Business Finance: Sources, Costs, and Investment Strategies

Posted on Dec 9, 2024 in Economy

Sources of Company Financing

Financing refers to liquid resources or means of payment available to a company to meet its monetary needs. It can be classified according to three criteria:

  • Classification Based on Repayment Timeframe:
    • Sources of financing in the short term (less than 1 year)
    • Sources of financing in the long term (over 1 year)
  • Classification Based on Source Origin:
    • Internal financing (reserves)
    • External financing (equity, loans)
  • Classification Based on Ownership of Funds:
    • Company’s own funds (capital and reserves)
    • External funds (loans, credits)

Own Resources or Equity

These are the resources available to the company. They also carry the most risk because, in bankruptcy, the members are the last to receive their share of the company’s liquidation. The company’s own resources consist of capital and reserves:

  • Capital: Contributions made by partners and by successive capital increases that may occur.
  • Reserves: Profits from other undistributed funding. Growth is not a result of external funding but the productive capacity of the company, as it comes from a portion of the output that does not leave the company.
  • Depreciation: Calculated by the value that assets lose in the productive process.
  • Provisions: A part of the company’s result, which creates a fund to deal with certain losses that have not yet occurred or future expenses.

Unlike stocks, amortization funds and provisions do not represent growth for the company but are a self-funding of maintenance.

Dividend: The fraction of the profits of a company or society which recognizes members and regular remuneration of capital invested.

External Financial Resources in the Medium to Long Term

Long-term debt capitals are those for which the company is available for a period exceeding the duration of a financial year and are to be repaid with interest.

  • Medium and Long-Term Loans: Firms borrow from lending institutions for financing.
  • Bonds: These are securities issued by companies and purchased by individuals and other companies in exchange for interest. When companies need a lot of money and loan conditions are not economically feasible, individuals borrow through the issuance of bonds and debentures.
  • Leasing: A system whereby the company can incorporate some element of fixed assets in exchange for a rental fee. This process involves three actors: the customer-company, the company that makes the asset, and the leasing company. The drawback is the high cost, but many companies use them because the company will also pay fewer taxes.
  • Renting: Consists of the rental of real and personal property in the medium and long term. The lessee undertakes to pay a debt for the rental period, and the company undertakes to provide a range of services, facilitating the use of the property during the contractual term and proceeding to the maintenance of the good.

Short-Term Debt Capital

The company also offers short-term loans that allow you to finance part of its operating cycle. The most commonly used are:

  • Short-term loans
  • Short-Term Bank Credits: There are two types:
    • Overdraft
    • Credit account
  • Trade Credit: Involves the company ceasing to owe for the purchases it makes to suppliers.
  • Discounting of Bills: Before their expiration, customer debts may be transferred to an entity that shall advance the amount net of fees.
  • Factoring: The sale of all amounts owed to the client to a company, which provides the company with immediate liquidity and avoids the problem of defaults because the company does not respond to non-payment of their customers. It has a high cost and interest.
  • Spontaneous Financing Funds: Sources that do not require prior negotiation. An example is the wages of workers earning at the end of the month and not daily.

Costs of a Funding Source

Most of the resources used by the company involve a cost. The company intends that this involves the lowest possible average cost.

Costs of Financial Resources

The contributions of the partners or reservations do not imply a commitment to pay interest. In market terms, the cost of equity could be equated with the profitability that the shareholder gets from these resources. It represents an opportunity cost to the extent that the profitability obtained by employing them within the enterprise must be higher than would be achieved using those same resources abroad.

Cost of Third-Party Financing in the Medium and Long Term

There is always a contract that specifies the loan conditions with interest. To calculate the cost, all expenses should be taken into account.

Cost of Short-Term Debt Capital

Among the funding sources in the short term, a distinction should be made between those that require some sort of negotiation and those that are spontaneous. Spontaneous sources (wages of workers, credit, etc.) are resources that have zero cost. Other resources represent a cost that will depend on the agreed conditions.

Weighted Average Cost of Funds

In determining the cost of resources used, one can calculate the weighted average of the different costs, taking as weights the percentage of each funding source represents the total of resources used. This is called the weighted average cost of funds.

Investment

To carry out its activities, the company needs items. For the manufacture of new products, it is necessary to acquire equipment and buildings. The company gets the resources it needs from the capital market.

Families, businesses, and the state act as providers of savings capital. Thanks to different operators, the company can get the resources they need to carry out their investments and thereby qualify for profit. Therefore, for investment to occur, there must be savings.

Investment is the act whereby a change of immediate satisfaction and a certain resignation to that for the hope that is acquired, of which the asset acquired is support.

Characteristics of an Investment

Any investment project is an immobilization of resources in the hope of obtaining an income higher than the immobilization. The financial characteristics are:

  • Payment: The amount you pay when purchasing the assets. It is called time zero and is the largest payment.
  • Duration of the Investment: The number of years during which there will be entry and exit of money as a result of implementing the investment project.
  • Net Cash Flows: The difference between receipts and payments.
  • Residual Value: The value of the property at the end of the investment’s life.

Methods of Selection and Valuation of Investments

Business decisions are taken by the company’s management. Financial management is responsible for assessing and selecting the most convenient investments. The resources available to the company are limited, so not all investments can be made, and criteria must be established for selecting an investment among the different alternatives. We can differentiate two methods:

Static Selection Methods

These methods do not take into account the time factor; therefore, cash flow has the same value although they are produced at different times.

Payback Period (T): The objective is to determine the number of years it takes to recover the initial investment outlay compared with cash flows. In the event that all cash flows are equal, select the investment that gives a lower value of T and reject those that do not exceed the initial investment.

Dynamic Selection Methods

These methods take into account the time at which money enters or leaves. Capital C0 becomes capital Cn after n periods at a certain interest rate for a period, i, is equal to Cn. If we know the quantity Cn after n periods at an interest rate i, and we obtain the equivalent n-periods, we divide. At present, the first quantity has the same value, and the rest is to be updated, 1, 2, and 3 years, respectively.

  • Value of the capital in two years.
  • Value of capital in the next four years.

Net Present Value (NPV) or Capital Value (CV): Consists of updating all the cash flows now and getting the capital value at this time. The net cash flow each year is different, and the rate is also different. If the NPV is negative, it means the total amount that causes the investment project is greater than the inputs, so the investment will not be made. If it is positive, it means that the sum of all inputs to outputs is higher, so the investment can be done.

Internal Rate of Return (IRR): The IRR is the discount rate or performance, which is represented by r and that makes the NPV value of r equal to 0. The IRR provides the average profitability. To select an investment, you need to compare this rate with the market interest rate, i. There are three possibilities:

  • If r > i, you should make the investment as it is more profitable than the market.
  • If r = i, the investment is indifferent; you will not win or lose.
  • If r < i, the investment is not of interest; you should leave the money in the bank.

Of all investment projects for which r is greater than i, the one with the higher r value will be identified.

Investment and Risk

To choose an investment, we have only considered profitability criteria. However, to select an investment, you must also take into account the rate of risk involved. The selection of the best investment at considerable risk depends on the type of employer. Some are more optimistic and like to be at risk; others are more pessimistic and will prefer lower profitability.

Business Cycles

The cycle of a business can be divided into the long course and the short course.

The Long Cycle

It starts with the capture of resources and their detention in bins of fixed assets: buildings, installations, and machinery. All these goods are worn with time. Amortization joins the product cost, allowing each year to recover a portion of the investment. When assets are fully depreciated, the sinking fund is used to renew them. The cycle time for each element of restraint is different.

The Short Cycle

It is called the cycle of exploitation. It starts with the immobilization of resources in acquiring raw materials and supplies, continues with the production, marketing, and venting of the product, and ends with the payment of the invoices from customers, which involves the recovery of money. The average cycle length is called the average period of maturation.

Average Period of Maturation

The average period of maturation is the time it usually takes the company to recover the money invested in the production process, i.e., the number of days that the elements of circulating normally complete a round or cycle of exploitation.

Subperiods that Form the Average Period of Maturation

If we consider an industrial company, we can decompose the average period of maturation into five subperiods:

  • Average Provisioning Period: Number of days that raw materials are usually in the warehouse. (PMA)
  • Average Manufacturing Period: Number of days it normally takes to manufacture the products. (PMF)
  • Average Sales Period: Number of days it takes to sell. (PMV)
  • Average Collection Period: Number of days it takes to collect bills from customers. (PMC)
  • Average Payment Period: Number of days it takes to pay invoices from suppliers. (PMP)

Average Period of Maturation in a Commercial Enterprise

Companies engaged in sales do not have a productive process; therefore, there are only three subperiods:

  • Provisioning Subperiod: The time that the merchandise is in the company warehouse until it is sold.
  • Recovery Subperiod (PMC): The time it takes the company to collect sales and customer letters.
  • Payment Subperiod (PMP): The time it takes the company to pay suppliers.

The financial average period of maturation for such a company is estimated as follows: PM = PMA + PMC – PMP