Corporate Finance: Structure, Cycles, and Funding
The Economic and Financial Structure of a Company
For a company to function, it needs to manage a number of assets (inventory, cash, raw materials, etc.). This constitutes its assets and defines the economic structure of the company. To acquire these assets, the company requires funding. The origin of these funds is its liabilities and defines the company’s financial structure.
The Financial Area of a Company
Objective:
- Design the most appropriate financial structure.
- Determine the extent to which candidates must apply to the various sources of financing.
Fixed assets may be divided into:
- Non-current: Liabilities that the company will not return in the short term.
- Current: Liabilities that may be claimed in the short term.
Assets can be split into:
- Non-current assets: Properties necessary for the company’s operation and not consumed during activity (long life).
- Current assets: Remaining assets, linked to production and trade, frequently renewed.
Business Activity Cycles
Two main cycles:
- Long cycle (fixed asset renewal cycle)
- Short cycle (operational cycle)
A) Long Cycle
Acquisition of property, plant utilization, and leveraging of resources to finance its renovation.
B) Short Cycle
Acquisition of raw materials, production of finished goods, sale of finished goods, and collection from customers to finance the purchase of new raw materials.
Average Maturity Period
Definition: Time of the operational cycle, from when raw material enters the warehouse until bills are collected from customers.
PME = PMA + PMF + PMV + PMC
This period can be divided into four sub-periods:
1) Average Procurement Period
(Time raw materials remain in the warehouse, waiting to be used)
PMA = 365 x (Maximum level of inventory in the warehouse / Annual consumption of raw materials)
Raw material rotation: Number of times raw materials in stock are renewed (annually)
Raw material rotation = (Annual consumption of raw materials / Average stock level in the store)
The average duration of supply can be calculated from the rotation of raw materials:
PMA = 365 / Rotation of raw materials
2) Average Manufacturing Period
(Time taken to produce goods and services)
Rotation = (Cost of production / Average level of manufactured product)
From the rotation of production, one can calculate the average period of manufacture:
PMF = 365 / Rotation of production
3) Average Sales Period
(Time it takes to achieve the sale of products once manufactured)
PMV = 365 / Sales rotation
Sales rotation (times production is renewed in stock each year)
Sales rotation = (Annual sales / Average balance of manufactured products in stock)
4) Average Collection Period
(Time it takes to collect payment from customers)
PMC = 365 / Recovery rotation
Recovery rotation: Number of times customers settle debts with the company in a year
Recovery rotation = (Annual volume of sales / Average balance of customer debt)
2. Sources of Company Funding
2.1 Types of Funding
According to the time of return:
- Short-term funding: Repaid in less than a year.
- Long-term financing: Repaid within a period exceeding one year.
- Permanent funding: The capital of the company, owned by shareholders, cannot require repayment while the company is running.
According to the source:
- Internal financing / Self-financing: Comes from ordinary activities; undistributed profits, cash items in anticipation of asset renewal (depreciation), and possible contingencies (provisions).
- External financing: Comes from contributions of others such as lenders, creditors, and shareholders (capital).
According to the degree of ownership:
- Own financing: Shareholders are holders of property rights generated by this financing.
- Financing of others: Lenders and suppliers are holders of rights resulting from external financing.
2.2 Self-Financing
- Social capital: Initial contributions made by partners at the time of the company’s creation.
- Shares: Property rights that divide the capital equally.
Capital increase: Shareholders are asked to make additional capital contributions. For each shareholder to maintain the same percentage of ownership, they would need to contribute proportionally to the number of shares held.
Preemptive rights: Give priority to existing shareholders to buy new shares, maintaining their ownership percentage. Shareholders not interested in the increase can sell these rights.
Companies often use retained earnings, owned by the shareholders. Part of those profits pay corporate tax, while another part is returned to shareholders as dividends. Part of the profit is reinvested, hoping for higher future dividends. These retained earnings are a source of internal financing.
Types of Self-Financing:
- Depreciation: Funds to cope with asset renewal. These funds can finance the company’s activity, avoiding external financing costs.
- Provisions: Allow the company to save money for future expenditures or losses (compensation, unpaid debt, taxes, etc.). It is more profitable to use provisions for normal operations than to keep them idle.
- Reserves: Profits used to finance growth without resorting to outside financing or capital expansions.
2.3 Financing from Others
Individuals and companies other than the shareholders lend money to the company. Entrepreneurs often avoid risking their own capital, so they choose this option.
Short-Term Financing from Others:
- Returned in less than a year.
- Used exclusively to finance current assets that can be sold without disrupting the company’s activity.
Commercial Credit: Granted by suppliers when there is a time difference between the acquisition of goods and payment. Usually granted to regular customers or when the company has an advantage due to its size.
Bank Credit: Granted by financial institutions. Advantages: The company gets the money and can plan, but the cost is never zero.
Types of Bank Credit:
- Loans: The company receives the requested amount in return for interest.
- Line of credit / Credit account / Credit policy: The company does not receive money but has it available in the bank if needed.
- Commercial discount: The bank pays the company money it expects to charge from a customer with delayed payment, but discounts an amount. The bank manages the collection and receives the client’s money.
Factoring: Sale of the client account to another company for collection management. Provides short-term financing and savings in administrative costs. Shortens the average maturity period by reducing the average collection period.
Promissory notes: Titles sold in the stock market in exchange for an amount today, promising a higher payment in the near future. Maturity of less than one year. An expensive process, so only large companies can afford it for critical operations.
3. Financial Costs
Cost of Own Financing
Shareholders receive dividends as remuneration for invested capital. Internal financing involves retaining money that would otherwise be returned to shareholders. This requires higher future dividends, as shareholders expect growth.
Cost of Trade Credit
The cost of commercial credit is not always explicit. If a discount is offered for payment upon receipt of goods, that discount is the cost of deferring payment.