Corporate Financing Pattern in India:

Changing Composition and Its Implications

J Dennis Rajakumar*

This paper examines the financing pattern of private corporate sector in India. Several studies in the last three decades
have increasingly emphasized the role of finance in influencing investment activities of firms. In India, the state had
actively fostered the development of financial system till the 1980s, though it favored bank-based system. With the
ushering in of financial sector reforms since the early 1990s, the emphasis on equity market has gone up. This paper
finds that while corporate sector relied more on bank/institution sources of funding till the early 1990s, its reliance on
equity market has gone up since then. The paper ends with a discussion on the implications of such changing
financing pattern.

Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is
serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital
development of a country becomes a by-product of the activities of a casino,
the job is likely to be ill-done.
– Keynes (1936, p. 159)

Introduction
Several theoretical and empirical studies in the last three decades have emphasized the
relationship between finance and investment, and argued that firms’ financing decisions had
implications for their investment activities.1 With the changes introduced in India’s economic
policies during the last two decades, the emphasis has been more on corporate investment-
led growth, replacing the hitherto public sector investment-led growth (Rajakumar, 2011).
Investment activity of corporate sector, thus, lies central to the economic performance of the
country. Given the link between finance and investment, this paper seeks to examine the
financing practices of corporate sector.

The Analytical Framework

The role of investment for economic growth is well emphasized in the economic literature.
Studies of investment behavior in the neoclassical tradition had, however, ignored the role
of financial factors.2 As Getler (1988) aptly remarks, the lack of emphasis on financial variables

* Director, EPW Research Foundation, C-212 Akurli Industrial Estate, Akurli Road, Kandivli (E),
Mumbai 400101, Maharashtra, India. E-mail: dennisraja@hotmail.com

1
See, Fazzari and Mott (1986/87), Minsky (1986), Gertler (1988), Stiglitz (1988), Fazzari (1992), Fazzari and
Variato (1994), Gordon (1992), Rajakumar (2005), Jangili and Kumar (2010), and Bolton et al. (2011).
2
See, for example, Eisner and Nadiri (1968); and Jorgenson (1971).

© 2014 IUP
Corporate . All Rights
Financing Reserved.
Pattern in India: Changing Composition and Its Implications 5
in the investment equation was due to the formal proposition of Modigliani and Miller
(MM) which had two important implications, namely, investment decision was the only
decision that mattered and firms need not care as to how to finance investment (MM, 1958).
Thus, a firm’s choice of a particular source of funds, whether it is retained earnings or issue of
bonds/equity or borrowing, had no bearing on its investment decision.
The crucial assumption underlying the MM theorem is the ‘existence of perfect capital
market’. Implicit in this was the symmetric distribution of information between firms and
investors, no transactions cost, no taxes, no bankruptcy, both firms and individuals had
equal access to capital market, securities issued had perfect substitutes, investors maximize
welfare (Fama and Miller, 1972), and that the existence of financial intermediaries would be
of no consequence to real activity (Bernanke and Gertler, 1987). The MM theorem and its
assumptions however came to be questioned in the course of time. Increasingly, there is a
wider recognition that factors such as tax, asymmetric information and financial intermediaries
could influence firms’ financing behavior and thereby their investment decisions. In what
follows, these factors have been discussed briefly.

Tax and Financing Practices

In corporate taxation, debt and equity finance are given different treatment. While interest
payments (cost of debt) are generally allowed to be treated as an expense, dividend payments
(cost of equity) are not. Because of this, the relative cost of debt decreases. Though this holds
good only if firms show taxable income and depends upon the tax rate facing firms, to the
extent of its deductibility, interest payments shield profit (known as interest tax shield),
which in turn increases value of firms. In their own later version, MM (1963) recognized the
gain associated with debt because of interest deductibility. They had shown that in the
presence of taxes that allowed interest deductibility, value of leveraged firms was greater than
that of unleveraged firms implying that a firm could increase its value by increasing leverage.
Firms would therefore prefer debt financing.
It is also argued that such leverage gain need not arise under bankruptcy and when non-
interest tax shields are available.3 Firstly, an increase in debt increases the probability of debt
obligations exceeding the earnings of firms. This could lead to bankruptcy and so debt is
considered risky. The risk aversive firms would, therefore, not be indifferent to debt. Thus,
firms tend to follow an optimal capital structure policy, which is essentially a trade-off between
tax advantage of debt and bankruptcy cost.4 Secondly, availability of non-interest tax shields,
arising from various investment-related incentives, also reduces tax liability of firms. The
higher the ceiling of such shields, the lower is the debt because the expected marginal interest
tax shield would decline with additional debt added to capital structure (DeAngelo and
Masulis, 1980). Thus, when there is a possibility of losing non-interest tax shield, there is
likely to be a substitution between interest tax savings and non-interest tax savings. This
shows that the presence of corporate tax and various tax incentives impact firms’ capital
3
For a survey of studies related to these issues, see, Smith (1990).
4
See, DeAngelo and Masulis (1980), Bradley et al. (1984), and Dammon and Senbet (1988).

6 The IUP Journal of Applied Finance, Vol. 20, No. 4, 2014

structure decisions. Fiscal environment, in which corporates operate, matters for their
financing choice.

Asymmetric Information and Financing Practices

Symmetric distribution of information between firms/borrowers and investors/lenders,
implicit in MM theorem, came to be questioned with the development in the theories of
economics of information in general and information asymmetry in particular, which got
extended to the study of financial market as well. Situations of information asymmetry arise
in the financial market (credit and equity) when a firm possesses information about its future
streams or investment opportunities but does not dispense it fully with suppliers of funds.5 So
much so, in a given situation, financial market can be inundated with projects of both low
and high quality. Due to information asymmetry, market would not be in a position to
distinguish between low and high quality projects. As a result, it is possible that the market
could place premium on low quality projects at the expense of high quality projects (Leland
and Pyle, 1977). This can drive out high quality projects, leading to inefficient functioning of
financial market.
When credit market is characterized by imperfect information with indistinguishable
borrowers, credit rationing occurs.6 Cost of credit is positively related to the riskiness of
loans, that is, the higher the risk, the higher is the interest rate. Because lenders cannot
observe the riskiness of borrowers’ projects, they raise the interest rate, leading to a revision
of critical value of investment, which affects the probability of repayment. This could attract
risk-neutral borrowers (adverse selection effect) or induce borrowers to switch from safe
projects to risky ones (moral hazard / incentive effect). As a result, those borrowers with good
projects get rationed out because of the hike in cost of credit. Firms’ ability to raise funds from
equity market beset with imperfect information remains limited. A firm, which comes to
equity market, is considered bad because good firms can always increase leverage. As a result,
equity market adds to the return of not only monetary interest rate but bankruptcy cost as
well, which eventually increases effective cost of equity (Greenwald et al., 1984). Thus, even
those firms not facing credit constraints also find it difficult to raise equity because of the
increase in effective cost. Besides this, the informational problems in equity market also lead
to underpricing of equity so that managers sometimes pass on the projects even with positive
net present value (Myers, 1984; and Myers and Majluf, 1984).
Problems of asymmetric information can also arise after contracting, leading to a moral
hazard situation. This arises because suppliers of external funds cannot monitor and control
allocation of funds by firms among different uses.7 Because of moral hazard, firms tend to put
their funds into assets that are poor generators of cash flows or whose realizable value oscillates,
so that cash commitments could exceed cash flows they would get over short period from
5
Direct transfer of information is not possible because firms would have to compromise their competitive advantage
(Fazzari and Athey, 1987).
6
See, Jaffee and Russell (1976), Stiglitz and Weiss (1992), and Greenwald and Stiglitz (1993).
7
Synonymous with the agency cost, as discussed in Jensen and Meckling (1976).

Corporate Financing Pattern in India: Changing Composition and Its Implications 7

their operation. Firms expect to meet the difference between cash commitments and cash
flows in the short period by refinancing. They are lured into investing in these assets because
they expect the cash flows to be greater than cash commitments in the long term. Minsky
(1986) calls these firms speculative firms. Information asymmetry, thus, creates uncertainty
which increases the likelihood of bankruptcy, aggravating risk factor. It affects both suppliers
of external funds and firms (Wolfson, 1996).
Information asymmetry in financial market, thus, has strong implications for the
availability and cost of credit and equity financing. And, consequently, firms face financial
constraints and such firms have to take greater recourse to internal funds.8 Faced with financial
constraints, firms may delay undertaking of investment or decide not to invest at all—thus,
drag capital formation in the economy9 (Campello et al., 2010). The problems arising from
asymmetric information makes the financing decisions of firms matter for their investment
activity.

Financial Intermediaries and Financing Practices

Yet another implication of MM’s theorem is that the existence of financial intermediaries is
of no consequence for real activity (Bernanke and Gertler, 1987). As noted by Gertler (1988),
the relevance of this proposition is questioned and the central place of financial system in
the development process of an economy is increasingly well recognized. Essentially, financial
system facilitates intermediation between savers (public) and investors (firms), and helps to
translate savings into investment. The system can be bank (credit)-based or market (equity
or bond)-based. Bank-based financial system is one where firms depend largely on credit from
banks and other financial institutions, whereas market-based financial system is one where
issuing of securities such as equity is the main source of funding (Studart, 1995/96).10
The severity of information asymmetry is likely to be different in each of these systems.
Banks have long-term relationship with firms and have less cost of obtaining information,
monitoring, and enforcing repayment, besides having the expertise to scrutinize projects. It
is, thus, easy in a bank-based system to eschew adverse selection and prevent moral hazard.11
Chava and Roberts (2008) argue that debt covenants, involved in commercial lending
activities, are found to be effectual in mitigating the ill-effects of informational problems as
it facilitates transfer of control rights—which acts as a disincentive for managers to violate
the covenants. Further they note that presence of such covenants help to reduce financial
8
A number of empirical studies lend credence to this hypothesis. See, for example, Fazzari and Athey (1987),
Fazzari et al. (1988), Hoshi et al. (1990), Whited (1992), Fazzari and Petersen (1993), Schaller (1993), Athey and
Reeser (2000), and Rajakumar (2005).
9
Based on a survey of 1050 US Chief Financial Officers, Campello et al. (2010) confirm that the inability of firms
to borrow leads to cancelation or postponement of planned investment activities.
10
Demirguc-Kunt and Levnie (2001) made an attempt to classify financial structure of about 150 countries by
constructing several measures of bank- and market-based system. While using the data, mostly pertaining to the
1980s, they observed that India followed bank-based financial system.
11
The main bank system in Japan was an effective monitoring device that helped to reduce problems arising on
account of informational problems. With capital market orientation of corporate financing since the early 1970s,
the monitoring capacity of main bank system has been under severe test. See, Aoki (1994).

8 The IUP Journal of Applied Finance, Vol. 20, No. 4, 2014

constraints and underinvestment as well. Though these authors do not mention about the
nature of commercial lenders, in a context like India, they are commercial banks and
development finance institutions, which enjoy preeminence in the country’s financial system.12
It is possible to enforce discipline on the borrowers by monitoring their actions. In sharp
contrast to such possibility, in market-based system, monitoring of actions of firms by public
(shareholders or individual bond holders) is costly. Under these circumstances, informational
problems tend to be severe. The presence of intermediary financial institutions can, thus,
reduce market imperfections arising from informational problems and thereby help to achieve
greater efficiency in resource allocation.

Trends in Corporate Finance13

Though in finance literature, debt and equity are considered as two broad categories of
financing, the structure of balance sheet of a company in India shows that there are different
sources from which it can mobilize funds. The relative share of each source in total funds
reveals the importance attached to a particular source of funds and determines the financing
pattern. We analyze the corporate financing pattern by using the data extracted from the
study of ‘Finances of Non-government Non-financial Public Limited Companies’, which is
annually conducted by Reserve Bank of India (RBI) and published in RBI Bulletin. It may be
mentioned that public limited companies are the dominant institutional category within
corporate sector and RBI provides valuable information on different sources of funds.14
Financing pattern of corporate sector has been examined for the period 1956-57 to
2010-11. The entire study period is divided into four distinct phases based on Rajakumar
(2011), who identified these phases after examining the institutional framework in which
corporate sector had to operate. These phases are: (i) 1956-57 to 1969-70 when both public
and private sector functioned, but public sector dominated; (ii) 1970-71 to 1979-80 when a
gradual decline in the role of the public sector was noticed and the private sector was severely
controlled; (iii) 1980-81 to 1991-92, a period marked by a gradual relaxation of controls and
a slow withdrawal of the public sector; and (iv) 1992-93 onward when private sector was
given greater freedom and assigned the leading role in industrial growth. The last phase is
further sub-divided into 1992-93 to 1999-2000 and 2000-01 to 2010-11.
The structure of corporate finance has been reported in Table 1. Rosen (1962) observed
that internal savings was the principal form of corporate financing in the 1940s. Firms were
then governed by a system of managing agents, who helped to transfer earnings of old
enterprises to new ones. Public deposits were the primary external funds. Banks were also
important external source, but mostly followed short-term financing. Bank financing depended
on the personal security and guarantee extended by managing agents. The dominance of
internal financing was attributed to the dormant and underdeveloped capital market
12
Banks accounted for 63% of financial assets of all segments of Indian financial system in 2012 and of this,
commercial banks had a share of 92.4% (Subbarao, 2013).
13
For a survey of studies on corporate financing in India, see Rajakumar (2008).
14
Studies pertaining to corporate sector normally use RBI’s studies. See, for instance, Seema (2005).

Corporate Financing Pattern in India: Changing Composition and Its Implications 9

(Rosen, 1962, p. 9). In the post-independence period too, the predominance of internal
sources of funds continued until the 1960s. Since then, corporate sector began to rely on
external sources of funds (see Table 1).

Table 1: Structure of Corporate Finance, 1956-57 to 2010-11 (% of Total)

1956-57 1970-71 1980-81 1992-03 2000-01
Average of to to to to to
1969-70 1979-80 1991-92 1999-2000 2010-11
A. Internal Sources 51.7 50.0 33.2 34.6 47.9
Of which: a) Paid-Up Capital 7.1 5.1 2.1 1.1 0.5
b) Reserves and Surplus 13.6 11.2 8.1 13.5 17.7
c) Provisions 30.9 33.7 23.0 20.0 29.7
B. External Sources 48.3 50.0 66.8 65.4 52.1
Of which: d) Issue of Fresh Capital [7.0]* 2.3 5.4 19.0 12.4
e) Borrowings 27.9 22.1 37.1 31.7 19.9
f) Trade Dues 15.7 25.5 23.9 14.3 19.3
Total (A + B) 100 100 100 100 100
Note: * Available since 1961-62.
Source: Author’s estimates based on the data extracted from RBI Bulletin, Various Issues

Using the broad classification of sources of funds into internal and external, and comparing
their relative shares in total funds, it is seen from Table 1 that internal funds contributed, on
an average, 51.7% of total funds during 1957-1970. Since then, it steadily declined and its
average contribution was 34.6% during the 1990s; however, it had risen thereafter to 47.9%.
As against this, we find that since 1970-71 external funds has gained importance, as its share
in total funds steadily increased, contributing about two-thirds of total funds in the 1990s,
which thereafter declined in the last decade.
Looking at the disaggregated data on various internal sources of funds, it is seen that
provisions constituted the major component of internal funds. While the decline in the
share of internal sources was brought about by the decline in the share of ‘paid-up capital’ and
of ‘reserves and surplus’ during the 1970s, it is the decline in the share of ‘provisions’ that
largely accounted for the overall decline in the importance of internal sources in the 1980s
and 1990s. In the 1990s, ‘reserves and surplus’ sharply increased its share from 8.1% of the
previous decade to 13.5% of total funds and further to about 17.7% in the last decade.
Nevertheless, we find that amongst internal sources, ‘reserves and surplus’ has gained
importance since the 1990s and ‘provisions’ in the last decade, which together increased the
relative share of internal funds in the total.
At the disaggregated level, it is seen that the rise in the share of external funds in total
funds is largely due to ‘trade credit’ in the 1970s, ‘borrowings’ in the 1980s, and ‘fresh issues
of share capital’ since the 1990s. Borrowing is the major component of external sources, next

10 The IUP Journal of Applied Finance, Vol. 20, No. 4, 2014

only to trade dues in the 1970s by a small margin. However, the share of ‘borrowing’ has
registered a marginal decline in the 1990s, but a sharp decline thereafter. While these are the
broad trends in internal and external funds in relation to total funds, it is important to
examine the composition of each of these to gain more insights into these broad changes. It
may be noted that RBI provides detailed classification of these funds from 1961-62 onwards
and so further analysis at the disaggregated level has been done starting from this year.

Composition of Internal Funds

Internal sources comprise paid-up capital, reserves and surplus, and provisions. The relative
share of each of these sources to total internal funds is presented in Table 2.

Table 2: Composition of Internal Sources of Funds, 1961-62 to 2010-11

(% of Total)
1961-62 1970-71 1980-81 1992-93 2000-01
Average of to to to to to
1969-70 1979-80 1991-92 1999-2000 2010-11
A. Paid-Up Capital 10.5 10.7 6.3 3.2 1.1
B. Reserves and Surplus 22.9 21.9 24.7 39.7 42.7
Of which: Investment Allowance 13.7 6.7 4.0 –0.8 –0.1
C. Provisions 66.6 67.4 69.0 57.1 56.2
Of which: Depreciation 65.5 58.6 65.6 54.5 42.3
Total (A + B + C) 100.0 100.0 100.0 100.0 100.0
Source: Author’s estimates based on the data extracted from RBI Bulletin, Various Issues

As seen in Table 2, the share of ‘paid-up capital’ was not only relatively low but had
dwindled over the years. It suggests that corporate sector had low reliance on own ‘paid-up
capital’. Second major source of internal funds was ‘reserves and surpluses’. It contributed
around 22-25% till the 1980s and this had increased sharply to 39.7% in the 1990s and
further to 42.7% thereafter. Within ‘reserves and surplus’, the component called ‘other
reserves’, which included profit retained, showed a phenomenal increase during the 1990s.
Provisions had dominated internal financing. Its share was not only the major one, but had
increased from 66.6% in the 1960s to 69.0% in the 1980s. However, in the 1990s its share
came down to an average of 57.1% and remained around that level thereafter. Thus, within
internal sources, ‘provisions’ (mainly depreciation) predominated during the period 1956-
57 to 1990-91, and both ‘reserves and surplus’ and ‘provision’ contributed almost entire
internal funds in the subsequent periods. These two dominant sources are affected by the
fiscal environment.

Fiscal Environment and Internal Funds

After a review of various fiscal measures pertaining to corporate sector, Rajakumar (2009)
identified corporate income tax, depreciation allowance and several other investment-related
tax concessions as having a direct bearing upon the ability of firms to generate funds internally.

Corporate Financing Pattern in India: Changing Composition and Its Implications 11

In order to understand whether fiscal measures were conducive for the generation of internal
funds, we view the corporate income tax rate in conjunction with other tax allowances. The
combined effects of this can be observed only by looking at the actual tax burden expressed as
Effective Tax Rate (ETR), which is defined as percentage of tax provisions to profit before
tax. The rate of depreciation allowance as such is not a clear indicator because the basis of its
calculation varies over the years—for some years it is based on individual assets and for
others on block of assets; methods used for estimation also varies across time (accelerated,
straight-line method, etc.). So the depreciation provision, which is the net result of all this,
is viewed as a better indicator and expressed with respect to net fixed assets to obtain the rate
of depreciation (see Table 3).
Table 3: Trends in the Indicators of Influence of Fiscal Measures
on Internal Funds, 1961-62 to 2010-11 (%)
1956-57 1970-71 1980-81 1992-93 2000-01
Average of to to to to to
1969-70 1979-80 1991-92 1999-2000 2010-11
1. Statutory Tax Rate 50.4 57.1 53.2 42.9 34.9
2. Effective Tax Rate 46.6 50.7 41.6 27.2 27.9
3. Profitability (PAT to Net Worth) 8.8 10.7 9.6 9.7 12.7
4. Retention Ratio 35.2 50.2 47.9 62.0 66.0
(Profits Retained to PAT)
5. Dividend Payout Ratio 64.8 49.8 52.1 38.0 34.0
(Dividend to PAT)
6. Other Tax Savings to PAT 6.7 11.7 19.2 21.1 9.6
7. Depreciation Provision to 8.6 10.1 9.3 4.7 5.3
Net Fixed Assets
Source: Statutory tax rates till 2008-09 were taken from Table 1 of Rajakumar (2009) and thereafter from Union Budget
Volumes, Various Issues. Other information was author’s estimates based on the data extracted from RBI Bulletin, Various Issues

As seen in Table 3, the Statutory Tax Rate (STR), which is the corporation income tax
rate proposed in the Union Budgets, has consistently gone up over the years until the 1980s.
There has been a considerable reduction in the STR during the last two decades. Though the
ETR has gone up in the 1970s, it declined sharply in the 1980s and 1990s. It suggests that,
though corporate sector was subject to higher level of statutory tax rate, the actual burden
was considerably low, particularly in the last two decades, and this was, ceteris paribus, favorable
for generation of internal funds.
However, what actually gets retained and goes as internal funds depends upon both the
level of profitability, measured as the ratio of Profit After Tax (PAT) to net worth, and profits
distributed. The ETR and profitability are negatively and significantly (at 1%) correlated
with a correlation coefficient of 0.7784 for the entire period between 1992-93 and 2010-11.
This clearly shows that the reduction in the ETR had enhanced profitability of firms. As far
as dividend is concerned, more than a half of post-tax earnings were distributed as dividend

12 The IUP Journal of Applied Finance, Vol. 20, No. 4, 2014

till the 1980s, and since then, it was gradually reduced to a little over one-third of post-tax
earnings. This also gets reflected in the rising profit retention ratio during the last two
decades. Thus, our analysis shows that though ETR is conducive to the generation of internal
funds, it also depends on the dividend policy being followed.
Tax savings accruing due to several other tax relief measures also protects income (profit)
from being taxed. To measure such savings on account of all other tax concessions, we first
take the difference between STR and ETR.15 The difference is used to blow up Profit Before
Tax (PBT) and then divided by 100, to arrive at the absolute figure. That is,
Other Tax Savings = [(STR – ETR) * PBT] / 100
When expressed as a percentage of PAT, it shows the extent of income shielded by utilizing
other tax concessions. It is seen that other tax savings to PAT has increased (see Row 6 in
Table 3), particularly in the 1980s and in the 1990s. It suggests that other tax concessions
were also favorable to generation of internal funds. The major tax saving instrument is
depreciation allowance. As a percentage of net fixed assets, this has improved in the 1970s
and more or less remained stable in the 1980s, but sharply came down in the 1990s (see Row
7 of Table 3). This shows that depreciation provision was conducive to the generation of
internal funds until about the late 1980s. Since then, its role has declined while tax saving
effect of ‘other tax relief measures’ improved.
Thus, the fiscal measures seem to influence the generation of internal funds. There is a
decline in the effective tax rate and a rise in ‘other tax savings’ since the 1980s. Depreciation
declined in the 1990s only. This shows that higher corporate tax rate could have discouraged
generation of internal funds, but for depreciation and other tax relief till the 1980s, and this
had reflected in the dwindling share of internal funds. However, the sharp reduction in
statutory corporate tax since the early 1990s and rising profit retention had a major role in
enhancing the share of internal funds in the last two decades.

Pattern of External Funds

Under RBI’s classification, external sources broadly comprise of ‘fresh issue of share capital’,
‘borrowing’, and ‘trade dues and current liabilities’. As seen in Table 4, share of ‘fresh issue of
share capital’ in external funds has continuously declined from an average of 13.9% in the
1960s to 5.0% in the 1970s. The trend has reversed since the 1990s and this contributed 29%
of external funds. The ‘fresh issues of share capital’ has two components, namely, ‘net issues’
(face value) and ‘premium on shares’. The premium component was meager during the 1970s
accounting for 0.8% of external funds. But in the 1980s, this gradually increased to 4.4% and
sharply increased to 21.7% in the 1990s. The observed increased share of ‘fresh issues of share
capital’ in external funds in the 1990s is, thus, largely due to the rise in the ‘share premium’.
The significance of ‘fresh issues of share capital’, particularly of ‘premium’, as a source of
external funds, has become a hallmark of corporate financing in India since the 1990s.
15
Tax savings obtained over and above depreciation provision is attributed to other tax concessions, which included
a plethora of tax incentives such as investment allowance, tax holidays, loss carry forward and so on. For more
details, see Rajakumar (2009).

Corporate Financing Pattern in India: Changing Composition and Its Implications 13

 Table 4: Composition of External Sources of Funds,
1961-62 to 2010-11 (% of Total)
1961-62 1970-71 1980-81 1992-93 2000-01
Average of to to to to to
1969-70 1979-80 1991-92 1999-2000 2010-11
A. Fresh Issue of Share Capital (a + b) 13.9 5.0 8.2 29.0 23.6
a. Net Issues NA 4.2 3.8 7.3 5.7
b. Premium on Shares NA 0.8 4.4 21.7 17.9
B. Borrowings (c + d + e) 54.7 42.6 55.5 48.5 35.9
c. From Banks 34.1 23.0 17.7 15.8 36.3
d. From Other Financial Institutions 3.7 –0.3 12.8 12.0 –3.4
e. Other Borrowings 16.8 19.8 25.0 20.7 3.0
C. Trade Dues and Other Current 31.3 52.6 35.9 21.8 39.5
Liabilities
Of which: Sundry Creditors 26.9 35.3 20.8 15.9 23.2
Total (A + B + C) 100 100 100 100 100
Note: NA means not available.
Source: Author’s estimates based on the data extracted from RBI Bulletin, Various Issues

In terms of relative share, ‘borrowing’ was the major external source of funds. Though its
share went up to 55.5% in the 1980s from 42.6% in the 1970s, it declined consistently
thereafter. To understand the role of various institutions, ‘borrowing’ has further been
classified by types of institutions. It is seen that ‘banks’ and ‘other financial institutions’ are
the major suppliers of institutional finance. Banks contributed about one-third of external
funds till the 1960s. Since then, its significance as an external source of funds declined
sharply and it contributed only 15.8% of external funds in the 1990s. Its share has, however,
gone up to 36.3% during the last period.16 As against this, borrowing from ‘other financial
institutions’ assumed significance in the 1980s and they became more important than banks
in the 1990s. Its relative importance has considerably come down in the last decade. The
category ‘other borrowings’ (consisting of ‘government and semi-government bodies’,
‘companies’, ‘public deposits’ and ‘others’) together constituted around 17-25% till the 1990s
with no definite trend. The decline in the share of ‘other borrowing’ has broadly contributed
to the overall decline in the share of ‘borrowing’ in total external funds. Notably, the share of
‘banks’ in external funds has gone up during the last decade with a concomitant reduction in
the share of ‘other financial institutions’. This was a period marked by the conversion of
some erstwhile large term lending institutions (development finance institutions) into
commercial banks (Subbarao, 2013).
16
Subsequent to nationalization of major banks in 1969 accompanied by the advent of social banking, the role of
commercial banks in financing corporate sector has declined till the early 1990s (Rajakumar, 2008).

14 The IUP Journal of Applied Finance, Vol. 20, No. 4, 2014

 Trade dues are another major source of external funds. In particular, it increased its share
in external funds substantially to about one-half in the 1970s. Since then, its share had
diminished to 35.9% in the 1980s and further to 21.8% in the 1990s, but increased substantially
to 39.5% thereafter. Sundry creditors constituted the major portion of trade credit. An
important characteristic of trade credit is that such source is less costly as compared to debt
and equity.
Although external funds have become more broad-based over the years, ‘fresh issues of
share capital’ and institutional borrowings together dominate external sources. In the 1950s,
corporate sector’s reliance on internal savings was largely attributed to underdeveloped
financial system (Rosen, 1962). There was a phenomenal progress in the development of
financial system during post-independence period.

Financial System and External Funds

Financial system helps to accelerate economic growth to the extent it facilitates migration of
funds to its best use. From firms’ point of view, availability and terms of finance affect their
investment decision. During the time of independence, financial system in India was in its
rudimentary form and the link between financial system and industrial finance was rather
weak (Rosen, 1962). The role of State in developing a broad-based financial system to facilitate
growth process was well recognized by the planners. In keeping with the strategy of planned
development, the State played a vital role in fostering the development of each of the different
segments of financial system to facilitate the growth process and also exercised control over
distribution of credit and finance so as to align the functioning of various financial institutions
to the overall priorities set out in the Plans. The control was extended to institutions,
instruments and interest rates. Several hitherto large commercial banks were nationalized in
1969, and further in 1980,17 new development financial institutions were created to provide
long-term loans to corporates18 and insurance and mutual funds were nationalized or created
to mobilize savings with specific fund deployment policies.19
As far as capital market was concerned, regulating the functioning of stock exchange has
been recognized as an integral part of economic policy since independence. More importantly,
the State exercised control over capital issues through the Capital Issues (Control) Act,
1947. Controller of Capital Issues (CCI) administered this. The capital issues of corporate
sector had to adhere to various guidelines as formulated by CCI from time to time. Companies

17
Government acquired ownership of 14 commercial banks by nationalizing them in July 1969 and further six more
banks in April 1980.
18
Industrial Finance Corporation of India in July 1948, with an objective to provide medium and long-term capital
whenever normal banking accommodation was not possible or recourse to capital market was found impracticable,
Industrial Credit and Investment Corporation of India in January 1955 to provide long-term funds to industry,
of which provision of foreign currency loan was an important one, and Industrial Development Bank of India in
July 1964 to reorganize and integrate the structure of industrial financing institutions. At the state level, State
Financial Corporations (SFCs) were established by the respective State Governments under SFC Act of 1951.
19
Life Insurance Corporation of India was established in September 1956, General Insurance Corporation of India
(and its subsidiaries) in September 1972 and Unit Trust of India in February 1964.

Corporate Financing Pattern in India: Changing Composition and Its Implications 15

were required to seek prior approval of CCI for fixing the issue price as well as quantum of
resources to be raised from the market. To promote an orderly and healthy development of
the securities markets and to provide adequate investor protection, the Government
established Securities and Exchange Board of India (SEBI) on April 12, 1988.
Through nationalization of some of the erstwhile major financial institutions, by
establishing new institutions and by controlling capital issues by companies, the State
attained control over financial system gradually in the 1950s and 1960s. The intervention of
the State had essentially promoted bank-based system rather than capital market-based one
(Rajakumar, 2001). This continued till the early 1990s.
Narasimham Committee (Government of India, 1991) argued that government control
over the financial system had diverted resources away from productive sectors and caused
operational inefficiency within the system on the whole. The Committee recommended
various measures to make Indian financial system ‘more efficient, competitive and vibrant’
and thereby enable them to complement reform measures addressed to real sector. These
recommendations found expression in the policy framework, culminating in financial
liberalization in the 1990s. As part of it, reserve requirements of commercial banks were
progressively reduced, entry of private sector into banking sector was allowed, issue of fresh
capital by banks to public through capital market was encouraged and interest rates on bank
advances was almost freed (Reddy, 1999). With the move towards financial liberalization, it
was found that the practice of Government control over capital issues as well as pricing of
issues including premium fixation had lost its relevance (Union Budget 1992-93). As a result,
CCI was abolished in 1992, which ended an era of government’s control over the volume and
pricing of capital issues. Companies were allowed to approach the market directly, provided
SEBI cleared their offer documents. Another development was, foreign institutional investors
were allowed to transact in the stock exchanges with a view to infusing more foreign savings
into Indian capital market. Thus, with the ushering in of financial sector reforms since 1992,
there was a gradual withdrawal of controls and a move towards greater autonomy in terms of
ownership and functioning for the different institutions within financial sector (Rajakumar,
2001). While these changes need not imply weakening of the bank-based financial system of
the pre-reform period, they have overwhelmingly increased the emphasis on equity market
within the financial system.
To test if such changing contour of financial system has reflected in the corporate financing
preferences, we have fitted a regression model with dummy variables, as follows:
Yt = a + bDt + et
where Yt is a measure of financing preference at time ‘t’, ‘a’ is the intercept, D is the dummy
(1 for all years since 1992-93 and 0 otherwise), ‘b’ is the coefficient of Dt and et is the error term.
We have run two different regression models: one is for the percentage share of fresh issue
of equity in total funds (henceforth referred to as equity financing) and another is for the
percentage share of borrowing from banks and other financial institutions in total funds

16 The IUP Journal of Applied Finance, Vol. 20, No. 4, 2014

(referred to as bank borrowing). A significant positive coefficient for D is expected if there is
a shift in the preference for that particular source of funds. For the purpose of estimation, we
have considered the period 1980-81 to 2010-11.20 We have also merged borrowings from
both banks and other financial institutions so as to reflect bank borrowings by corporate
sector. The estimates are reported in Table 5.

Table 5: Regression Results

Dependent Variable Estimates
Equity Financing a 5.428 (1.874)*
b 9.764 (2.393)*
SEE 6.49
R 2
0.365
F-stat. 16.644*
n 31
Bank Borrowings a 20.484 (1.629)*
b –1.990 (2.081)
SEE 5.643
R 2
0.031
F-stat. 0.915
n 31
Note: * indicates significance at 1% level.

As reported in Table 5, intercept (a) is significant for both equity financing and bank
borrowing. The dummy coefficient (b) is positively significant in the case of equity financing.
On the other hand, it is negative but insignificant for bank borrowing. Equity financing used
to be about significant one-fourth of bank borrowings during the pre-reform period, and it
accounts for significant three-fourths in the post-reform period. These results indicate a
significant shift in corporates preference for equity financing during the financial sector
reform period (that is, since 1992-93), whereas their reliance on borrowings from banks and
other financial institutions remained more or less the same as that of pre-reform period.

Conclusion
The above analysis brought out the changing pattern of financing in India. Until the 1960s,
corporate sector had greater reliance on internal savings and subsequently external sources
of funds became dominant. In the last one decade or so, internal funds have once again
become more important. Larger reliance on internal generation of funds till the 1960s is to
be seen in the background of the then underdeveloped state of financial system. Thereafter,
the State promoted and regulated the financial system comprising banks, development
financial institutions and capital market, and this could have stimulated a shift to external

20
Regression results do not change significantly even if we consider other periods.

Corporate Financing Pattern in India: Changing Composition and Its Implications 17

financing. An examination of the fiscal framework suggests that it had been conducive to the
generation of internal funds. It is possible that the requirements of large investments could
also have compelled the shift from internal to external financing.
The nature of intervention made in the development of financial system since the early
1950s had mostly resulted in creating a bank-based system. With the changes brought about
by financial sector reforms since the early 1990s, the thrust on equity market has increased.
As much as the growth and functioning of these institutions have implications for the
availability and cost of funds, they have implications for the pace of corporate investment
activities. In line with the changing contour of financial system, the financing pattern of
corporate sector has also changed, with increased reliance on issue of equity, which suggests
a certain degree of financial disintermediation. As noted above, capital market system can be
replete with adverse selection or moral hazard problems, which could cause information
inefficiency in the financial system. Under this, resource allocation need not be efficient
(Tobin, 1984) and this need not result in a desired level of corporate investment, which has
become a key to sustaining growth. Moreover, the shift to equity financing can potentially force
the firms to become shareholder-centric. Unless there is strong corporate ethics and governance
practices, such tendency may make the firms speculative and manipulative as well.
The preponderance of banks with greater monitoring facilities can help to mitigate
informational problems in the financial system and thereby help achieve greater efficiency
in resource allocation. The dilution of government ownership and entry of private players
have however increasingly made banks profit-centric. The recent move to grant bank license
to corporate houses could potentially lead banks to extend more finance facilities to group-
affiliated companies and eventually the banking system could become a channel of economic
wealth concentration. Though the RBI has instituted several safeguards in bank licensing
(Subbarao, 2013), it is imperative that the central bank continues to regulate credit
intermediation process so as to strengthen the role of banks as agents of development. 

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Corporate Financing Pattern in India: Changing Composition and Its Implications 21

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