INTERNAL FINANCING :

Internal financing refers to accumulation of earnings over a period of time. This method is followed by well-established profit making companies. Instead of distributing the entire profits to shareholders in the form of dividend, the company retains a part of its earnings for the purpose of accumulation of earnings.

DEFINITION:
Internal financing can be defined as the process of setting aside a portion of profits earned for the purpose of investing in fixed assets and or to meet working capital needs, if the need so arises. It is also called as Ploughing back of profits or Self-financing. It is called internal financing because the firm relies on its own internal funds for financing business. It is called self-financing because the firm generates funds by way of retaining earnings for the purpose re-investment in business.

Importance or Advantages of Internal Financing:

(1) To the Company:

Working capital: Retained earnings come in good use to meet the working capital needs at the time when the company faces a financial crunch during the recession period. Stable dividend policy: It helps the company to follow a stable dividend policy. Even if the company has not done well in a particular year, it can declare dividend from its retained earnings. Modernization and automation: Internal financing help a company to modernize itself and automation could be introduced because of internal earnings. Repayment of debentures and term loans: Retained earnings help in the repayment of debentures and term loans. Shareholders confidence: Retained earnings increase the confidence of the shareholders. Expansion and diversification: It helps a firm to expand its existing business and diversify it to some other business. Not to rely on external sources: It also helps a firm not to rely on external sources.

Less financial risks: It reduces financial risk of business as companies do not have much pressure to pay interest and installments.

(2) To the Shareholders:

Bonus issue: Retained earnings enable a company to issue bonus shares as bonus share are issued out of accumulated profits and reserves. Regular dividend: Shareholder gets a regular dividend because of internal financing. Even in the years when the company has not done well, the company is able to declare and give dividend to its shareholders because of internal financing. Increase in security value of shares: Retained earnings by the company increases the security value of shares, as the banks may willingly accept the shares as a security in advancing loans to the shareholders. Appreciation in shares: The value of the shares appreciates considerably because of huge reserves of the company.

(3)To the Society:

Capital formation: Retained earnings increases the capital formation of a company. Social welfare: Retained earnings can be utilized for social welfare purposes like maintenance of gardens, roads, donation to educational institution etc. Goods at reasonable price: Consumers are able to get goods at a reasonable price as the company can use a part of the retained earnings freely reducing the cost of production and making goods available at a reasonable price. Development of industry: Retained earnings help in the speedy development of the industry and thereby giving way to more employment opportunities.

Disadvantages or Demerits of Internal Financing:

(1) Over capitalization: The company may not be able to make optimum use of its retained earnings. (2) Excessive speculation: It do generate excessive speculation on the stock exchange. This is harmful for genuine investors. (3) Concentration of economic power: It leads to concentration of power in the hands of a few leading to red tap-ism. (4) Employees demand increases: It leads to an increase in the demand of employees. this may result in disputes as it is not always possible for a company to meet the ever increasing demands of their employees. (5) Loss to shareholders: Retained earnings may prevent shareholders from getting their share of dividend. (6) Chances of manipulations: There are chances of manipulations as the retained earnings may be utilized for the personal interest of the Board of Directors / Managers etc.

External financing: External financing is the phrase used to describe funds that firms obtain from outside of the firm. It is contrasted to internal financing which consists mainly of profits retained by the firm for investment. There are many kinds of external financing. The two main ones are equity issues, (IPOs or SEOs), but trade credit is also considered external financing as are accounts payable, and taxes owed to the government. External financing is generally thought to be more expensive than internal financing, because the firm often has to pay a transaction cost to obtain it. External finance can be raised by two principal means:

By borrowing money to be repaid over time in return for interest (loan finance) By selling a stake in the ownership of the business (equity).

Loan Finance Characteristics The main characteristic which distinguishes loan finance from equity is that there is a contractual obligation on the borrower to pay interest and to repay the principal (that is the sum borrowed) on a given date or by a given date. The lender to an unquoted company will almost certainly have specific rights above those of a normal creditor to enable him to recover his interest or principal in the event of default (that is failure by the borrower to pay the full amount due on a given date). The lenders who have such rights in the case of a quoted company are described as holders of senior debt. Conversely, lenders who hold the appropriately named "junk bonds" (usually in smaller, more risky, public companies) have few rights to recover the money owing to them in case of default. Types of lending Standard forms of lending include: term loans, which have a fixed life and repayment schedule; mortgage loans, which are loans secured against property; overdrafts, which are a flexible form of finance where the borrower can draw down and repay funds at will within agreed limits; leasing, where an asset is borrowed and interest paid against its capital value less tax allowances; and factoring, where the debts owed to a business are assigned to a finance house which lends against the value of those debts. More esoteric loans include loan stock and company (including 'junk') bonds and other products which may have unusual repayment rights or rights to interest and which may have special rights, such as conversion into shares, and which may not be secured against the assets of the business.

Security Usually, however, the lender will have some specific rights to recover the outstanding debt. These rights, in the form of a charge, may be against a particular asset or assets, when it will be called a fixed charge. Generally, these charges give the lender priority in the recovery of his debt, to the extent of the value of the assets charged, over the unsecured creditors. Additionally, the Company can grant a charge against its assets in general, called a floating charge which, while it gives priority to the lender over most unsecured creditors, ranks after the preferred creditors (Inland Revenue for PAYE and Customs & Excise for VAT, but see the definition in the glossary). The lender must register these charges; with Companies House in the case of charges on business assets and additionally with the Land Registry in the case of charges on property (ie buildings and land); enabling later lenders or other creditors to establish whether there are uncharged assets in the business available for them to seek fixed or floating charges over, or to take a general view of the quality and solvency of the business. Interest The return for a lender is interest payable periodically (usually monthly, quarterly, bi annually or annually) at a rate or a margin fixed at the outset of the loan agreement. If the

interest is at a fixed rate then this expressed as a percentage of the capital borrowed (ie 12% is 12 interest payable annually per 100 borrowed). If the interest is variable then it is usually expressed as a percentage margin over one of the standard base rates, such as finance house base rate (for leasing or lease purchase), three month LIBOR (for lending by city institutions) or bank base rate (for loans from the clearing banks). Equity Characteristics The alternative to loan finance is equity finance; that is money or assets provided by an investor in return for a share in all the profits of the business. The investor accepts the risk of losing his investment in return for participating, without limit, in all the profits that the business realises. Ordinary shares The investor will usually buy shares in the business in return for cash. Although shares can carry a wide range of different rights, and have names to match, the standard share is called an ordinary share. Even the ordinary share may have special rights, but usually has the following basic rights and characteristics: the holder can vote at general meetings of the company (usually on the basis of one vote per share held); the holder has the right to receive any dividend that the directors declare payable (expressed as x pence per share); and the holder will receive his share of the proceeds of the assets of the company on sale or liquidation. The extent of a shareholder's participation in a Company's payment of dividend or distribution of capital is determined by the proportion of the total ordinary shareholding which he holds:

For example: A shareholder owns 250 1 ordinary shares in a company with a total issued share capital of 1,000 1 ordinary shares. He owns 25% of the company's equity. This means that when a dividend is declared he will receive 25% of the total dividends which the company pays out. Similarly, if and when the company is sold or liquidated, he will receive 25% of the shareholders' proceeds. If the company's total assets are less than its total liabilities to creditors when it is liquidated, then he, along with the other shareholders, will sacrifice their investment in the company to the extent of that investment. He may have paid more for his shares than their face, or 'par', value of 1 each. If so, then the amount he has paid over the par value is entered into a share premium account which is part of the company's permanent capital and which is part of a shareholder's potential liability.

A shareholder does, of course, have the right to sell his shares or to buy further shares (subject to the company's articles of association and his ability to find a buyer or seller).

Normal shareholders' rights The ordinary shareholders appoint the directors and auditors (or, more usually, approve their appointment) and must approve any amendment to the memorandum and articles of the company, its legal status or changes to its capital structure. Finally, they must approve any resolution to wind up the company. The resolutions effecting these changes require differing majorities of the shareholders entitled to vote dependant on the proposed change.

Special shareholders' rights A venture capitalist may insist on some special rights for his equity, which give it preference over that of ordinary shareholders, but all equity ranks after all lenders, all creditors and all preference shareholders. This means that not only will he seek rights to preference over the ordinary shareholders, he will also take other control rights to secure the value of investment. These rights may include the requirement to seek his permission to: alter the company's share capital; acquire, dispose of, or charge assets; fix managers' salaries and other payments; determine a mandatory dividend policy; make acquisitions; and sell the company. Preserving Your Resources One of the advantages of external funding is it allows you to use internal financial resources for other purposes. If you can find an investment that has a higher interest rate than the bank loan your company just secured, it makes sense to preserve your own resources and put your money into that investment, using the external financing for business operations. You can also set aside your internal financial resources for cash payments to vendors, which can help improve your company's credit rating. Growth Part of the reason organizations use external funding is it allows them to finance growth projects the company could not fund on its own. For example, if your business is growing to the point that you need additional manufacturing space to keep pace with demand, external financing can help you get the funding you need to build your addition. External funding can also be used for making large capital equipment purchases to facilitate growth that the company cannot afford on its own. Ownership Some sources of external financing, such as investors and shareholders, require you to give up a portion of the ownership in your company in exchange for the funding. You may get that large

influx of cash you need to launch your new product, but part of the financing agreement is the investor is allowed to vote on company decisions. This can compromise the vision you originally had for your company when you founded it. Interest External funding sources require a return on their investment. Banks will add interest to a business loan, and investors will ask for a rate of return in the investment agreement. Interest adds to the overall cost of the investment and can make your external funding more of a financial burden than you had originally planned.

ADVANTAGES OF EXTERNAL FINANCING

Faster Growth

A business needs investments to grow. Even the most profitable companies cannot rely solely on reinvested profits to finance their expansion. Accordingly, a business needs to secure bank credit, partner with venture capital firms or in any other way tap external sources of finance. External finance provides the room for faster growth, allowing the company to operate on a far bigger scale, capturing new markets and providing products and services to an ever greater number of customers.

Greater Economies of Scale

Large businesses are generally more efficient than small ones. They have a greater bargaining power with suppliers and they can spread their fixed costs, such as administrative expenses, over larger sales. This results in lower costs per unit of production, which, in turn, gives the company a competitive edge in the marketplace. External sources of finance help a company grow faster, achieving the economies of scale necessary to compete with the rival firms on regional, national, or even international level.

Leveraged Returns

External sources of finance also leverage the returns for the entrepreneur. If, for example, an entrepreneur starts a business with the return on investment rate of about 20 percent, providing $100k of her own money as the seeding capital, then, if no external sources of finance are used, her return should be about $20k (20 percent * $100k) a year. If, on the other hand, she takes a bank loan with an interest of 10 percent in the amount of another $100k, then the overall return from her business will be $200k * 20 percent = $40k, of which $10k will be the bank's interest ($100k * 10 percent). The leveraged return our entrepreneur will get is, then, $30k, or $10k less than would have been if she didn't employ the external sources of finance.

Hence it is evident that it makes sense to use external sources of finance if the cost of capital is less than the returns generated by the business.

DISADVANTAGES OF EXTERNAL FINANCING

Loss of Ownership

For a corporation, external financing may come from the issuance of new stock. This can decrease the owner's equity and means a loss of ownership. Other business types may be forced to sell an interest in the business as a means of raising capital. Venture capitalists are often relied upon for external financing in exchange for a share in the business. The distinct disadvantage in ownership loss is the possibility of giving up untold shares of future profits for a bit of working capital in the present.

Loss of Control

Debt based external financing normally means control of a company is secure. If a default were to take place, legal proceedings may force a loss of control if a judge appoints someone to oversee operations. Equity based financing almost always means a loss of control. Shareholders or other investors usually will have a vote or representation at annual meetings and can influence many corporate decisions. Proxy voting fights or attempts at hostile takeovers are two potential types of control loss. A company that relies too heavily on external financing may find itself being manipulated by outsiders. This loss of control is difficult to regain.

Cost

The cost of external financing is a major factor. Debt financing has associated interest payments and a struggling company may be forced to accept high interest rates on a loan or be forced to issue bonds with a higher than anticipated interest rate. Equity financing can mean fewer future profits are kept within the company as investors and shareholders claim profits or dividends. A fast growing company needs to make careful profit projections and understand that future profits lost to outside ownership interests may be the biggest cost of external equity financing.

Cash flow

The future of any company depends on working capital. Cash flow can be greatly affected by external financing. Payments for principal and interest for debt financing or dividends for equity financing can limit a company's ability to invest in expansion,

research and development, marketing, or advertising. This loss of working capital may make it impossible for a company to continue operations without taking on more financing.

ABOUT COGNIZANT
Cognizant Technology Solutions Corp. (NASDAQ: CTSH) is an American multinational provider of custom information technology, consulting and business process outsourcing services. Its headquartered in Teaneck, New Jersey, United States and is a member of NASDAQ-100, the S&P 500 andFortune 500. Cognizant has been named to Fortune magazine's 100 FastestGrowing Companies list for nine consecutive years, including 2011 when it was ranked first in the "All-Stars" list of 16 companies that appear on the fastest-growing list year after year. Cognizant Technology Solutions is ranked #484 in Fortune 500 list of 2011 of top U.S companies. Cognizant Technology Solutions made its debut in 2008 in the Fortune 1000 ranking at the 859th position. Cognizant was listed on NASDAQ in 1998 and moved to the NASDAQ-100 Index
in 2004. After the close of trading on 16 November 2006, Cognizant moved from the mid cap S&P 400 to the S&P 500. The company claims to be in excellent financial health, reporting over $2.2 billion in cash and short term investments for the quarter ending June 30, 2011.According to the 2011 figures, the

major portion of the Cognizant revenues is derived out of clients from US. (North America: 77.2%, Europe: 19.2%, Rest of World: 3.6%). Most of this revenue comes from the clients in the Financial Services (42.3%) and Health-care (25.9%) industries. Other substantial revenue sources include clients from Manufacturing, Retail & Logistics (18.6%) and Communications, Information, Media & Entertainment and Technology (13.2%) industries.