Financing Decisions:Sources and Forms of Financing Flashcards
The Art and Science of Raising Funds
- Financial needs and financing requirements
- Internal and external financing
- Risk-related financing options
- Lender criteria
- Differing financing vehicles & their relative cost
- Financing over the life-cycle of a firm
Things that require Financing
a) Buy PPE
b) Additional investments in research and development
c) Promote the launch of a new product
d) Acquire a new business
e) Additional Working Capital
Forms & Sources of Financing
- Intangible assets - Equity (Retained Earnings) - Reinvested earnings, Ownership investment
- CAP Assets/PPE - Long-Term Debt (Leases, Bonds) - Leasing Companies, Investment dealers
- CAP Assets/PPE - Intermediate (Term Loans, Leases) - Chartered Banks, Trust Companies
- Flexible CA - Short-Term Financing (Inventory Financing) - Confirming institutions
- Trade Receivables Cash - Short-Term Financing (Notes Pay, single loans) - Factoring Companies, Chartered Banks
- Durable CA - Short-Term Financing (Working Capital Loans) - Chartered Banks
Differentiate between internal financing and external financing.
Internal
- comes from business and assets
- most common
- reinvesting of profit
- retained earnings (bootstrapping)
- Firms that grow using internal funding = bootstrapping!
External
- Comes from outside company
- Three forms
- equity (investment into your company by you or someone else)
- debt (long and short term)
(3) leasing (which can be a subset of debt)
Risk-related financing options (Types)
- Business
- Built-into firm’s operation
- Uncertainty in marketplace - Financial
- Related to firm’s capital structure
- Debt vs equity - Investment
- Quality of security
- Secured vs Unsecured loans
Risk-related financing options – Risk vs. return from the investor point of view
More Risk more reward
Things like: Govt Bond = Low risk Unsecured Debt = Med. Risk Common Shares = High Risk
Things to note:
- Investing in business is riskier (but potentially more rewarding) than providing a loan
- Unsecured debt is more risky but commands more interest income than secured debt from the lender’s perspective
- Investing in safe government instruments provide the lowest risk and lowest return
Strategies for Approaching Lenders.
- Matching Principle
- Acquisition of investments – payouts will coincide with individual firms Liabilities
- Chosen based on risk profile/cash flow requirements
- Requires Rev/any related Exp be recognized in same period (may consist of Dividends, coupon payments or principal repayment- If there is a cause-and-effect relationship between revenue and the expenses, record and same time
- no such relationship, then charge the cost to expense at once
- Lender Criteria
- for extending credit
- some lenders- more restrictive/focus on different priorities
- Relationship/reputation matters as much or more than technical requirements
- Creditworthiness
- How safe you are as a borrower in the perspective of the lender.
- How likely you are to make your payments on time and pay a loan in full
Lender Criteria
Character – Past payment responsibilities, how long has the business been in operation, etc. The lender is looking for stability and reliability.
Collateral – Pledge of property or other assets you are borrowing against? How marketable is your collateral? If a lender perceives weakness elsewhere, they may ask for more collateral or more money to be put down.
Capacity – Can you afford payments? What does the debt/service ratio look like? Is the interest expense too much for the business to handle? Looking at cash flow, payment history and contingent sources for repayment.
Capital – Positive net worth? Positive assets – liabilities? Do you have access to funds if there is an unforeseen circumstance?
Circumstances – what are the circumstances under which this company is looking for financing? What is occurring in the industry and in their business that could impact their creditworthiness.
Coverage – i.e. insurance or ability to cover interest and principle payments should something unforeseen occur.
Barriers to Creditworthiness
- Poor earnings record
- Questionable management ability
- Collateral of insufficient quality or quantity
- Slow and past due in trade or loan payments
- Poor accounting system
- New firm with no established earnings record
- Poor moral risk (character)
Equity financing can happen one of two very similar ways:
- A company can raise new capital as a result of issuing more shares. This would dilute current shareholders (i.e. they would now have a smaller % of a company).
- A company could sell a piece of already issued shares to another shareholder. This may not dilute current shareholders, but may take away some of other shareholders’ stakes depending upon the ownership interest sold and the arrangement made.
Types of Equity Financing
Common shares Voting rights Dividends if available Preferred shares Preferential access to dividends May have voting rights
Sources of Equity Financing for a Private Company
- Founders
- Love money
- Professional investors
Venture capital
Angel investors - Government
- Crowdfunding
Public corporations
- Publicly traded company / publicly held company
- Offers securities (stocks, bonds, and/or loans) to the public
- Stocks of the company are traded on a stock exchange
- Required to disclose company information publicly
Government financingGrants, subsidies, loans
- Direct or indirect form of financial assistance
- From municipal, provincial, or federal agencies
- Helps businesses carry out capital expenditure projects or expansion of their activities
- Without such assistance, these projects would be
delayed/abandoned
- Without such assistance, these projects would be
- Important federal government financial institutions:
- Innovation, Science and Economic Development.
Canada (Industry Canada) - Export Development Canada
- Farm Credit Canada
- Business Development Bank of Canada
- Innovation, Science and Economic Development.
Conventional Intermediate and Long-term Financing
Term loan:
Financing amount depends on what can be offered as security and is determined by lender
Banks, trust companies, insurance companies, and pension funds
Conditional sales contract:
Agreement made between a buyer and a seller for the purchase of an asset (e.g., truck) by instillments
Bonds:
Long-term loans that could be secured or unsecured (20 to 30 years)
Mortgages:
Long-term loan to finance real property, land, and buildings
