products.
4. Infrastructure: Funds invested in large scale projects excluding investments in public
infrastructure firms and listed firms.
5. Natural Resources: closed end funds that invest in in real assets like agriculture, farm
land, oil and gas reserves, mines, metal processing, plants and timberland etc.,
According to Venture Intelligence, India’s First Venture Capital and PE Funds
Transaction Data Base disclosed that in the year 2015 nearly $17,300 million invested by
domestic and global PE/Venture Capital Companies in India. Consecutively in the next years
i.e.2016 $15600 million, 2017 $11300 million invested across various deals.
According to Grant Thornton, a tax and advisory firm report on private equity
investments in India indicated that by May 2017, $963 million of PE investment in 67 PE
deals materialized in the country and majority of the deals in the real estate sector and contributed
40% of the PE investments. Where as in the last year May 2016, there were 74 PE deals
worth $587 million. PE fund invested in start- up sectors such as Enterprise Application,
Infrastructure, Travel, Logistics and Transport and Fintech Companies. Bain & Co, a leading
agency in PE and Venture Capital Investments reported that PE and Venture Capital Investments
in India increased 13% to $5 billion in the first quarter of 2017.
Some of the major deals in the quarter included Canada Pension Plan Investment
Board (CPPIB) and Caisse de Depot Quebec (CDPQ) buying a 1.5% stake in Kotak
Mahindra Bank from Uday Kotak for Rs2,254 crore; Bharti Airtel Ltd selling a 10.3% stake
in its tower unit for about Rs6,193.9 crore to a consortium of investors that included KKR &
Co. and CPPIB; Apax Partners selling about a 48% stake in GlobalLogic Inc. to CPPIB,
among others.
Private Equity investors are investing in Distressed assets as well as adopting strategic
approach to invest their funds at a competitive price. PE investors are partnering with promoters
in the areas of expansion of the existing business,de-consolidation, go global etc., PE investors
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are concentrating in the sectors like health care, manufacturing, insurance and business process
outsourcing etc.,Predominantly private equity investments and funding agencies are using
financial instruments like debt, structured debt, equity and asset purchases.
12.10 PEER TO PEER LENDING (P2P)
P2P lending (a pure form of debt lending) is a form of crowd-funding used to raise
loans and paid back with interest. It can be defined as the use of an online platform that
matches lenders with borrowers to provide unsecured loans.
P2P lending is a form of lending, where an individual raises funds directly from another
individual or a group of individuals, at an interest rate, decided through mutual negotiation.
The new form of P2P lending is usually mediated through an online platform which acts as a
meeting point for the investor and the borrower.
As formal credit channels are not serving the sudden or unexpected financial needs
viz., medical emergencies, personal requirements of funds, P2P lending emerged as an innovative
mode of financing to the individuals with less documentation and paper work. In majority of
the cases after verification of the records and social network, as well as credibility assessment,
individuals can raise funds from various platforms.
The borrower can either be an individual or a legal person requiring a loan. The
interest rate may be set by the platform or agreement between the borrower and the lender.
Fees are paid to the platform by both the lender as well as the borrower. Borrowers pay an
origination fee — either a flat rate fee or as a percentage of the loan amount raised — according
to their risk category.
The lenders, depending on the terms of the platform, should pay administration and
additional fees if they choose to use any additional service for example, legal advice, which
the platform may provide. Unique feature of this avenue is both lenders and borrowers are
youngster with an average age group of 30 -35 years and employed in the IT and ITES sector
and digital savvy members. Loan purpose includes like business funding, financing car and
two wheelers, family events, house requirements, debt consolidation at individual level etc.,
P2P lending interface will come under the purview of RBI’s regulation by defining
these platforms as NBFCs under the RBI Act. These companies should maintain minimum
capital requirement of Rs.2 crores and they should not enter any lending activity directly. They
should only act as an online platform to bring lender and borrower together. It is also emerging
as a lucrative platform for financial inclusion, SME sectors etc., Examples of such platforms
are Faircent.com, Lendbox, i2iFunding, Zopa,
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Research Reports indicates that globally, P2P lending space is growing at a CAGR of
48% and is expected to reach $800 plus billion by 2024. Similar potential lies within the
Indian market which is expected to grow up to $5+ billion in the next 4-5 years.
12.11 INNOVATIVE CAPITAL MARKET INSTRUMENTS
Having discussed debentures including convertibles, let us have an idea of some financial
innovative instruments that entered the Indian capital market in recent years to suit the
requirements of investors.
i) Warrants
A warrant is a security issued by a company, granting its holder the right to purchase
a specified number of shares, at specified price, any time prior to an expirable date.
Warrants, also called sweeteners and they may be issued with either debentures or
equity shares. They clearly specify the number of shares entitled, the expiration date,
along with the stated/exercise price. The expiration date of warrants in USA is generally
5 to 10 years from the date of issue and the exercise prices is 10 to 30 percent above
the prevailing market price. Warrants have a secondary market. The minimum value
of a warrant represents the exchange value between the shares at current price and
the shares to be purchased at the exercise price. They have no flotation costs and
when they are exercised, the firm receives additional funds at a price lower than the
current market price, yet higher than those prevailing at the time of issue. Generally,
new/growing firms and venture capitalists issue warrants. They are also issued during
mergers and acquisitions. Warrants have been issued by a few Indian companies
since 1993. Debentures issued with warrants, say convertible debentures, carry
lower coupon rates.
ii) Bond
Bond is not defined under Companies Act, 1956, but according to Section 2(5) of
the Indian Stamp Act, 1989, bond includes any instrument attested by a witness and
not payable to order or bearer whereby a person obliges himself to pay money to
another.
Bond can also be issued with or without warrants. Bond may be attached with a
detachable warrant which entitles the holder to buy more bonds of the company with
certain concessions. Some companies issue high yield bonds which have high interest
rates and are issued by lower credit rated companies. Bonds may also be issued
with buyback option.
215
iii) Inflation Bonds
Inflation bonds are the bonds in which interest rate is adjusted for the inflation rate.
Thus, the investor gets an interest rate, free from the effects of inflation. These types
of bonds are more in use in countries like US. These bonds are called inflation bonds
or inflation protection bonds giving a fixed rate of interest after making allowance for
inflation. For example, if the interest rate is 10 per cent and the inflation is 6 percent,
the investor will earn 16 per cent meaning thereby that the investor is insulated against
inflation.
iv) Floating Rate Bonds or Notes
Floating rate bond as the name suggests is a bond where the interest is not fixed and
is allowed to float depending upon the market conditions. This is an ideal instrument
which can be resorted by the issuers to hedge themselves against the volatility in the
interest rates.
v) Government Guaranteed Bonds
These are medium to long term debt instruments issued by Government agencies and
Public Sector undertakings owned by Central or State Government. The repayment
of principal and payment of interest is guaranteed by Government. Such bonds have
been issued by various electricity boards, power Corporations, Road Transport
corporations and state owned utility services.
vi) Zero Interest Bonds
These were introduced in Indian markets in early nineties. The debentures or bonds
are convertible into equity shares after a certain period but no interest is payable till
such conversion. Since no interest is payable maturity when it is converted equity,
company is able to service the equity in a better position. The investors are rewarded
by way of a low premium on conversion. This instrument has been used by very few
and provides a tax shield to the investor. The benefit accrues to the investor by way
of lower premium paid for acquisition of shares. This instrument can also be used for
managing cash flows.
vii) Zero Interest Fully Convertible Debentures/Bonds
These are fully convertible debentures which do not carry any interest. The debentures
are compulsorily and automatically converted after a specified period of time and the
holders thereof are entitled to equity shares of the company at a pre-determined
price.
216
viii) Deep Discount Bonds (DDB)
These bonds are sold at a discounted value on maturity, face value is paid to the
investors. Recently, deep discount bonds were issued by IDBI with a maturity of 25
years at Rs.2,700 with a maturity value of Rs.1Lac. Subsequently, happy return
bonds were issued by SIDBI for Rs.2,500 with face value of Rs.1 lac payable at
maturity after 25 years. These are negotiable instruments transferable by endorsement
and delivery by the transferor. Institutions like ICICI, IDBI and IFCI have issued
such bonds several times (for example, family bonds, liquid bonds, flexi bonds, etc.)
ix) Secured Premium Notes (SPN)
This instrument frees the firm from debut servicing costs in the first three years. Investors
are repaid the principal in four equal instalments between the fourth and seventh
years, with the option of taking their returns as either interest or redemption premium.
Besides, investors are given a warrant entitling them to buy the company’s share one
year after the allotment of SPNs.
x) Euro Convertible Bonds (ECB)
Euro convertible bonds are quasi-debt securities (unsecured) which can be converted
into depository receipts or local shares. They are targeted at non-US investors. In
the past, Reliance and Siterlite Industries have given investors an option of converting
their ECBs into global depository receipts(GDR) as it is at no cost to the company
(The Depository makes money on trading in GDRs). ECBs offer the investor an
investor an option to convert the bond into equity at a fixed price after a minimum
lock in period. The exchange rate for the conversion price is fixed as is the conversion
price. Investors are offered a put option, which allows him to get his money back
before maturity. A call option allows the company to force conversion if the market
price of the share exceeds a particular percentage of the conversion price.
xi) Bunny Bonds
A Bunny Bond is a debt instrument in which investors will not draw the interest but
reinvest in the firm with the same terms and conditions as the original issue. This is a
concept of US, where the issuer does not pay any interest and the outflows are
deferred to long-term future. It is similar to that of the cumulative debenture in the
Indian Context.
xii) Secured Premium Note
An instrument issued by TISCO Tata Iron and Steel Company Ltd. In the year 1992,
SPN is a new financing instrument in which the features embedded were: 217
a. The SPN is issued at a nominal value and does not carry any interest;
b. The SPN is redeemed by repayment in several installments at a premium
over the face value. The premium amount is distributed equally over the period
of maturity of the installment;
c. The SPN may carry a detachable warrant, which will give the holder the right
to claim allotment of one share for cash at a certain price. This right can be
exercised by the holder after a certain period from the date of allotment of
SPN;
d. The instrument is secured by a mortgage of all the immovable properties of
the company.
e. The instrument is suited for companies with good track record for highly
capital-intensive projects as there is no outgo on account of interest during
the gestation period of the project.
xiii) Pay In Kind Bonds
The returns on these bonds are specified in terms of physical quantity of a commodity,
such as one kg of sugar per annum on a Rs. 100 paid up bond. The arrangement
implies that the issuer would pay the subscribers an amount equal to the price of one
kg of sugar every year. An arrangement where returns are linked to price of sugar is
of immense value to sugar producing firm because of the positive correlation between
financial costs and revenues. When the sugar price is down and the revenue earned
by the firm is low, the financing charge would also be low. The subscribers to such
bonds benefit too. They are fully protected against rise in the prices of sugar. A family
consuming say 50 kgs of sugar per year can completely hedge its annual expenditure
on sugar by investing Rs. 5,000 in such sugar bonds.
Check Your Progress - 3
List out innovative Financial Instruments.
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12.12 SUMMARY
Finance is the life blood of business. Procuring funds is the primary task of an
organization. You will recall that we have listed out modern sources of finance begining from
leasing, an off-balance sheet method of financing assets and gradually moved to innovative
capital market instruments highlighting innovative instruments that entered the Indian Capital
Market in recent years.
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12.13 CHECK YOUR PROGRESS: MODEL ANSWERS
1. An affluent individual who provides capital for a business start-up usually in exchange
for convertible debt or ownership equity. Angel investment is relatively of a recent
origin in India howevwe, it took-off in a big way. For example, Mr. Ratan Tata in
collabration with University of Califonia established a venture capital fund with a
corpus of $100-$150 million to invest in start-ups.
2. Executives turned entrepreneurs launching ventures with modest personal funds. Most
of these ventures are funded with funds from own personal sources, credit cards,
handloans and mortgages. Sometimes Venture Capital firms chip in with their help.
The uniqueness of this method lies in the fact that founders raise money from venture
capital firms without launching any of their products in the market.
3. i) Leasing ii) Hire Purchase iii) Venture Capital iv) Private Equity v) Forfaiting vi)
Crowd Funding vii) Angel Investors viii) Bootstrapping ix) Private Equity Investments
x) Peer to peer Lending.
12.14 MODEL EXAMINATION QUESTIONS
I. Short Answer Questions
1. Define Financial Instrument?
2. List out benefits of Floating Rate Notes for both the investors and issuers.
3. How do you classify Financial Innovations?
4. Explain the process of Factoring?
5. What is Forfaiting?
II. Long Answer Questions
1. List out the new financial instruments recommended by Abid Hussain Committee.
2. The companies in India have issued more variety of new financial instruments than
suggested by the M J Pherwani Committee. Discuss
3. Small and Medium Enterprises can access finances through factoring services extended
by the specialized financial companies or commercial banks. Discuss
4. Discuss the factors that contributed to financial innovations and introduction of new
financial instruments by companies.
5. Discuss various new financial instruments an Indian company can float around the
globe to raise funds. (including equity and debt instruments)
219
III. Objective Type Questions
A.Multiple Choice Questions
i) The following instrument is not advised by the Abid Hussain Committee – development
of capital markets.
a. Equipref b. Floating Rate Notes
c. Commercial paper d. Clip and Strip Bonds
ii) The instrument is advised by both the committees but not found to be issued in the
capital market of India.
a. Convertible Debenture
b. Non-Voting Shares
c. Debenture with Warrant
d. Secured Premium Note
iii) The financial innovations are classifiable into:
a. Risk transferring Innovations
b. Liquidity Enhancing Innovations
c. Credit Generating Innovations
d. All the above
iv) M J Pherwani committee on introduction of new financial instrument in India has not
advised this instrument but issued by a company:
a. Non-voting Shares
b. Detachable Equity coupons/warrants
c. Secured Premium Note
d. Participating preference shares
v) Pick the odd man out from the instruments below:
a. Foreign Currency Convertible Debenture
b. Alpine Convertibles
c. Certificate of Deposit
d. American Depository Receipt
Answers: i–a ii – b iii – d iv – c v–c
B. Fill in the Blanks
i) The three waves dominated the international financial systems across the world are
……………………………., and …………………………………………
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ii) ………………… is nothing but unbundling and repacking of the lending and
borrowing characteristics to suit the day-to-day and modern financial requirements
of a firm.
iii) The financial innovations are classifiable into ……………… number of categories.
iv) A floating rate note is issued with a ……………………….. interest rate as a minimum
rate of interest.
v) A ……………………………………. is convertible into equity shares of a company
at the option of the holder.
Answers:
i) Disintermediation; Securitization and Sophistication of Risk Management
ii) Financial Innovation iii) Four
iv) Benchmark v) Convertible Debenture / preference share
C) Match the Following:
Sl. No. Particulars Sl. No .Particulars
i) Financial innovation a) This security has two parts – one equity and
the other preference equity
ii) Floating Rate Notes b) Interest on this security is accumulated and
paid at the date of maturity
iii) Commercial Paper c) The interest on this security is payable at a
benchmark interest rate + the risk rate;
iv) Equipref d) The security is sold in the money market and
used for short term financial requirement of a
firm
v) Zero Coupon Bond e) nothing but unbundling and repacking of the
lending and borrowing characteristics
Answers: i – e ii – c iii – d iv – a v–b
12.15. GLOSSARY
1. Disintermediation : the firms accessing capital directly from the capital market
without the intermediation of banks;
2. Intermediation : the banks acting as intermediaries enabling savers to
deposit their money and lend for investments in the
corporate 221
3. Option : Option is a right but not an obligation to the holder either
to buy or sell;
4. Call Option : Option to buy;
5. Put Option : Option to Sell;
6. Future : Futures are financial contracts obligating the buyer to
purchase an asset or the seller to sell an asset, such as a
physical commodity or a financial instrument, at a
predetermined future date and price.
7. OTCEI : Over the Counter Exchange of India
8 SEBI : Securities Exchange Board of India;
9. Non-Voting Equity : A share where the holder will have no voting rights;
10. Floating Rate Note : Interest on the debt security will be floating and will be
dependent on a benchmark interest rate;
11. Financial Innovation : A process of unbundling and repacking of the lending
and borrowing characteristics to suit the day-to-day and
modern requirements of the firm;
12. Warrants : Warrants are generally known as sweetener; it is an option
attached with a debt certificate for the holder to buy a
share of the company or any other security.
12.16. FURTHER READINGS
1. Marshall, J. F. and Bansal, V. K.: Financial Engineering: A Complete
Guide to Financial Innovation,
New York Institute of Finance
2. Walmsley, J. : New Financial Instruments,
Wiley Publications
3. Fabozzi, F.J. and Modgiliani, F : Capital Markets: Institutions and
Instruments, Pearson.
4. Bhole, L. M. and Mahakud, J. : Financial Institutions and Markets:
Structure, Growth and Innovations,
Mcgraw Hill Education, New Delhi.
5. Goetzmann, W. N. and : The Origins of Value: The Financial
Rouwenhorst, K. G. Innovations that Created Modern
Capital Markets, Pearson.
222
BLOCK – V : STOCK EXCHANGE AND
COMMODITY MARKET
Unit – 13 : STOCK EXCHANGE
Unit – 14 : COMMODITY MARKET
223
224
BLOCK – V STOCK EXCHANGE AND
COMMODITY MARKET
UNIT – 13 : STOCK EXCHANGE
Contents
13.0 Aims and Objectives
13.1 Introduction
13.2 Meaning and Definition
13.3 Functions of Stock Exchange
13.4 Services of Stock Exchange
13.5 Organization and Management
13.6 Membership
13.7 Investment and Speculation
13.8 Types of Speculators
13.9 Listing of Securities
13.10 Need for Listing of Securities
13.11 Advantages of Listing
13.12 Stock Market Reporting
13.13 Stock Exchange – Indices
13.13.1 Bombay Stock Exchange
13.13.2 National Stock Exchange
13.14 Important Terms Used in Stock Exchanges
13.15 Summary
13.16 Check your Progress: Model Answers
13.17 Model Examination Questions
13.18 Glossary
13.19 Further Readings
13.0 AIMS AND OBJECTIVES
The primary aim of this unit is to explain the meaning, functions, services of stock
exchange, listing procedure followed by an attempt to know the technology advancement and
225
its impact on the stock exchanges. An attempt is also made to make the reader understand the
construction of indexes on the stock exchanges.
After studying this Unit, you should be able to understand-
• the meaning of stock exchange
• functions and services of stock exchange
• organization and management of stock exchange
• investment Vs speculation
• types of speculators
• listing of securities and its procedure
• role of Securities Exchange Board of India (SEBI)
• types of Indices
• impact of technology advancement on the stock exchanges
13.1 INTRODUCTION
Companies issue securities from time to time to raise funds in order to meet their
financial requirements for modernization, expansion and diversification purposes. These
securities are issued or sold directly to the investors (both individuals as well as institutions) in
the primary market or new issue market. The primary market discharges the important function
of transfer of savings of individuals to the companies, the mutual funds and public sector
undertakings. While the secondary markets refers to the system for the subsequent sale and
purchase of securities and provide liquidity to the securities sold in the primary market. An
investor can apply and get allotted specified number of securities by the issuing company in
the primary market. However, once allotted, these securities can be thereafter be sold and
purchased in the secondary market only. The secondary market is represented by the stock
exchange.
The stock exchanges provide an organized market for the investors to trade in the
securities. In India the secondary market is represented by the stock exchange which is more
than hundred years old. The first stock exchange started the operations in Bombay, in 1875.
The secondary market in India got a big boost when the OTCEI (Over The Counter
Exchange of India) and National Stock Exchange (NSE) were established besides there is
one ICSE established by the fourteen regional stock exchanges.
In order to protect and safeguard the interest of the investors, the operations, the
functioning and working of stock exchanges and their members are supervised and regulated
226 by the Securities Contract Act, 1956 and SEBI Act, 1992.
13.2 MEANING AND DEFINITION
The Securities Contract (Regulation) Act, 1956 the term Stock Exchange has been
defined “As Association, Organisation or Body of Individuals, whether incorporated or not,
established for the purpose of assisting, regulating and controlling business in buying, selling
and dealing in securities”. Generally, a stock exchange plays a vital role of being an organized
institution in the financial market enabling trading of the securities like shares, debentures and
bonds. It enables the participants in the markets i.e., buyers and sellers of securities to exchange
cash with securities and vice-versa in the simple, cheap and fair manner. It is also called as a
second hand securities market where the securities once sold by the corporate get sold and
bought.
13.3 FUNCTIONS OF STOCK EXCHANGE
The following are the important functions of stock exchange:
1. A stock exchange provides continuous market for the sale and purchase of securities.
It will work as means of converting locked up capital in securities into ready cash by
selling them. It provides a network or / and a meeting place for buyers and sellers or
their representatives creating conditions of ready martketability.
2. Prices of securities are determined by the market forces, supply and demand, through
stock exchange on a continuous basis. Such prices will be normally based on the
perceptions or expectations of the investors on the present and future income yielding
prospects of various companies. This function of price fixation is most important to
investors as it promotes healthy speculation in trading of securities. Further the prices
at which transactions take place are recorded and published in the form of market
quotations.
3. Since the working of stock exchange is regulated by the provisions of Securities
Contracts (Regulation) Act, equity and safety in dealings are assured. This is necessary
to promote and inculcate just and equitable principles of trade. Stock exchange,
through its set of rules, checks overtrading, illegitimate speculation and manipulations.
This would ultimately strengthen the investors confidence and stimulate the large
investment in corporate securities.
4. Stock exchange helps in mobilisation of savings of individuals, business firms and
corporations for investment securities. In this way, it facilitates capital formation and
assists the process of economic development. The surplus funds available with
individuals and institutions would not have found remunerative channels had there
been no stock exchange. Wide network of stock exchange operations promote
savings and investments. 227
5. The securities market facilitates the process of distribution of capital among different
plants, industries and regions. It channelizes the flow of funds into most productive
ventures because it checks the flow of capital when an industry or an enterprise
begins to show diminishing returns.
6. Stock exchange secures good public response even to the fresh issue of shares if
routed through it. Thus costs of underwriting of such issues are likely to be less.
7. The stock market is a barometer of business activity. The prices quoted for different
securities on the trading network of stock exchanges indicate their profitability. Funds
tend to be attracted by the companies of good standing and securities of losing concerns
attract no investors. Thus stock exchange always reflects the market conditions.
Husband and Dockeray stated that a stock exchange functions like a traffic signal,
indicating a green light when certain fields offer the necessary inducement to attract
capital and blazing a red light when the outlook for new investment is not-attractive.
8. The changing economic health of a country is reflected in the operations that are
carried on in the securities exchanges. Booms and depressions find their echoes in
the dealings on the trading networks of stock exchanges.
9. Stock exchanges frame their rules and regulations. Any company, which wants to get
its securities listed, has to comply with these rules and regulations. Thus, stock
exchanges exercise a healthy influence on the working and management of companies.
13.4 SERVICES OF STOCK EXCHANGE
The above listed functions of stock exchange reveal that its operations are beneficial
to the community, investors and also to companies. The following are a few such services:
a) Service to Community
i) It inculcates savings habit among the people and helps in capital formation in the
country. Thus it is an important intermediary promoting the economic development
of the country. The enormous increase in industrial activity in the country would not
have been possible but for the important part played by the stock exchanges.
ii) Stock exchanges continuously publicise the prices of all the listed securities through
notifications and circular letters. This will enable the investors to make comparative
study of the enterprises and decide to invest only in high yielding securities. In this
way stock exchange is instrumental in allocating financial resources of the community
among the companies of good prospects.
iii) Stock exchange indicates the various avenues of investments for the individuals with
savings. It motivates the investors to further invest their earnings in the securities viz.,
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dividends and interest in the shares and debentures of new companies. This process
of investment and reinvestment of earnings lead to capital formation. Edward Meeker
graphically expressed this aspect in the following manner. Silently day after day,
week after week, year after year this great flow of capital through the stock exchange
into industry and the ebb of dividends, interest and profits (or losses) back from
industry to the public, goes on’.
iv) Since stock exchange engages in continuous mobilisation, allocation of savings of the
community and publication of prices of securities of various companies, it portrays
the prevailing economic situation in the country.
b) Service to Investors
Stock exchanges work like investment guides to the people with savings. It always
keeps up the confidence of investors in securities by providing price information. The
following are a few benefits that accrue to investors due to stock exchange:
i) Liquidity of investments in securities is preserved by securities market as it brings
buyers and sellers together continuously. The sellers of securities will get buyers
through the trading network of stock exchange whenever they want to withdraw their
investment.
ii) The securities of listed companies will have negotiability. As such, for temporary
accommodation, any investor can pledge his security holdings with some banks and
raise funds. Thus short-term needs can also be met with the help of listed securities.
iii) Purchase of listed securities of stock exchange by anybody is less risky. The brokers
who deal in listed securities are duly registered and approved by the SEBI. Therefore
investors develop confidence in their choice of investment.
iv) Daily price quotations of listed securities are notified by stock exchange to its members
and general public. This helps the investors to assess the value of the investment.
v) Constant observation and study of published price quotations of listed securities even
by the people with little interest in investment may slowly develop a liking for the
dealings on stock exchange. In this process such persons ultimately become potential
investors in corporate securities.
vi) Guidance to the investors regarding the choice of securities to be purchased is
provided by the pattern of transactions that take place in stock exchange.
vii) Undue fluctuations in prices of listed securities are avoided by balancing operations of
speculators and-hedgers.
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c) Service to Companies
As companies have to essentially raise capital through stock exchanges, they are
entitled to various benefits. The following are a few of such facilities.
i) The creditworthiness and goodwill of the corporation will be enhanced when its
securities are listed on stock exchange. This will enable the companies to secure
wide investor base to the issue of their securities.
ii) Market for the listed securities is expanded once they are quoted in stock exchange.
This will increase the demand for the shares of listed companies consequent to which
reputation will also be built up. Further, wide dispersal of shareholders over the
length and breadth of the country is beneficial to the management of companies because
there is a little scope for the not-so serious investors to come together as a group
building up opposition.
iii) A company which gets itself admitted into stock exchange and its shares listed will be
able to command better response from the investors than a non-listed company.
Such company is considered as a sound and a genuinely widely held company with
reference to shareholding.
iv) The market price of listed shares tends to be higher in relation to earnings, reserves
and dividends because of their easy marketability and attractiveness. This would
enhance the financial status and increase its bargaining power in collective ventures,
mergers, etc.
v) Companies that intend to raise capital through public issue have to get their shares
listed on exchange as per the regulations of SEBI. Thus, stock exchanges regulate
the price fluctuations of listed securities. Therefore, the listed securities on such stock
markets always maintain confidence of its investors and others who deal with it.
Check Your Progress –1
i) Define Stock Exchange.
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ii) What are the functions of Stock Exchange?
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13.5 ORGANISATION AND MANAGEMENT
As per the Securities Contract (Regulation) Act, 1956 a stock exchange is a body of
individual, whether incorporated or not. Therefore it is managed by the governing board or
executive committee or council of management. The members of this body are elected from
among the members of the concerned stock exchange. In the day to day management the
governing board is assisted by a number of committees; such as listing committee, arbitration
committee, discipline committee; admission committee; etc. The governing board is empowered
to make rules and regulations in consultation with the government and the members of stock
exchange.
13.6 MEMBERSHIP
Only the members of the stock exchange can have direct access to the trading network.
A non member can buy or sell securities through a member. In order to become a member, a
person must have sound financial position and sufficient experience in this field. A qualified
person who is willing to become a member is required to pay entrance fee, membership
deposit and annual subscription.
A person to be elected as a member must satisfy certain criterion. They are:
1. He / she should be an Indian Citizen;
2. He / she should be of at least 21 years of age;
3. He / she should not have been adjudged bankrupt / insolvent;
4. He / she should not be engaged in any other business or employment;
Members of stock exchange can be either a broker or a jobber. Any member can act
as a broker or both but not simultaneously;
Brokers
Brokers are the registered members of the stock exchange licensed to trade on
behalf of investors – either to buy or sell securities on behalf of the shareholders. There are
laid down rules enabling the broker to charge on the trading of securities.
Jobbers
A member of the stock exchange who buys and sells securities on his own behalf.
Generally a jobber is a dealer in securities and usually specialises in one type of security. On
the Bombay Stock Exchange a jobber is also known as tarawaniwala. He is not prohibited
from the buying and selling of shares on behalf of others.
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Broker Vs. Jobber
Broker Jobber
Broker is an agent who buys and sells Jobber is a dealer in securities who buys
securities on behalf of others and sells for himself
Indulges in buying and selling all types Specialises in certain types of securities
of securities
He is a middleman between buyer and He can be a middleman if he trades for
seller others but generally will buy or sell for
himself – not a middleman
He receives brokerage for his services He receives profit or suffers loss depending
on market conditions
13.7 INVESTMENT AND SPECULATION
The terms investment and speculation overlap and are used interchangeably. However,
both are quite different. In speculation there is an investment of funds with an expectation of
some return of capital gains in a short period of time resulting from the price changes. Generally,
the speculators make money in short period of time with high risk. The speculators who trade
daily buy/sell the shares in the morning and sell/buy them in the evening to see that there is no
delivery either received or given. Whereas, in the case of investment the investor puts in the
money with an intention to hold the securities for a long period of time to have long term gains
and periodical income (dividends) with less risk.
13.8 TYPES OF SPECULATORS
At a particular moment of time, for particular securities, some speculators may foresee
a rise in prices and some may expect a fall for the same type of securities. Depending upon the
nature of behaviour, speculators are classified into Bulls, Bears, Stags and Lame Duck.
Bull: A bull is a speculator who expects a rise in prices of shares in future. Bulls have an
optimistic opinion on the shares picked up and therefore, buy the securities to sell in future at
a higher price and make money. In India they are also known as tejiwala.
Bear: A bear is again a speculator expecting a fall in the prices of shares in future. Bears sell
the shares to acquire them back at a lower price in future. In India these bears are known as
“mandiwala”.
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Bulls Vs. Bears
Bulls Bears
The bulls spread a bullish trend for shares The bears spread a bearish trend for shares
i.e., increase in prices of shares in future i.e., decrease in prices of shares in future
The bulls advise the investors to buy or The bears advise the investors to sell or we
we can match them with buy side analysts can match them with sell side analysts
The activities of bulls improve and The activities of bulls dent and decrease the
increase the brand image of the company brand image of the company and value of
shares and value of shares
He is described as bull – because he Bears are compared as such – because bears
pushes up prices like a bull push down prices
Bulls are also recognised as “Tejiwala” Bears are also known as “Mandiwala” in .
in India India.
Stag: A stag is an applicant of new issue, who applies with a view to resell the allotted shares
at a premium on the day of listing. He subscribes to a good number of shares of the issue
expecting that these bulk offers will push the prices upwards at which he can sell them later to
make a good profit.
Lame Duck: A member of stock exchange who is unsuccessful with his speculation and
thereby fails to meet his obligations.
13.9 LISTING OF SECURITIES
Listing of corporate securities constitutes and integral part of the machinery to stock
exchange. It is to be noted that stock exchanges do not deal in all the securities of all the
corporations. It will deal in the securities of those corporations which are included in its official
trade list. On the application of the companies the stock exchange will consider whether their
shares can be allowed to be bought or sold through the stock exchange. The stock exchange
operations are regulated by the provisions of Securities Contracts (Regulation) Act and
Securities Exchange Board of India keeps a close watch on the trends of stock markets and
issues guidelines from time to time. Hence, to know the protective measures offered to investors,
a study of the above is essential.
Listing of securities may be defined as the “admission of securities in the
official list of stock exchange for the purpose of trading”. It is believed that dealing in
securities by their way nature are susceptible to undesirable practices by vested interests.
Further they cause erratic fluctuation in the prices of securities. Therefore, stock exchanges 233
should ensure that only those securities which can meet certain prescribed standards of legality
and security are listed in its official lists for trading. In other words, the stock exchange offers
an open market for listed securities where buyers and sellers meet together through their
agents viz., brokers on terms of equality. This will lead to the creation of competitive market
conditions. The business transacted in stock exchanges is subject to a well-designed code of
bye-laws and regulations. Further, wide publicity is also given to each and every transaction.
They will keep the investors informed about the legality and solvency of the company. Listing,
therefore, creates a favourable impression in the minds of investors. Thus, main purpose of
listing of securities is to safeguard the investors, companies and general public.
Listing will also improve the marketability, negotiability, and liquidity to the securities.
It may be pointed out that stock exchanges neither sponsor the listed securities nor do
they guarantee the investment value. But listing ensures the development of higher standards
of corporate practice and procedure. However, price determination and estimation of
investment value involve constant scrutiny and assessment of each company from the business,
financial, legal and technical points of view which are the basic requirements for investment
decisions taken by the prospective investors.
The conditions for inclusion in the trading list are:
a. There must be adequate public participation in the companies i.e. 49% of the share
capital must be held by large number of shareholders;
b. Securities should be fully paid up equity shares of a company other than a banking
company;
c. These securities should not have been included in the cleared securities list of any
other stock exchange;
13.10 NEED FOR LISTING OF SECURITIES
Listing of security can be understood as the approved list of companies
whose securities are allowed to be transacted on the floor of stock exchanges. In
other words, the shares of all companies cannot be traded in the stock exchange.
Stock exchanges generally provide the financial information of the companies, the market
trend analysis of shares etc. to the members. Unless the companies whose shares are proposed
to be traded are recognised by the exchange, the financial information etc., cannot be collected
and analysed. A close watch on the activities of the companies could be effective only when
the companies in question agree for it.
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13.11 ADVANTAGES OF LISTING
Listing arrangement is made to serve the dual purpose of ensuring stability of prices of
securities and also to supply adequate information so as to judge the merits of the securities
traded on the stock exchange. The advantages of listing can be classified into-
i. Advantages to investors;
ii. Advantages to companies; and
iii. Advantages to general public.
1. Advantages to Investors
The following advantages accrue to the investors an account of listing of securities:
a. The listing of securities will make the investor to believe that the issue of securities is
legal, the company is legally incorporated and it is financially solvent;
b. It protects the investor against unreasonable commission and low standards of business
practices;
c. The securities are subject to much narrower fluctuations as compared to the unlisted
ones;
d. It helps to evaluate the holding of investor in a proper and fair manner as he receives
constant quotations as to the value of the securities;
e. It imparts liquidity to the investors as they can sell the securities whenever they require
cash;
f. It is also advantageous in the matter of assessment of income-tax, wealth tax, estate
duty and other taxes payable by the shareholders;
g. Since the listed securities are rated high in market quotations they are preferred as
collateral securities by banks for lending money to their holdings.
2. Advantages to Companies
The following are some of the important advantages -
a. Free dealing and public ownership of shareholders qualify the companies for substantial
tax relief;
b. Listing confers on the company a higher status which contributes to the expansion of
its activities and helps its growth by facilitating future financing and gaining wider
public support in the sale of company’s products;
c. Listed securities are generally preferred for investment as they command a much
higher value in the market;
235
d. Several tax advantages also accrue to the companies as it helps assessing the income
tax, wealth tax, and other taxes payable by the shareholders and assessees;
3. Advantages to General Public
Listing of securities safeguards the interest of the general public also in the following manner:
a. It enforces timely disclosure of corporate information relating to dividends, bonus
shares, new issues of capital, etc.
b. It insists upon giving due notice in advance of closure of transfer books and or record
redemption and payment dates;
c. It provides reasonable facilities for transfer, registration of rights, and for fair and
equitable allotment.
On account of the above numerous advantages, Hasting remarked that “ a listed
security will receive more attention from investment advisory services than an unlisted one”.
Therefore listed securities help the investors, companies and general public consequent to
which the sound investment opportunities in the economy will improve.
13.12 STOCK MARKET REPORTING
Activity in the stock market is reported in various media. These include, daily
newspapers, business periodicals, radio, television news, and channels specifically devoted
towards the business, and are published in financial dailies The Economic Times, Financial
Express, Business Standard, The Hindu – Business Line, Mint, etc. on the following day. A
detailed report may be obtained from the daily official quotation list of the Bombay Stock
Exchange, or National Stock Exchange.
13.13 STOCK EXCHANGE – INDICES
A stock index or stock market index is a measurement of the value of a section of
the stock market. It is computed from the prices of selected stocks (typically a weighted
average). It is a tool used by investors and financial managers to describe the market, and to
compare the return on specific investments. Stock market indices are a measure of market
sentiment. They reflect the general feeling of investors for a category rather than for a single
company.
13.13.1 Bombay Stock Exchange
BSE Sensex comprises of 30 companies that are well established and financially
sound companies representing the Indian Economy and its industrial development. These
companies are well established and the market capitalization weighted index and is widely
reported in both domestic and international print and electronic media. This BSE Sensex is
236
widely used to measure the performance of India’s stock markets and is a benchmark of the
Indian capital market. The Sensex serves the following objectives:
a. Sensex is widely used to understand the movement of the stocks in the market and
also the moods in the stock markets of the players. Sensex reflects movements of
market (trends) i.e. rises and dips on the basis of participants’ purchases and sales of
securities.
b. The managers of mutual funds and asset management companies use it as benchmark
to judge the performance of investments made by them. Therefore, it can be called as
benchmark for funds and their performance.
c. In fact, all the participants in the market from the petty small investor to the money
managers across the market for specific purposes.
d. The analysts make an attempt to take various factors like “Market Capitalisation of
the Scrip”, “Industry Representation”, “Liquidity and Regularity of Trading of Scrip”,
“Number of Trades” and “Volume of Trade” to compare and contrast with various
bench-marks in order to advise either to sell or buy a share.
e. The Sensex is reconstituted periodically in order to represent the true face of Indian
economy. The companies in the Sensex and their weights are revised periodically.
Therefore the readers are advised to get the latest position from the website of the
BSE.
13.13.2 National Stock Exchange
To give boost to the overall development and an alternative index to the BSE Sensex
National Stock Exchange is developed. NSE Nifty is a flagship index of the newly established
National Stock Exchange. The Nifty’s primary index to enable the world read and analyse the
development of Indian economy is been built with fifty companies weighted index called “Nifty
Fifty”. These stocks represent more than 50 per cent of the traded values of all stocks on the
NSE. Nifty is also useful in the following ways:
a. Similar to that of the BSE Sensex – Nifty Fifty also enable investors to understand
and analyse the movement of Industry and Indian Economy to further judge in investing
in various sectors.
b. All the investors including institutional investors and retail investors can follow and
track the index in making decision either to hold, sell or buy the securities;
c. The shareholders and stakeholders of the companies can evaluate the boards of
management in various companies; 237
d. Mutual Funds and Asset Management Companies have started creating market based
“Exchange Traded Funds” on the basis of indices of NSE.
e. The Nifty Indices also can be used to evaluate the performance of mutual funds and
benchmark;
f. Nifty is also helpful in enabling and decision making of trades in derivatives market.
13.14 IMPORTANT TERMS USED IN STOCK EXCHANGE
a) Ex-Dividend
The companies announce the dividend and announce a date on which whosoever
holds the shares will earn the dividend on the shares. If the shares are sold after that
date, the buyer will not be entitled to receive the dividend hence forth the seller of
shares will receive the dividend. The shares when sold ex-dividend, the right to receive
the dividend shall remain with the seller.
b) Cum-dividend
Cum-dividend means the buyer is going to get the right to get the dividend. When the
shares are bought cum dividend, the right to receive the dividend will be passed on to
the buyer from the seller. For example if a company pays a dividend on 30th April for
the shares sold by Mr.Ramana Murthy to Mr.Lakshman on the 30th March of that
year, the buyer Mr.Lakshman will be eligible to receive the dividends on the shares.
c) Spot Delivery
The securities sold by a member on the stock exchange will be delivered as per the T
+ 1 settlement procedure. In contrast there is a F&O market with price of the shares
fixed for the future with an option either to sell or buy i.e. put option and call option.
A contract which provides for the actual delivery of securities and payment of price
thereof as per the norms laid down in the trading system is known as trading in the
spot market.
d) Square Off
There are some speculators in the market and trade on the same share by buying in
the morning and selling in the evening before the close of the market or vice-versa.
These traders are known as speculators and they do not take the delivery of make
one. They only square off by the end of the day. Example: Mr. Speculator buys the
shares of a company at Rs. 165 in the morning and sells at Rs. 168 in the evening will
receive the money that earned after deducting the brokerage charges.
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e) Forward Delivery
A forward delivery contract is one which has to be settled on the fixed settlement
date. The settlements in such contracts are usually made once a month. Such contracts
are allowed only in cleared securities which are settled through the clearing house.
Forward delivery contracts are generally made for speculative purposes. Therefore
the settlements are made by payment of difference in purchase and sale prices. In
very few cases, actually delivery of securities is made. Such contracts may be postponed
or carried over to the next settlement day.
f) Group A Shares
These are the listed equity shares of large and well established companies having
broad investor base. These shares are actively traded and for these shares the facility
for carrying forward a transaction from one accounting period to another is available.
Naturally, these attract a lot of speculative multiples. These facilities are not available
for group B shares. However, shares can be moved from Group B to Group A and
vice versa depending on criteria for shifting. For instance the Bombay Stock Exchange
has laid down several criteria for shifting shares from Group B to Group A; such as,
an equity base of Rs.10 crores, a market capitalisation of Rs.25-30 crores, a public
holding of 35 to 40 percent, a shareholding population of 15,000 to 20,000, good
dividend paying status,etc.
g) Group B Shares
These are those listed shares which do not follow the criteria prescribed for Group A
shares, Group B shares are again divided into B1 and B shares on BSE B1 shares
represent well traded scrips among B group and they have weekly settlements.
h) Group C Shares
Under Group C only odd lots and permitted securities are included. A number of
shares that are less than the market lot are called odd lots. Market lot refers to the
minimum number of shares of a particular security that must be transacted on a stock
exchange. Odd lots have settlement once in a fortnights or once on Saturdays.
Permitted securities are those that are not listed on a stock exchange but are listed on
other exchanges in India. So they are permitted to be traded on BSE. Odd lots
cannot be easily transacted on the stock exchange and so they are illiquid in nature.
i) Arbitrage
Arbitrage is undertaken to make a profit out of differences in prices of a security in
two different markets. It is a highly skilled speculative activity. If the prices of a
security differ substantially in the two stock markets, the speculator purchases the 239
security in the market where it is cheap and sells it at a profit in another market where
it is quoted high and thus makes huge profit. The speculator has to act very fast since
the prices are highly sensitive and they may get equalised within a short span of time.
j) Bad Delivery
A delivery of shares turns out to be bad if there is a company objection on Brokerage
means the commission charged by a broker for purchase or sale of securities done
through him. The maximum brokerage as stipulated by SEBI is at present 2.5% of
the trade value.
k) BOLT
Bombay Stock Exchange has introduced BOLT, That is, BSE – On – Line – Trading
– System for listed securities. Trading is order driven as quote driver system is
discontinued. For this purpose BSE classified the listed securities into 5 categories.
Viz. A,B1,B2,F,G and Z. Out of these A, B1 and B2 groups represent equity segment.
Group F represents securities which have fixed income. ‘G’ group represents
Government Securities whereas ‘Z’ represents those companies which failed to comply
with listing norms or failed to redress investors’ complaints or failed to comply with
depository requirements. Trading of securities of listed companies of other exchanges
is also permitted and these securities are categorised in ‘Permitted Securities’.
l) Insider Trading
It means trading in a company’s shares by a person who is associated with that
company. As a result of his association he has a secret price sensitive information
about the company such as expansion plans, financial results, takeover bid, bonus or
right issue etc. He tries to exploit that information and maximise his profit through
trading in the scrip of that company. It is a crime and hence prohibited by stock
exchanges.
m) Market Lot
Market lot refers to the minimum number of shares of a particular security that must
be transacted on the exchange. Market lot may be 10 shares, 20 shares, 50 shares
or 100 shares. Multiples of the market lot may also be transacted. In demat scrips
the market lot is 1 share.
n) Settlement
It refers to the scrip-wise netting of trades by a broker after the trading period is over.
240
13.15 SUMMARY
Stock Exchanges are the secondary market for the securities issued by the corporate
in the primary market. The stock exchanges are bodies established either incorporated or not
by the individuals. In nut shell one can conclude by saying that the stock exchanges provide
liquidity to the securities in the secondary market. The members like brokers, jobbers’ etc.
help the investors sell and buy the securities in the market and keep the track through the rules
and regulations of the stock exchanges. The stock exchanges are also governed by the various
rules and regulations and have to adhere to the laws laid down under the Securities Contracts
(Regulation) Act, 1956. Performance of shares in the stock exchanges is also viewed by the
members across the world as a barometer for the performance of the Indian Economy.
Securities Exchange Board of India regulates the participants in the stock exchange by laying
the guidelines for the participants and not allowing any participant earn abnormal gains.
13.16 CHECK YOUR PROGRESS: MODEL ANSWERS
1. Features of Stock Exchange: providing liquidity to the investors; enable formation of
capital in the economy; it is a barometer of a country’s economic situation and reflects
industrial development of the country; attracts foreign portfolio investments from
investors abroad; brings transparency and improves disclosure practices of companies;
efficiency of price discovery of the security by increasing the number of players;
2. Various services are provided by the stock exchange to the corporate, investors and
to the economy. They are
1. stock exchange is the gate way for the issue of securities by the company;
2. efficient price discovery of the securities issued by the corporate by bringing
large number of traders on to one platform;
3. enforces transparency in the corporate for better disclosure practices;
4. enables savings to be channelized into productive purposes; and
5. it also enables to evaluate the progress in the industrial development by acting
as a barometer of the economy.
3. Go for initial listing before offer of securities to the public by paying initial listing fee;
after that final listing of securities by entering into a listing agreement with stock
exchange; the third step is to enlist or register and place on record the securities for
trading by members of stock exchange; and continue to remain listed on the stock
exchange.
4. T + 1 – settlement means – the process of exchange of securities for money is completed
in one day. For example if the security is purchased on Monday the money has to be 241
paid buy the buyer and security has to be transferred by evening to settle it within one
day after the transaction. All these things are feasible and possible because the shares
are held in the dematerialised form. Dematerialised means the shares are given to the
public in an account like a bank account. Physical shares are not transferred.
13.17 MODEL EXAMINATION QUESTIONS
I. Short Answer Questions
1. Define Stock exchange.
2. List out three functions of a stock exchange
3. List out two primary indexes of stock exchange.
4. Discuss three primary functions of a stock exchange.
5. Discuss the importance of SEBI.
6. Explain the terms:
a. Bears
b. Bulls
c. T + 1 Settlements
d. Floor Trading vs. digital trading;
II. Long Answer Questions
1. Discuss the functions of a stock exchange and evaluate the role of SEBI.
2. A Stock Exchange is a barometer of the progress of an economy. Discuss.
3. A Stock exchange is a gambling den and therefore not a place to invest. Discuss.
4. Discuss the important functions of stock exchange in providing liquidity in the secondary
markets.
5. Bears and Bulls speculate whereas the jobbers and brokers improve investments –
do you agree? If yes / no substantiate.
6. List out the services of stock exchanges to the corporate, investors and the economy.
III. Objective Type Questions
A. Multiple Choice Questions
i. A market where new securities are bought and sold for the first time is known as a
__________ market.
a. Primary b. Secondary
c. Tertiary d. Money Market
242
ii. One who trades on his behalf and on behalf of the clients in the stock exchange is
known as:
a. Broker
b. Jobber
c. Tarawaniwala
d. Bull
iii. A market for existing (used) securities, such as the BSE or NSE, rather than new
issues is known as the __________ market.
a. Primary
b. Secondary
c. Tertiary
d. Debt market
iv. One who expects quick profits in a short period with big risk
a. Investors
b. Speculator
c. Manufacturing Company
d. SEBI
v. Which securities law(s) is (are) involved with state laws regulating the offering and
sale of securities?
a. Transfer of Property Act
b. Stamp Duty Act
c. Securities Contracts (Regulation) Act
d. Bailment Act
Answers: i) a ii) c iii) b iv) b v) c
B. Fill in the Blanks
1. The secondary market is represented by ……………………………….
2. The Companies sell the securities (equity / debenture) to the investors in the
…………… (Primary / Secondary) market.
3. …………………… protects and safeguards the interest of the investors and the
working of stock exchanges.
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4. Only …………………………….. of a stock exchange can trade in stock market.
5. …………………….. is a member of stock exchange who fails to meet his obligations
because of unsuccessful speculation.
Answers: 1. Stock Exchange 2. Primary Market 3. SEBI 4. Members
5. Lame Duck
C. Match the Following
i) Bear a) Expects the prices of shares to go upwards
ii) Bull b) Index
iii) Remesiers c) Expects the prices of shares to go downwards
iv) Stag d) Non-member
v) NSE – Nifty Fifty e) Invests in IPO expecting the share prices to be
higher at the time of Listing
Answers: i–c ii – a iii – d iv – e v–b
13.18 GLOSSARY
1 Capital Formation : Channelising of savings for investment into productive
purposes
2. Liquidity : Cash availability in the business and capable of easy
conversion into cash
3. Negotiable : Transferability from one person to another of
securities
4. Solvency : Ability to pay all the debts;
5 Stock Exchange : A market for purchase and sale of securities issued
primarily by the companies;
6. Primary Market : A market where the companies issue shares /
debenture for the first time for the investors;
7. Secondary market : A market where an investor who holds the securities
issued by the company will sell;
8 Bull : A speculator who expects prices to rise in near future;
9. Bear : A speculator who expects prices to fall in near future
10. Lame Duck : A speculator struggling to meet his commitment;
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11 Tarawaniwala : Member of a stock exchange who trades on their
own account as well as act as commission agents on
behalf of clients;
12. Speculation : A risky investment of money for the sake of earning
profits
13.19 FURTHER READINGS
1. Avadhani, V. A. : Investment and Securities Market in
India
Himalaya Publishing House, Bombay.
2. Kulkarni, P. V. : Financial Management
Himalaya Publishing House, Bombay
3. Rustagi, R. P. : Financial Management
Galgotia Publishing Co., New Delhi
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UNIT -14: COMMODITY MARKET
Contents
14.0 Aims and Objectives
14.1 Introduction
14.2 Definition of Commodity
14.3 Types of Commodities
14.4 History and Evolution of Commodities Market
14.5 Price Discovery Mechanism at Commodities Market
14.6 Indian Commodities Market
14.6.1 Features of Spot Markets
14.6.2 Risks in Commodity Markets
14.6.3 Effects of Commodity Risk
14.7 Commodity Derivatives Defined
14.8 Features of derivatives
14.9 Economic Functions of Commodity Derivatives Markets
14.10 Existing System
14.11 Indian Commodity Market’s Potential
14.12 Summary
14.13 Check your Progress: Model Answers
14.14 Model Examination Questions
14.15 Glossary
14.16 Further Readings
14.0 AIMS AND OBJECTIVES
The primary aim of this unit is to make the reader appreciate and understand the
developments in the commodities spot market and commodities derivatives market in India.
After going through this unit you should be able to understand
246 • What is a Commodity?
• What is a Commodities Market?
• What is a Commodities Spot Market and Commodities Derivatives Market?
• What is the existing system that is enabling improvements in the spot and
derivatives markets?
• What is Multi-Commodities Exchange? and
• What is the role of SEBI – in regulating the Commodities Markets?
14.1 INTRODUCTION
Commodity is exchanged in the market on the spot and physically. Commodity markets
were different from a stock exchange in the past. Over a period of time the Commodity
Markets have also evolved like that of a stock exchange and trading of securities where the
derivatives of the commodities like futures, options, etc. are traded. These securities are
created on the basis of the commodities and markets exist across the country of commodities
as Spot Market and Futures Market. Every commodity produced or grown finally must be
brought to the place where it can be bought and sold (traded). It is in this marketplace that all
the elements of commerce will come together to settle a price at which the commodity will be
traded.
14.2 DEFINITION OF ‘COMMODITY’
A commodity is an economic good, tradable good, product or article of commerce;
something for which there is an established market where the commodity can be bought and
sold in commercial transactions between the willing buyers and sellers. Commodity refers to
any good that possesses a physical attribute. The word commodity comes from the French
word “Commodite”, which is used to refer to an object of utility that offers some convenience
or useful service.One of the important characteristics of a commodity is that its price is
determined as a functionof its market as a whole. So a commodity is understood to mean a
good that has the following properties:
• Is usually produced and/or sold by many different producers
• Is uniform in quality between producers that produce and sell it.
• Is traded at a price resulting from its demand and supply.
‘Commodity’ is a thing possessing a value and uniform in quality generally
mined or cultivated or produced in large amount of quantity by variety of producers.
This definition, any physical substance, like pepper or aluminium, which is interchangeable
with another product of the same type, is a commodity. Commodities are frequently used as
inputs in the production of other goods or services. They are the basic goods used in commerce
247
that is interchangeable with other commodities of the same type, so that even though the
quality of a given commodity may be at variance slightly, it is effectively uniform across
producers.
14.3 TYPES OF COMMODITIES
Commodities can be perishable or non–perishable. Metal Products are generally not
perishable. Commodities also known as hard commodities are typically natural resources that
are mined or extracted like gold, rubber, oil, etc.Agricultural Produce is known as soft
commodities as the products are perishable over a period of time and these commodities are
agricultural products or livestock like corn, wheat, coffee, sugar, soybeans, etc.
Agricultural Industrial Precious Energy
Commodities Metals Metals
Oil and Oil Seeds Copper Gold Crude Oil
Cereals, Spices and Nickel Silver Natural Gas
Pulses
Plantations and Zinc and Platinum Furnace Oil
Fibers Aluminum
Potato, Sugar Palladium and Lead - Aviation Turbine Fuel
(ATF)
Livestock Tin, Steel and Iron - Power
14.4 HISTORY AND EVOLUTION OF COMMODITIES
MARKET
Commodity Markets have existed for centuries around the world because producers
and buyers of good products and other items have always needed a common place to trade.
Though the place of trade and many of the detailed mechanisms have changed, the basics of
commodity trading remain the same. The trading of commodities in commodity markets consists
of direct physical trading (spot trading) and derivatives trading. A market in which goods are
sold for cash and delivered immediately is called the physical market.
One needs to understand and keep in mind that in India, for long, the futures markets
and trading in forwards and futures have been a subject of the central government and the
spot or physical markets and spot trading have been a subject of the state governments
across the country.
The Bombay Cotton Trade Association Ltd., was set up in the year 1875 for the
purpose of trading in cotton futures in the form of commodity futures market. Following the
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same, a number of trade associations for futures trade came up in various parts of the country
and that include Gujarati Vyapari Mandali in 1900 to facilitate futures trade in oilseeds; the
trade association in gold futures in 1920; and exchanges also were established enabling trade
in other commodities such as jute, pepper, turmeric, potato, gur (jaggery), sugar, etc.
In the post-independence era the government of India passed the Forward Contracts
(Regulation) Act, 1952 covering trade in all transferable forward and futures contracts. India
Pepper and Spice Trade Association (IPSTA), Cochin, was set up in 1957 as the first organized
futures market under the Forward Contracts (Regulation) Act. Further the government had
suspended futures trade in several commodities such as cotton, jute, edible oilseeds, etc.,
because it was alleged that the futures markets played a key role in fuelling inflation, resulting
in increase in prices of essential commodities.
14.5 PRICE DISCOVERY MECHANISM AT COMMODITIES
MARKET
Price Discovery is one of the most vital purposes of a commodity market where the
sellers and buyers meet at one place without any constraints. Commodity markets function
efficiently as a mechanism for discovering price. The commodity prices being determined by
the supply of and demand for the commodity and the prices are discovered through an auction
mechanism such that one mutually agreeable price is derived by interaction of sellers asking
for a certain price, and buyers offering them a price. Most often, sellers and buyers will
participate in the market through intermediaries or agents, called brokers. Such goods are
raw or partly refined materials whose value mainly reflects the costs of finding, gathering, or
harvesting them; further they may be traded to additionally process or incorporate them into
finished goods. e.g. include crude oil, cotton, rubber, grains, and metals andother minerals.
Check Your Progress-1
What is a commodity?
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14.6 INDIAN COMMODITIES MARKET
Indian Commodities Market has a very long history of trading in commodities and
related derivatives. However, during the 1940s, trading in forwards and futures became difficult
due to imposition of price controls. The policy decisions to address scarcity situation initiated
by the governments immediately after the independence adversely affected the development
of futures and forwards markets. The Forwards Contracts (Regulation) Act, 1952 promoted 249
and enabled development of commodity derivatives trade in India. The Act controlled all
transferable forward and futures contracts. The Forward Markets Commission (FMC) was
set up to regulate all forward trading.
The commodity markets can be classified broadly into Cash or Spot markets and
commodity derivatives markets. Commodity derivatives market again will have various
instruments like forwards, swaps, futures, options, etc.
14.6.1 Features of Spot Market
i. Deals in the spot markets are immediately effective.
ii. The physical market is also known as the cash market or spot market, because prices
are settled in cash on the spot at current market prices, as opposed to forward
prices.
iii. In the spot markets, participation is restricted to people involved with that commodity,
say, the farmer, processor, wholesaler, etc. since transactions take place directly
between principals, there is a high degree of flexibility in these transactions.
iv. The most popular physical commodities contracts can be broken down into metals,
energy, grains, livestock, food and fiber and exotic commodities.
v. For most commodities that are physically traded, there is no market in a central meeting
place, and where it exists, it typically handles only a small part of the total trade.
vi. Spot trading is delivery based, and is typically done through brokers and other
intermediaries. The spot price or spot rate of a commodity is the price that is quoted
in the physical market for immediate or spot settlement (payment and delivery).
vii. Spot settlement is normally one or two business days from trade date. This is in
250 contrast with the forward price established in a forward contract or futures contract,
where contract terms (price) are set now, but delivery and payment will occur at a
future date.
viii. Depending on the item being traded, spot prices can indicate market expectations of
future price movements in different ways.
ix. For a non-perishable commodity spot price reflects market expectations of future
price movements. In theory, the difference in spot and forward prices should be
equal to the finance charges, plus any earnings due to the holder of the commodity,
according to the cost of carry mode. In contrast, a perishable commodity does not
allow this arbitrage. The cost of storage is effectively higher than the expected future
price of the commodity. As a result, spot prices will reflect current supply and demand,
not future price movements. Spot prices can therefore be quite volatile and move
independently from forward prices.
14.6.2 Risks in Commodity Markets
The risks after producing the goods, whether the demand exists and will it get expected
price are a serious issues which all the producers face and it is a big challenge. Particularly, this
risk is said to be high in the case of agriculture – because of lack of information of how many
farmers have gone for that crop and what will be the produce which will hit the market is a big
question. Prices of the commodity will surely fluctuate on account of excessive supply or
excessive demand and such uncertainty will lead to fluctuating commodity prices and act as a
serious dampener on the production and pricing mechanisms.
It’s a cause of concern for producers of agricultural, industrial and consumer products
alike, and distracts them from concentrating on the more imperative issues related to the
carrying on of production activities. The volatility in commodity prices makes the business
environment undesirably erratic and avoidably problematic for business activities to be
performed optimally. Ability to manage this risk can affect the producers’ output as well as
income positively.
Further, we can put it as, commodity risk arising out of unpredictability because of
variations in yields of produce and prices in the markets. These fluctuations may cause concern
on the incomes of participants in the commodities markets. Hence, commodity risk may
arise in the form of 1) price risk and 2) yield risk.
1. Price Risk
This risk comes about due to the unpredictability of the cost at which production
inputs can be obtained in the future, or the price at which the final produce can be
sold, in the future. Price risk reflects risk associated with changes in the price of
output, or of inputs, that may occur after the commitment to production has been
made. 251
2. Yield Risk: Also known as Production Risk, this risk arises from the unpredictability
of the quantity of output that can be obtained from the production process, and is
most real for the farmers. Yield risk occurs because agriculture is affected by many
uncontrollable events that are often related to weather, including excessive or insufficient
rainfall, extreme temperatures, hail, insects and diseases.
Hence, the risks arising in the commodity markets have to be managed by the
participants in the markets and bearing losses to improve their profits and gains. The need for
establishment of derivatives market arose from the risks that the spot commodities market is
giving birth to.
14.6.3 Effects of Commodity Risk
1. All producers of commodities, including farmers, plantation companies and mining
companies. They face price risk, cost risk, on the prices of their inputs, and quantity
or yield risk.
2. Wholesale buyers, who face the same risk between purchase from wholesalers and
sale in the retail market.
3. All retailers, who also face the same risk between purchase from wholesalers and
sale in the retail market.
4. Exporters, who face a similar risk, especially when they buy from the country of
production and export to the country of consumption. In addition, exporters also
face risks with regard to foreign exchange conversion.
5. Governments, as they might face price and yield risk with regard to tax revenues,
particularly where tax rates rise as commodity prices rise, or if support or other
payments depend on the level of commodity prices.
Check Your Progress-2
Discuss the types of Commodity Risks.
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14.7 COMMODITY DERIVATIVES DEFINED
The word derivative is to mean that it is derived from an underlying asset. Therefore
one should be able to understand clearly that “a financial contract whose payoff structure is
determined by the value of an underlying asset (commodity, security, interest rate, share price
252
index, exchange rate, oil price, and the like) is a derivative instrument. The value of a derivative
instrument is derived from some or the other underlying asset. A derivative instrument by
itself does not constitute ownership. It is, instead, a promise to convey ownership. In
other terms a derivative is defined as a specialized contract that is used for a variety of purposes
including reduction of funding costs by borrowers, enhancing the yield on assets, modifying
the payment structure of assets to correspond to the investor’s market view, etc.
The most important feature of a derivative is to transfer market risk, called hedging,
that is a protection against losses resulting from unforeseen price or volatility changes in future.
The participants in the market use derivatives as a very vital instrument to manage risk.There
is a tremendous awareness spread across the participants about the utility of derivatives in
managing risk leading to huge growth of the markets for derivatives. In the latest trends, it is
observed that, the derivatives have become a prominent tool in the field of finance and seem
to be driving Indian and global financial markets.
14.8 FEATURES OF DERIVATIVES
In the process of reducing the risk inherent with the commodities these instruments
are developed and used across the globe. The primary features of a derivative could be
listed as:
1. Derivatives are financial instruments whose value is derived from the value of something
else.
2. A tool or an instrument that can eliminate uncertainty and reduce market risks.
3. Derivatives can be used for redistribution or reallocation of risk, such that the party
that seeks to minimize risk can do so by transferring it to another party interested in
accepting this risk for the potential of a high return.
4. Derivatives generally take the form of contracts, traded on or off an exchange, under
which the parties agree to payments between them based upon the value of an
underlying asset or other data at a particular point in time.
5. The main types of derivatives are forwards, futures, options and swaps, or even
combination of these products.
6. Derivatives act as a tool to manage risk originated in the commodities markets.
7. Depending on the underlying asset from which the derivatives derive its value, they
can be classified as financial derivatives (such as Equity derivatives, Fixed Income
derivatives, Currency derivatives) and Commodity derivatives. The underlying could
even be a basket of assets, or an index. 253
The basic concept of a derivative contract remains the same whether the underlying
happens to be a commodity or a financial asset. However there are some structureswhich are
very peculiar to commodity derivative markets. In the case of financial derivatives, most of
these contracts are cash settled. Even in the case of physical settlement, financial assets are
not bulky and do not need special facility for storage. Due to the bulky nature of the underlying
assets, physical settlement in commodity derivatives creates the need for warehousing. Similarly,
the concept of varying quality of asset does not really exist as far as financial assets underlying
are concerned. However in the case of commodities, the quality of the asset underlying a
contract can vary largely. This becomes an important issue to be managed.
14.9 ECONOMIC FUNCTIONS OF COMMODITY
DERIVATIVES MARKETS
Commodity derivatives markets are a good source of critical market information, and
an indicator of market sentiments. One can highlight the three vital economic functions of
these markets as:
1. Price Discovery
Due to their highly competitive nature, the commodity derivatives markets have become
an important economic tool to determine prices, based on current and future estimated amount
of supply and demand. Derivatives market prices depend on a continuous flow of information
from around the world, and thus require a high amount of transparency. This kind of information,
and the way people absorb it, constantly changes the price of the commodity. This price
information is used as a benchmark to determine the value of a particular commodity or
financial instrument on a given day and time. This process is known as price discovery. Price
discovery is important because futures prices have an informational content. The price discovery
process that takes in commodity derivatives markets plays a much larger role in the economy
than simply facilitating transactions. Specifically, when prices of a particular good are high
relative to other goods, less of those goods are consumed and, where possible, are substituted
by cheaper goods or commodities. Hence, these prices are used to allocate resources in the
economy.
2. Risk Reduction
Commodity derivatives markets are also places for participants to reduce risk when
making purchases. Risks are reduced because the price is pre-set, therefore letting participants
know how much of the commodity they will need to buy or sell. Market participants use these
contracts to offset the risk caused by changes in prices, to discover commodity prices, and to
speculate on price changes. Hedging is important because it allow individuals and businesses
to operate more efficiently.
254
3. Liquidity
Speculators or individual investors who can either buy or sell commodities by
participating in the global commodities market that facilitate the business of the producer and
of the end-user. Speculators fulfill several vital economic functions, as they facilitate the marketing
and trade of basic commodities and financial instruments. They do not create risk; they assume
it in the hope of making a profit. In addition to assuming risk and providing liquidity and
capital, speculators help ensure the stability of the market.
14.10 EXISTING SYSTEM
Presently, there are 22 Commodity Exchanges in India which are regulated by Forward
Market Commission under the administrative control of Ministry of Consumer Affairs and
Public Distribution. Out of 22 commodity exchanges, six are National Commodity Exchanges
and 16 are Regional Commodity Exchanges in India which are given in the table below:
Commodity Exchanges in India
Sl. No National Exchanges
1 Multi Commodity Exchange of India Ltd. (MCX), Mumbai
2 National Commodity & Derivatives Exchange Ltd. (NCDEX), Mumbai
3 National Multi Commodity Exchange of India Limited (NMCE), Ahmedabad
4 Indian Commodity Exchange Limited. (ICEX), New Delhi
5 Ace Derivatives and Commodity Exchange Limited. (ACE), Mumbai
6 Universal Commodity Exchange Ltd. (UCX), Navi Mumbai
Regional Exchanges
7 Bikaner Commodity Exchange Ltd., Bikaner
8 Bombay Commodity Exchange Ltd., Vashi
9 Chamber of Commerce, Hapur
10 Central India Commercial Exchange Ltd., Gwalior
11 Cotton Association of India, Mumbai
12 East India Jute & Hessian Exchange Ltd., Kolkata
13 First Commodities Exchange of India Ltd., Kochi
14 Haryana Commodities Ltd., Sirsa
15 India Pepper & Spice Trade Association., Kochi
16 Meerut Agro Commodities Exchange Co. Ltd., Meerut 255
17 National Board of Trade, Indore
18 Rajkot Commodity Exchange Ltd., Rajkot
19 Rajdhani Oils and Oilseeds Exchange Ltd., Delhi
20 Surendranagar Cotton oil & Oilseeds Association Ltd., Surendranagar
21 Spices and Oilseeds Exchange Ltd. Sangli
Having started operations in December 2003, today, NCDEX holds a market share
of over 11.3% (FY 2013-14) of the Indian Commodity Futures market, Rs 11,291 Crore –
the highest daily turnover of NCDEX since inception (on January 3, 2012), over Rs 3,834
Crore – average daily turnover and has 844 registered members operating through over
46,273 trading terminalsspanning over 1000 centers across India (as of FY 2013-14). It has
been enhancing storage and deliveries through 405 Accredited Warehouses with a capacity
of 2 million MT across warehouses and making 72,603 MT average monthly deliveries.
14.11 INDIAN COMMODITY MARKET’S POTENTIAL
1. The growth of the overall economy in India is expected to drive the underlying demand
for commodities.
2. The increase in physical market volumes may increase the hedging requirements of
industry players, which influences derivative trading volumes.
3. Commodity derivative volumes are generally a multiple of the underlying physical
commodity volumes. In India, the volume traded on commodity futures exchanges is
very low as compared to the size of the physical market for the commodity. Thus, the
potential for commodity derivatives is huge.
4. Products like options, indices, weather derivatives and intangibles may belaunched in
future;
5. Institutions like FIIs, Banks, Mutual Funds may be allowed to enter commodity futures
market going forward;
6. Creates an opportunity for commodity exchanges to enter other segments such as
currency & equities moving towards ‘universal exchange’.
Check Your Progress-3
What is the potential of Indian Commodity Market?
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14.12 SUMMARY
The commodities spot markets and commodities derivatives markets have evolved
over a period. Particularly, in the current context the commodities markets are developing in
the country. Various committees have enabled the overall development of commodities
derivatives markets to function and grow in the interest of the participants in the market.
14.13 CHECK YOUR PROGRESS: MODEL ANSWERS
1 Commodity means it is an economic good, tradable good, product or article of
commerce; something for which there is an established market where the commodity
can be bought and sold and has the following properties:
• Is usually produced and/or sold by many different producers;
• Is uniform in quality between producers that produce and sell it;
• Is traded at a price resulting from its demand and supply.
2 The future is uncertain and may not be predictable. This unpredictability causes risks
to the participants in the commodity markets and because of which one may witness
gains or losses arising on account of variations in yields of quantity, quality and prices.
Therefore, once can simply put the commodity risk into two:
a. Price Risk: unpredictability on account of the price that the buyer needs to
pay on the date of purchase and the seller may realize in the due course of
sale in the future. This risk is associated with changes in the price of output for
seller, or of inputs for buyer, that may occur after the commitment to production
has been made; and
b. Yield Risk: risk in terms of yield or quantity risk is the uncertaintyof the quantum
of output and is most real for any agricultural produce.This risk arises on
account of agriculture being affected by many uncontrollable factors related
to weather like excessive or insufficient rainfall, extreme temperatures, insects
and diseases, etc.
3 The growth of the overall economy in India is expected to drive the underlying demand
for commodities and increase volumes. This will lead to huge growth in the derivatives
markets. Commodity derivative volumes are generally a multiple of the underlying
physical commodity volumes. The potential for commodity derivatives is huge because
of expected increase in trade in the volumes of physical commodities There is every
possibility that innovative and variety of products like options, indices, weather
257
derivatives and intangibles may be introduced in future and there is also a view that
many institutions like FIIs, Banks, Mutual Funds will enter this market and create
opportunities for the commodity exchanges.
14.14 MODEL EXAMINATION QUESTIONS
I. Short Answer Questions
a. What is a Commodity?
b. What are the types of Commodities?
c. Discuss the Price Discovery Mechanism.
d. What is a commodity Derivative?
e. What is MCX?
II. Long Answer Questions
a. Discuss the features of Spot Market?
b. What are the risks of commodities? How do the participants in the commodities
market manage risks?
c. Discuss the History and Evolution of Commodities Market in India.
d. What is a commodity Derivative? Discuss the Economic Functions of Commodity
Derivatives Market.
e. What are the New Initiatives of SEBI for the Commodities Markets?
III. Objective Type Questions
a. Multiple Choice Questions:
i) One (more) of the statements below is a feature(s) of commodity.
a..Commodity is an economic good, tradable good, product or article of
commerce;
b. Commodity is usually produced and sold by many different producers;
c. Commodity need to be uniform in quality between the producers that produce
and sell;
d.All the above;
258
ii) One of the below mentioned statement is not false
a. The word commodity comes from the French word “Commodite”, which is
used to refer to an object of utility that offers some convenience or useful
service;
b. Commodity does not include agricultural produce like gur and potato;
c. Commodity generally is uniform in quality between producers that produce
and sell it.
d. Commodity is traded at a price resulting from its demand and supply in the
market at that point of time;
iii) One of the commodities in the list below is a Soft Commodity
a. Gold
b. Potato
c. Silver
d. Platinum
iv) One of the commodities in the list below is a Hard Commodity:
a. Platinum
b. Cereals;
c. Spices & Pulses;
d. Plantations
v) One of the below mentioned statements is not false:
a. Deals in the spot markets are effective after two months.
b. The physical market is also known as the futures market where financial
derivatives like futures, forwards, etc. are traded on the commodities;
c. In the futures markets, participation is restricted to people involved with the
said commodity and that could a farmer, processor, wholesaler, etc.
d. The most popular physical commodities contracts can be broken down into
metals, energy, grains, livestock, food and fiber and exotic commodities.
Answers: i) d ii) b iii) b iv) a v) d 259
b. Fill in the blanks
i) Every commodity produced or grown finally must be brought to the
……………………………………. for trade.
ii) A commodity is an……………………………, tradable good, product or article of
commerce.
iii) Agricultural Produce is known as ………………………………… because the
products are perishable over a period of time.
iv) The Forwards Contracts (Regulation) Act, 1952 promoted and enabled development
of ……………………………………….trade in India.
v) Commodity risk may come in the form of ………………….. and
…………………………………….
Answers:
i) Market ii) Economic good iii) Soft Commodities
iv) Commodity derivatives v) Price and Yield (quantity)
c. Match the following:
i) Hard Commodity a) Delivery Based
ii) Soft Commodity b) Gold
iii) Spot Trading c) Function of a commodities market
iv) Price Discovery Asset d) Value is derived from an underlying
v) Derivative e) Potato
Answers: i – b ii – e iii – a iv – c v–d
14.15 GLOSSARY
1. Spot Market : The commodities are bought and sold on the spot.
2. MCX : Multi-Commodity Exchange is an exchange where
many commodities are tradeder;
3. Soft Commodities : Commodities that are perishable like potato, gur, etc.
4. Hard Commodities : Non-perishable commodities like gold, silver,
Platinum, etc.
5. Industrial Metals : Copper, Nickel, Zinc & Aluminum, Palladium &
Lead, Tin, Steel and Iron;
260
6. Precious Metals : Gold, Silver and Platinum.
7. Agricultural : Oil and Oil Seeds, Cereals, Spices & Pulses,
Commodities Plantations & Fibers, Potato, Sugar and Livestock
8. Energy : Crude Oil, Natural Gas, Furnace Oil, Aviation
Turbine fuel, Power
9. IPSTA : India Pepper and Spice Trade Association
10. Price Discovery : Where the supply and demand is not restrained;
11. Price Risk : The risk of variation in prices of commodities in
Future
12. Derivative : A financial instrument whose value is derived on the
basis of underlying asset;
13. FMC : Forwards Market Commission.
14.16 FURTHER READINGS
Pavaskar M. Commodity Derivatives Trading – Theory and Regulation
Notion Press, Chennai (2016)
Rajib, P. Commodity Derivatives and Risk Management
PHI Learning Pvt Ltd. New Delhi (2014)
PWC and MCX Commodity Insights Yearbook (2011)
IIBF Commodity Derivatives. Macmillan (2007)
Geman, H Commodities and Commodity Derivatives: Modeling
and Pricing for Agricultural, Metals and Energy.
John Wiley & Sons Ltd., (2005)
261
Dr. B. R. AMBEDKAR OPEN UNIVERSITY
FACULTY OF COMMERCE
B.Com. I YEAR (3YDC) - I SEMESTER EXAMINATION
MODEL QUESTION PAPER
BUSINESS ORGANISATION
TIME: 3 Hours Max.Marks: 100
Min. Marks: 40
SECTION – A
Short Answer Questions
(Marks: 5 x 4 = 20)
Instructions to the Candidates:
i) Answer ANY FIVE of the following questions.
ii) Each question carries FOUR marks.
1. What do you mean by Aids-to-Trade?
2. What do you mean by ‘social responsibility of business’?
3. Define unlimited liability.
4. What do you mean by Partner by Estoppel?
5. Explain “patronage dividend.”
6. Explain: (i) One Person Company (OPC) (ii) Small Company
7. Define ‘Memorandum of Association’.
8. What is Minimum Subscription?
9. Discuss the concepts of Gross and Net Working Capital
10. List out three functions of a stock exchange
SECTION – B
Long Answer Questions
(Marks: 5 x 12 = 60)
Instructions to the Candidates:
i) Answer all the questions using internal choice.
ii) Each question carries Twelve marks.
11. a) Explain the objectives of business.
OR
b) List out the factors to be considered for selecting the form of organization.
262
12. a) Explain the differences between Partnership and Joint Hindu Family business.
OR
b) What do you mean by a co-operative society? Explain its features.
13. a) What is a Prospectus of a Joint Stock Company? What are its contents?
OR
b) Define working capital and discuss the importance of working capital
management in the present day context.
14. a) Discuss the advantages and disadvantages of equity shares.
OR
b) Discuss the factors that contributed to financial innovations and introduction of
new financial instruments by companies.
15. a) “A Stock exchange is a gambling den and therefore not a place to invest”
Discuss.
OR
b) What is a commodity Derivative? Discuss the Economic Functions of
Commodity Derivatives Market.
SECTION – C
Objective Type Questions
(Marks: 20 x 1 = 20)
Each question Carries One mark
a) Multiple Choice Questions
i) Who said that the job of the entrepreneur is “creative destruction”?
a) Peter Drucker.
b) Pierre Trudeau.
c) Joseph Schumpeter.
d) Brian Mulron
ii) Members of Joint Hindu Family are known as:
a) Partners
b) Members
c) Coparceners
d) Owners
263
iii) There exists a special form of partnership called a Limited Partnership.
Which ONE of the following statements concerning limited partnerships
is NOT true?
a) Limited partners do not have power to bind the firm
b) A limited partnership must have at least one general partner.
c) Limited partnerships are formed by registering documents with the
Registrar of Companies.
d) Limited partners have limited liability while taking part in the
management of the firm.
iv) For commencement of business, registration is not compulsory.
a) Joint Stock Company
b) One Person Company
c) Foreign company
d) Partnership
v) From the following which clause cannot be altered-
a) Name Clause
b) Domicile Clause
c) Objects Clause
d) Liability Clause
vi) Under Companies Act, 2013, maximum duration for transfer of shares in a private
company would be-
a) 120 days
b) 90 days
c) 60 days
d) None of these
vii) The discussion of finances relating to the individuals and the issues relating to the
savings and investments is related to:
a) Public Finance
b) Business Finance
c) Personal Finance
d) Governmental Finance
viii) Identify the odd source out in the finances that a company can mobilise;
a) Debentures
b) Public Deposits
c) Borrowings from Banks
d) Retained Earnings
264
ix) M J Pherwani committee on introduction of new financial instrument in India has not
advised this instrument but issued by a company:
a) Non-voting Shares
b) Detachable Equity coupons/warrants
c) Secured Premium Note
d) Participating preference shares
x) A market where new securities are bought and sold for the first time is known as a
__________ market.
a) Primary
b) Secondary
c) Tertiary
d) Money Market
b) Fill in the blanks
i) The process of setting up a business enterprise is known as ________.
ii) The liability of karta in Joint Hindu Family business is _____________.
iii) A __________company can commence business immediately after getting the
certificate of incorporation from the Registrar.
iv) The Finance function is the process of________ and ________ funds by a business.
v) A commodity is an________ tradable good, product or article of commerce.
c) Match the following
i) Entrepreneur A) Interest on this security is accumulated and
paid at the date of maturity.
ii) A minor partner will have B) Index
iii) Zero Coupon Bond C) Delivery Based
iv) NSE – Nifty Fifty D) Risk taker
v) Spot Trading E) Limited Liability
*****
265
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