--- GIT.IR e-Learning Platform ---
In the last topic, we learned about the uses of capital.
But before we get there, what are the sources that a company can obtain capital?
In this topic, we shall examine the sources of capital and the ways to manage liquidity for these first
lesson.
Let's start with the sources of funds where we'll study internal financing, sourcing from financial
intermediaries and sourcing from capital markets.
We'll end with a short discussion on the factors that affect a company's choice of financing.
A lot to cover, so let's get rolling.
In essence, a company can source for funds internally, which can come from generating its own operating
cash flows.
Increasing working capital efficiency, that's through the management of payables, receivables and
inventory.
The company can also convert liquid assets such as receivables, inventory and marketable securities
into cash for short term financing needs.
External funding sources include borrowing from financial intermediaries, which can be banks or non-bank
entities.
Funding from capital markets include issuing commercial paper debt, common stock and preferred stock.
Other forms of external funding can include leasing as well.
Let's examine each of these categories, starting with internal financing.
Operating cash flows are straightforward.
These are the companies after tax operating cash flows, less interest payments and dividend payments.
A company with higher, more predictable after tax operating cash flows has greater ability to internally
finance itself.
Accounts receivables are amounts owed by customers.
The sooner a company can collect what it is owed, the less its need to finance the operations in some
other way.
Accounts payable are amounts owed by the company to suppliers of goods and services.
You may be wondering how can something a company owes be thought of as a source of funds?
To answer that, you need to understand trade credit.
Trade credit is a spontaneous form of credit that arises from the terms of payment, where suppliers
usually extend a grace period for payments to be made.
For example, if the supplier extends net 60 terms to the company, the payment is due 60 days from
the invoice date.
One can see this as a 60 day interest free loan extended by the supplier.
Sometimes suppliers may offer discounts as a reward for early payment.
For example, a 210 net 62 term means that the payment is due in 60 days, but a two percent discount
is applied if the payment is made within 10 days from the invoice date.
If we take the discounted amount as the bait, we can see it as a form of interest free loan from the
supplier for the first 10 days.
After 10 days, the full payment is required so we can see the discount as an interest to be paid to
the company.
This can be seen as a short term unsecured loan from the supplier.
If the cost is cheaper than other sources of short term loans, the company may want to make the payment
later instead of borrowing.
Inventory on goods waiting to be sold when the inventory is sold.
Potential cash receipts are a source of funds.
But the implications on a firm's cash position go beyond that.
Investing in and holding inventory costs money.
So companies would prefer not to put a lot of money into inventory when that money could be used for
more productive means.
The longer the inventory remains unsold, the longer that money is tied up and not usable for other
purposes.
As a result, an efficient company holds as little inventory as is necessary and sells or turns over
the inventory as quickly as possible.
Many companies use it just in time inventory system, which means the inventory arrives from suppliers
when it is needed.
This approach makes the supply chain much more efficient, but it also increases the risk of a critical
component or item being out of stock when needed.
And lastly, marketable securities on financial instruments such as stocks and bonds of other entities
that can be quickly sold in the market and convert it to cash.
Companies can sell some of the marketable securities that they hold if they need funds for any reason,
such as when making a capital expenditure.
Next, let's move on to external sources, starting with funding from financial intermediaries, which
can be banks or non-bank entities.
Banks typically provide lines of credit for large financially sound companies, an uncommitted line
of credit is one where a bank extends an offer of credit for a certain amount but may refuse to lend
if circumstances change.
This may not be a very reliable source of credit for some companies, as the company is seeking, financing
is likely to get rejected when it needs it the most.
Companies should not rely on uncommitted lines for most of their short term financing needs, a committed
or regular line of credit is one where the bank commenced to lend up to a specific amount for a period
of time, typically less than a year.
This commitment to lend makes it a more reliable source of short term funding than an uncommitted line
of credit.
Regular lines of credit typically require the borrower to pay a commitment fee to the bank as a form
of compensation for setting aside the amount for borrower.
A revolving line of credit, commonly known as revolver, is even more reliable than a committed line
of credit.
The commitments can last for multiple years and often involve larger sums of money with a revolving
line of credit.
Companies may borrow and repay funds as their needs change over time.
As such, agreements pose a higher risk to the banks.
They are typically offered only to very large and established corporations.
Along with committed lines of credit, revolving credit lines can be verified and can be listed on the
firm's financial statements in the footnotes as a source of liquidity.
Lines of credit are typically unsecured loans, and the interest charges are stated in terms of a short
term reference rate, such as LIBOR or the U.S. prime rate, plus a margin for the credit risk.
Smaller companies or companies with weaker credit may have to pledge assets as collateral under a secured
loan from a bank receivables or inventory are usually collateralized for short term loans, while longer
term loans are usually secured with a claim to fixed assets.
Receivables can be collateralized through assignment arrangement or factoring arrangement in a receivables
assignment arrangement, the firm assigns its receivables to the bank.
However, the firm still services the receivables and remains responsible for any receivables that are
not paid.
Under a factoring arrangement, the firm's receivables are sold to the bank at a discount from their
face values, the size of the discount will depend on how long it is until the receivables are due.
The credit worthiness of the firm's credit customers and the firm's collection history on its receivables.
The factor, which is the buyer of the receivables, takes on the responsibility for collecting receivables
and the credit risk of the receivables.
Non-bank lenders include Web based lenders, which typically lend to small to medium sized firms and
charge commissions and fees in addition to interest.
Capital market sources include issuing commercial paper for short term financing and debt, common stock
and preferred stock for longer term financing.
Commercial paper is short term unsecured debt typically issued by large and well rated companies, such
companies may prefer commercial paper to bank loans as the interest costs are typically lower.
However, issuers of commercial paper are often required to have a backup line of credit from banks
to assure investors that they will be able to repay the short term nature of commercial paper, along
with the credit worthiness of the borrower and the back up line of credit.
Generally make commercial paper a low risk investment for investors.
Commercial paper can be sold directly to investors or through dealers.
For longer term financing firms typically issue a mix of debt and equity.
You would have sufficient knowledge of these instruments by now, so this is just a summary.
Long term debt often carries a fixed interest rate through maturity and can be public or private debt.
Debt payments of priority overpayments to equity holders and the interest paid on debt is typically
tax deductible.
In addition to current market conditions, interest rates on a company's debt depend on its credit worthiness
and the collateral.
Companies can issue common stock both in public markets and privately.
Dividends are paid at the discretion of the management and are not tax deductible.
Preferred stock is a hybrid security that has qualities of both debt and equity.
That is, it has promised fixed payments like debt and no maturity date.
Like common stock, dividend payments on preferred shares have priority over common stock dividends,
but lower priority than interest payments on debt.
Like common dividend, preferred stock dividends are not tax deductible.
Besides preferred stock, other hybrid securities include convertible, preferred stock and convertible
bonds.
Each of these specifies a number of common shares that the security owner can convert their securities
into.
And lastly, leases can be considered an alternative form of financing.
Instead of borrowing to make a lump sum purchase, the firm promises to make regular lease payments
in exchange for the right to use an asset over a specified period.
One can view leasing as a bundle of financing and purchase in a single package.
So given all the choices, what are the considerations that companies take when deciding on the financing,
we can study it from the perspective of specific factors and macroeconomic factors.
First, the company size large companies with strong operating cash flows can rely more heavily on internal
financing, and their credibility usually allows them to source additional funds from capital markets
at low cost.
Smaller companies might not have the positive, unpredictable cash flows needed to meet fixed periodic
debt payments, so they tend to depend on private equity financing.
Secondly, the volatility of operating cash flows, high levels of uncertainty in cash flows can make
servicing debt obligations challenging.
So companies with unpredictable cash flows tend to use little debt financing.
Rather, they rely primarily on equity financing.
Third, the quality of assets available as collaterals, real property and equipment, a good collateral
for mortgages and asset backed bonds.
In contrast, assets that are unique, highly specialized and intangible might not be valuable as collateral.
So debt financing using such assets as collateral are rare.
Fourth, the management of maturities between asset and liabilities when issuing debt to fund specific
assets.
Companies tend to match the maturity of the debt to the useful life of the asset.
However, some companies may choose to issue short term debt to fund long term assets.
This is because short term interest costs tend to be lower over long term interest costs.
So if short term rates are expected to stay low for an extended period, some companies may prefer to
finance with short term debt and continually refinance with new short term debt.
However, there is rollover risk where short term rate increases when refinancing, or the company could
not refinance at all due to market or company specific conditions.
There is also the possibility of currency risks for companies whose revenues are in one currency and
debt repayment is in a different currency.
If the foreign currency strengthens, the company may have difficulty repaying its debt.
Short term debt in foreign currencies can be hedged using derivatives.
Besides all these factors, other important firms specific factors to consider include the cost of financial
distress, agency costs and flotation costs.
These will be explained later in this course.
Macroeconomic factors that affect companies financing decisions include taxation, inflation expectations,
government policy and monetary policy.
Let's briefly discuss each of them.
As mentioned earlier, interest payments on debt are tax deductible.
So there is the advantage of issuing debt over equity, particularly for companies whose marginal tax
rate is high.
Inflation expectations can also affect financing decisions if inflation is expected to be high, long
term fixed rate debt becomes more attractive to issuers because future debt payments will be less in
real terms.
On the other hand, uncertainty about future inflation rates can make issuing long term fixed rate debt
riskier and issuing short term or floating rate debt more attractive.
Policy wise, some governments make provisions for loans to specific industries at lower interest rates
to stimulate the economy or to grow certain sectors.
The government could also provide loan guarantees to the lenders, such that lenders would agree to
lend greater amounts and at lower interest rates.
And lastly, monetary policy.
Central banks around the world have at times set benchmark interest rates to historically low and even
negative levels to stimulate economies.
Access to capital is made much cheaper for companies.
Many companies use the opportunity to issue debt at low rates, refinance existing debt and repurchase
common stock.
All these have an effect of increasing leverage in companies, thus stimulating the economy.
And these are the factors that affect a company's financing decisions and concludes this lesson on the
sources of funding in our next lesson, we shall learn liquidity management and the ways to measure
liquidity.
See you again!