Unlocking the Sources of Funds for Businesses | CFA Level I Corporate Issuers
In this topic, we’ll explore various sources of capital for a company and how to manage liquidity. We’ll discuss internal financing, sourcing from financial intermediaries, and tapping into capital markets. So, let’s dive in!
Internal Financing Sources
A company can obtain funds internally through:
- Operating cash flows – These are the company’s after-tax operating cash flows, less interest and dividend payments. A company with higher, more predictable after-tax operating cash flows has a greater ability to finance itself internally.
- Accounts receivables – Amounts owed by customers. The sooner a company collects what it’s owed, the lesser its need to finance its operations externally.
- Accounts payable – Amounts owed by the company to suppliers. Trade credit, a spontaneous form of credit arising from payment terms, can be seen as a short-term unsecured loan from the supplier. Sometimes, suppliers offer discounts for early payments, making this an attractive form of financing.
- Inventory – Efficiently managing inventory can free up cash for other uses. Many companies use a just-in-time inventory system, increasing supply chain efficiency but also the risk of stockouts.
- Marketable securities – Financial instruments that can be quickly sold for cash, such as stocks and bonds of other entities.
External Financing Sources
Funding from Financial Intermediaries
Financial intermediaries, such as banks and non-bank entities, provide external funding through:
- Revolving line of credit – A multi-year, high-capacity credit line, available only to large and established corporations. These lines are verifiable and listed on a firm’s financial statements as a source of liquidity.
- Committed line of credit – A more reliable source of short-term funding, where the bank commits to lend up to a specific amount for a period of time, typically less than a year. A commitment fee is usually required.
- Uncommitted line of credit – An unreliable source of credit, as the bank may refuse to lend if circumstances change.
- Secured loans – Smaller or weaker-credit companies may need to pledge assets as collateral to obtain loans. Receivables or inventory are typically collateralized for short-term loans, while fixed assets secure longer-term loans.
Receivables can be collateralized through assignment or factoring arrangements. In an assignment, the firm assigns its receivables to the bank but remains responsible for their collection. In factoring, the firm sells receivables to the bank at a discount, and the bank takes on collection responsibility and credit risk.
Non-bank lenders include web-based lenders, which typically cater to small-to-medium-size firms and charge commissions and fees in addition to interest.
Funding from Capital Markets
- Commercial paper – Short-term unsecured debt issued by large and well-rated companies. Lower interest costs make commercial paper an attractive alternative to bank loans. Issuers often need a backup line of credit from banks to assure investors of repayment. Commercial paper can be sold directly to investors or through dealers.
Firms generally use a mix of debt and equity for long-term financing:
- Debt – Often carries a fixed interest rate through maturity and can be public or private debt. Debt payments have priority over equity payments, and interest paid on debt is typically tax deductible.
- Common stock – Can be issued publicly or privately. Dividends are paid at the discretion of management and are not tax deductible.
- Preferred stock – A hybrid security with qualities of both debt and equity. Promised fixed payments like debt, and no maturity date like common stock. Dividend payments have priority over common stock dividends but lower priority than interest payments on debt.
Leasing as an Alternative Financing Option
Leasing is an alternative form of financing that allows firms to acquire the right to use an asset for a specified period without making a lump sum purchase. Instead of borrowing to buy the asset, the company promises to make regular lease payments. This approach can be viewed as a combination of financing and purchasing in a single package.
Leases come in two main types: operating leases and capital leases. Operating leases are typically short-term and leave the responsibility of maintenance, insurance, and taxes to the lessor. Capital leases, on the other hand, are more long-term and transfer ownership rights, risks, and benefits to the lessee.
By choosing to lease rather than purchase an asset, a company can free up capital for other investments or expenditures, manage cash flow more effectively, and avoid the risks associated with asset ownership, such as depreciation and obsolescence.
Firm-Specific Factors Affecting Financing Decisions
- Company size – Large companies with strong cash flows can rely more on internal financing, while smaller companies may depend on private equity financing.
- Volatility of operating cash flows – Companies with unpredictable cash flows tend to use little debt financing and rely primarily on equity financing.
- Quality of assets as collateral – Real property and equipment are good collateral, while unique, specialized, and intangible assets are not as valuable for collateral purposes.
- Management of maturities – Companies tend to match the maturity of the debt to the useful life of the asset when issuing debt to fund specific assets.
Macroeconomic Factors Affecting Financing Decisions
- Taxation – Interest payments on debt are tax deductible, providing an advantage for issuing debt over equity for companies with high marginal tax rates.
- Inflation expectations – High inflation expectations make long-term fixed-rate debt more attractive, while uncertainty about future inflation rates can make short-term or floating-rate debt more appealing.
- Government policy – Some governments offer loans or loan guarantees to stimulate the economy or grow specific sectors, which can affect financing decisions.
- Monetary policy – Central banks may set benchmark interest rates to historically low or negative levels, making capital access cheaper for companies and increasing leverage.
With this understanding of the sources of funding and the factors that affect financing decisions, we’ll move on to liquidity management in our next lesson.