Financing instruments for businesses
The company is financed through financial means made available by the owner or through third-party capital financing (loans, payment extensions, etc.)—corporate financing instruments.
For their concrete functioning, companies need financial resources. These resources are the “fuel” useful to put in place the mechanism that will lead them towards the creation of value:
- Realization of a product
- Provision of a service.
Each production activity requires the exercise of certain elements, human, material, intangible, which, combined with each other, make it possible to carry out the business of the company.
Knowing how to choose the best sources of finance is not an easy thing. The choice of one rather than another source can lead the company into a financial imbalance.
A financial imbalance occurs when the financial resources of third parties are clearly higher than the equity (equity). In the long run, this situation may jeopardize business continuity. Below we want to analyze the main sources of finance available to businesses.
The aim is to identify the optimal financial balance for each company through the mix between the various sources of financing. Let's start!
Financing instruments and financial balance
The financial management of a company is one of the most delicate aspects of the whole business. Immobilizing too much liquidity or, on the contrary, not having flexible and programmed sources of financing can lead to disastrous consequences for the life of the company. It becomes essential to have the appropriate knowledge to identify and solve the financial problems that your company may face. The concept of “financial balance " becomes an essential element. From a strictly corporate point of view, an enterprise is in a situation of financial equilibrium when:
Short-term sources of finance
Short-term finance refers to the need for the short-term sources of finance normally for one tear. It is also known as working capital financing in businesses. In practice, the financial structure of an enterprise is balanced when the sources of financing (own or third-party capital) are destined for the lasting financial need (purchase of fixed assets). While other current sources of financing (shareholder loans, or credit elasticity loans), are intended to finance short-term financial investments.
There is no doubt that situations of financial insufficiency can occur throughout the life of the company. These are cases related to the need to expand its business, if not in the most serious cases of market crisis. In these cases, knowing the correct financial instruments to use can really make the difference between survival and extinction of the company.
The structure of the financing sources
The goal to be achieved for each company, as we have seen, is the financial balance. It is a question of achieving the correct mix between the various possible sources of financing. However, it is not such a simple thing to achieve. In order to obtain financial balance, it is necessary to identify the essential characteristics of a financial structure.
Characteristics that can make it solid and able to withstand the financial difficulties that a company can face in its life.
The fundamental characteristics of corporate financing instruments can be summarized as follows:
The capital invested must be homogeneous with respect to the type of requirement to be covered. For example, if you intend to buy a property, it will be more appropriate to think of a medium-long term rather than a short-term form of financing. Which may be more suitable for hedges linked to current assets;
Ability to modify the financial structure in relation to the evolution of corporate events. In order to reproduce a constant balance between uses and sources.
The possibility for the company to have more room for maneuver in its financial choices.
The maximization of the differential between return on investment understood as profit linked to sales and cost of own or third-party capital.
Achieving financial balance through achieving these principles is not easy. However, achieving this can lead the company to reduce them:
- Insolvency risk
- Illiquidity risk
The risk of insolvency is linked to the inability to honor medium-long term commitments.
The risk of illiquidity is linked to the temporary cash deficit during the performance of the business activity.
Types of company financing sources
Each company requires financial resources in the form of capital to carry out its business. The financing instruments that a company can use can be of two types:
- Equity financing: share capital increases
- Third-party capital financing (loans, payment extensions granted to suppliers).
Let's look at these categories of corporate funding sources together.
Own capital financing
The share capital represents the value of the contributions made by the owners of the company, from its establishment onwards. Next to the capital, there are reserves, which can be made up of additional capital paid by the shareholders or profits not distributed by owners (self-financing). Share capital and reserves then form corporate equity. It is the difference between the total business activities net of third party financing.
Share capital increases can be:
- Free of charge ( nominal capital increase ) or
- For a fee (real capital increases).
Let's see them in detail.
Free share capital increases
The shareholders' meeting may order to increase the capital by allocating the reserves and other funds recognized in the financial statements to capital as available.
No free liquidity is added to the company in the free share capital increases. Simply the assembly arranges a different allocation of some ideal items of the net worth. For this reason, a free share capital increase cannot be considered a source of corporate financing. Or rather, this is nominal and not real, financing. In practice, this tool only increases the value of the shareholdings held by the shareholders, without an increase in the corporate assets.
In this type of transaction, the newly issued shares:
- They must have the same characteristics as those in circulation, and
- They must be assigned free of charge to the shareholders in proportion to those already owned by them.
Payment capital increases
The paid capital increases, on the other hand, to determine the main internal source of financing for the companies. This operation generates an increase in corporate assets due to the contributions. The share capital increase procedure is remitted to the extraordinary shareholders ' meeting, in the presence of a lawyer. The articles of association may grant directors the right to increase the capital up to a specified amount and for a maximum period of 5 years from the date of registration of the company in the Company Register.
As regards advertising obligations, in the 30 days from the subscription of the newly issued shares, the directors must file for registration in the commercial register a certificate that the capital increase has been carried out.
If the capital increase takes place through cash payments, the subscribers must pay the company at least 25% of the nominal value of the shares subscribed. Furthermore, if the shares are issued at a premium, this must be fully paid.
If the capital increase takes place through the transfer of assets in kind or credits, the corresponding shares must be fully paid up at the time of subscription.
In addition, those who confer assets in kind or credits must submit a sworn report by an expert appointed by the court, containing:
- The description of the goods transferred
The capital increase cannot be carried out until the previously issued shares are fully paid up. In case of a violation, the directors are jointly and severally liable for damages caused to shareholders and third parties.
Third-party capital financing
In addition to equity financing, the company can also finance itself using third party capital. In this case, the company will turn abroad to find liquidity. The procurement of third party financing is also functional to the good performance of the company. However, it is always advisable to maintain a balance between the company's own and third-party financial resources. The main external financing means can be the following.
Long term medium financing granted by financial institutions
Long-term financing refers to the needs of financial instruments with a maturity exceeding more than a year such as leasing, bank loans, bonds, etc.
These are loans, also in the form of a mortgage guaranteed by a mortgage, securities, or personal guarantees. The firm will repay the loan in installments. This refund includes:
- A share capital
- An interest portion (which represents the bank's remuneration).
It can be useful for your company to make such a loan if you have to make medium to long term investments.
A classic case is that of investments linked to the increase in production capacity. Examples may be:
- Purchase of machinery and industrial plants
- The renovation of sheds
- Purchase of a new vehicle fleet.
The examples can be many. The important thing is that financing is linked to an increase in business efficiency or productivity.
The financial leasing
Financial leasing is also among corporate financing instruments.
Leasing is a form of long-term financing. It is a financing instrument usually used by companies as an alternative to the direct purchase of fixed assets instrumental to production. A lease is a contract by which a lender provides the company a movable or immovable property upon the payment of a periodic fee. Ownership of the asset remains with the lender; in fact, the company cannot account for the asset in the financial statements as if it were its own but will constitute the commitment entered into with the lender in the memorandum accounts. Upon expiry, the company that owns the asset can decide whether to acquire the property by paying a redemption price.
Issue of bond loans
The issue of bonds is a form of long-term financing, which can be used by joint-stock and limited partnerships. The issue of bonds allows new capital to be raised by offering debt securities to the public. Finally, the issue of bond loans can be delegated to the administrative body by the extraordinary assembly.
The disposal of credits
Another form of third party capital financing is the disposal of credits.
It is a financing instrument which usually includes:
- Advance on invoices
- The portfolio unless successful
- The discount of promissory notes
We see below schematically the different financing instruments related to the disposal of credits.
Invoice advance is one of the financing instruments most used by commercial enterprises. With the advance on invoices, a bank, subject to the granting of a credit line, advances the number of invoices issued by the latter to a company. This form of financing allows for immediate disposal and allows for short-term liquidity to be obtained by anticipating the number of unexpired invoices. The objective of financing instruments of this type is to find short-term liquidity.
Portfolio unless successful
This is also among the financing instruments most used by businesses. The operating mechanism is the same as for the invoice advance. The portfolio consists of the advance by a bank of the number of bank receipts. Again, short-term liquidity is desired.
The company, which also for this type of transaction must have obtained a credit facility, presents the bank receipts by means of a list in which the effects are listed in order of expiry. The bank credits the total amount of the slip to the company's current account and charges the related fees. If successful, the debtor (client of the company) makes the payment directly to the bank. Otherwise, the amount of the unpaid effect, advanced by the bank, is debited from the company's current account.
The discount of bills
With the discount of promissory notes, a company submits a promissory note to a bank in order to mobilize the credit before maturity.
The bank, which must have granted a credit to the company, assesses the regularity of the effect, decides whether or not to grant the discount, and calculates the amount to be advanced.
To date, this is among the least used financial instruments. The instrument of bills, in fact, is increasingly used in the payment of commercial transactions.
The factoring, finally, is an operation that involves the mass transfer of receivables owed by a company to a factoring company, which undertakes to collect the same.
The assignment of credits can take place:
- with recourse
- Without recourse
In the first case, the factoring company purchases the credits with the right of recourse on the transferor company. On the other hand, the assignment without recourse does not provide for the right of recourse, and therefore the factoring company bears the risk of insolvency.
This means that making a transfer without recourse is much more expensive for the company that has to finance itself. What you need to know is that when a company decides to resort to financing, it must always set itself the objective of identifying the maximum amount of debt that it can bear.
In fact, too high indebtedness results in the impossibility of paying the financial charges and repaying the capital to the creditors. The situation in the medium term can lead to the default of the company itself.
The assessment of the maximum level of indebtedness must be made by looking at the risk and rigidity of the investment instruments adopted.
In addition, leverage should also be referred to.
In particular, it is necessary to evaluate the profitability of the capital of the company invested in company activity.
The return on capital, in fact, can be improved or worsened by the leverage factor.
Financial lever determination
In particular, return on capital improves if the return on investment (ROE) is higher than the cost of debt (i.e., the interest rate applied on debt) the return on capital worsens if the financial charges to be borne to obtain the loan of capital exceed the return on the investment There is talk of leverage to highlight the ability of debt to expand corporate profitability. In this sense, the use of third party capital acts as a multiplier of investment opportunities.
If the situation is favorable, the leverage effect is positive, and in this way, the indebtedness is remunerated. However, if the leverage effect is negative, the increased indebtedness translates into a situation of corporate weakness.
The use of leverage varies widely by sector and sector of activity. There are many areas where businesses operate with a high degree of leverage. Retail stores, airlines, food vendors, service companies, and banking institutions are the most classic examples. Even your company could make the most of the leverage effect.
Financing tools for businesses: the role of the professional
In recent years, the need for companies to manage financial aspects in the best way has become essential. The management of your financial planning and relations with banks must be managed in the best way. To get the company new finance, it is necessary to know the most appropriate traditional and innovative financing instruments. Inevitably, the role of the professional alongside the company is fundamental.
Author: Vicki Lezama