Professional Documents
Culture Documents
DHBW - VMU - Brief Introduction To Financing
DHBW - VMU - Brief Introduction To Financing
Alexander Winkler
at Vytautas Magnus University
October 2019
2
DHBW Heilbronn / Alexander Winkler 2
Financial Management – Dipl.-Kfm. Alexander Winkler
Financing Methods
1. External Financing
1.1. Equity
1.1.1. Private Equity
1.1.2. Venture Capital
1.1.3. Employee Participation Schemes
1.1.4. Shares
1.2. Debt Financing
1.2.1. Medium and long-term Loans
1.2.2. Overdraft Facilities
1.2.3. Corporate Bonds
1.2.4. Trade Credits from Suppliers
2. Internal Financing
2.1. Retained Earnings
2.2. Financing from sale of assets
2.3. Spontaneous Financing
3. Financing Surrogates
3.1. Leasing
3.2. Factoring
4. Mezzanine Capital
5. Modern Financing Instruments
D
L E
I B
ASSETS LIABILITIES T
Q
U -
EQUITY S
I
D E
I R
T V
Y I
C
E
Current Liabilities
Current Assets Net
Working
Capital
Long Term Debt
Fixed Assets
•Tangible Fixed
Assets Shareholder‘s
•Intangible Fixed Equity
Assets
Total Value of the
Total Value of assets company to investors
DHBW Heilbronn / Alexander Winkler 6
Financial Management – Dipl.-Kfm. Alexander Winkler
Briefing Accounting
1.1 Equity
Equity provides several important functions within a company. First, it determines the
voting rights regarding management and allocation of profits. Secondly, it provides
insides on the liability: a high equity ratio signalizes that the investors trust in the
company and that they are willing bear the risks related with the business. Last, in case
of bankruptcy the investor is liable for the receivables of business associates (mostly
limited to the amount of his investment). Equity exists in various forms, which will be
introduced in the subsequent paragraphs.
Via private equity investors (e.g. Business Angels) participate in a company. The risk of a total loss is
compensated by participating in the profits of the company.
Private equity evidently increases the equity ratio what results in a better rating and thereby facilitating the
acquisition of debt from banks.
With private equity large sums of capital can be acquired without additionally burdening cash flow.
Beside this, companies can profit from the investors’ experience and from the network investors have at their
disposal.
Investors participate in taking the entrepreneurial risk and they intent to sell their shares with profits after a
medium or long-term period (so called “Exits”). In most cases these shares are sold to an investor or another
Private Equity company. This long-term relinquishment gives the company a high degree of certainty.
Disadvantages:
The most evident disadvantage of private equity is the influence of the investors and the loss of independence.
By providing capital the investors gain voting rights regarding management and profit allocation.
Furthermore the company has to provide detailed information to the potential investors because they want to
reduce the uncertainty for their investment. This procedure is both time consuming and cost intensive.
Application:
Private equity can be used either when an enterprise is founded, the growth of an existing company has to be
financed or even during a financial crisis of a company. It is especially suitable for mid-sized enterprises
(investment 150,000€ and above). An important part of private equity transactions is conducted via MBOs
(Management-Buy-Outs) or MBIs (Management-Buy-Ins).
Another reason why this financing instrument is important for SMEs is the fact that private equity companies
also invest low sums (less 1 Mill. €).
Application:
Venture capital is primarily used to finance start-up companies or innovative enterprises.
Venture capital is suitable for all sizes of SMEs because the investments sums starting at 20,000€.
Characteristics:
The idea behind that approach is to enable the employees to participate in the entrepreneurial risk and, in
return, to participate in the profits the company makes.
Advantages:
The advantage of this approach is the increase of equity that mostly comes along with no voting rights of the
employees.
Employee participation schemes demand no collateral and the capital are remunerated for a duration of 10
years or above.
This financing instrument fosters the relationship between the employees and the company. Often a higher
identification with the company can be observed, commonly resulting in a higher productivity.
Application:
Employee participation schemes are suitable for firms which set great store by tight relationships between
employees and the company and which want to increase both the motivation as well as the equity.
Employee participation schemes are especially suitable for mid-sized companies because a high number of
employees yields in higher possible investments.
This financing instrument can be applied at any stage of the company history and should be used as long-term
financing instrument.
1.1.4 Shares
Characteristics:
No other financing instrument has such deep impacts like the issue of shares.
The consequences of an IPO (Initial Public Offering) are manifold and in most cases cannot be reversed.
To be a stock-quoted company a lot of criteria have to be matched (e.g. frequent publication of balance sheet
and profit/loss statement).
Advantages:
Shares are used as long-term investment and provide a high level of certainty regarding the capital.
IPOs receive large investment sums and thereby they increase the equity ratio what facilitates the acquisition of
debt in the future.
1.1.4 Shares
Disadvantages:
An IPO does not only have advantages and positive effects but also disadvantages. One important point to
mention here are the costs of an IPO. In average the costs are about 7 – 10% of the IPO volume.
Later on there are also frequently recurring costs (e.g. payments for supervisory board, stock exchange fees,
annual general meeting, publication of company results).
Long Term Debt Financing usually applies to assets your business is purchasing, such as
equipment, buildings, land, or machinery. With long term debt financing, the scheduled
repayment of the loan and the estimated useful life of the assets extends over more than
one year.
Short Term Debt Financing usually applies to money needed for the day-to-day operations of
the business, such as purchasing inventory, supplies, or paying the wages of employees.
Short term financing is referred to as an operating loan or short term loan because
scheduled repayment takes place in less than one year. A line of credit is an example of short
term debt financing.
Characteristics :
Medium and long-term loans are granted for example by banks after the borrowing company was internally
rated.
Due to the leverage effect medium and long-term loans play an important role in corporate financing.
Intracompany loans and intracorporate loans are common financing tools in international business.
Advantages
The ROE (Return on Equity) can be increased by acquiring debt if the interest rate is less than the current ROE
and the current equity is held constant.
Even more, debt financing plays an important role because the interest payments are tax deductible. Debt
financing was the most important source of capital for SMEs in continental Europe in the past and still is.
Medium and long-term loans provide easy access to capital.
Beside this, a fixed interest rate and the agreed point in time when the amount is due gives a high degree of
certainty for the borrowing company.
Information only has to be provided to the lending bank.
Furthermore there is no additional party gaining voting rights and the cost of capital can considered being low
compared to other debt financing instruments.
Disadvantages:
Due to the internal rating process it is time consuming to acquire long-term debt capital.
By decreasing the equity ratio further acquisition of debt capital will be more difficult.
When granting credit banks also ask for collateral what negatively influences the independence of the company.
Debtors have to provide insights into the company and its strategy to creditors. The internal rating process of
banks requires extensive information about the company and its finance.
Application:
Medium and long-term bank loans are suitable for all SMEs.
Nevertheless, caused by financing regulations like Basel II, the acquisition of debt capital from banks will became
more difficult recently.
SMEs, which traditionally have low equity ratios and are not keen on providing insights into the company and its
strategy, will face new challenges when asking banks for loans.
Characteristics :
Overdraft facilities are short-term credits offered by banks. They allow their (business) customers to overdraft
their accounts up to a certain extend. The bank, in return, charges interest rate for the amount borrowed by the
company. Usually a service fee is imposed on these so called credit lines.
Advantages:
One advantage that comes along with overdraft facilities is the fast and easy access to capital due to
standardized processes and little formalism attached to this financing instrument. It is very flexible because at
times there are no additional costs if the overdraft is not drawn.
In addition, overdraft facilities positively contribute to the company’s liquidity.
Application:
Overdraft facilities are suitable for SMEs because usually these companies have higher working capital needs,
hence the requirement for short term (debt) financing is higher than for LSEs.
Overdraft facilities should primarily be used to compensate short-term fluctuations in capital needs caused by
salary payments or payments to suppliers.
Even though the costs for overdraft facilities are relatively high it should be preferred over trade credits from
suppliers which are even more expensive.
Characteristics :
Corporate Bonds can be defined as medium or long-term obligations offered by a company to investors on
financial markets.
A bond is defined by the issuer regarding the amount of money borrowed, the maturity date, the interest rate to
be paid, and the frequency of interest payments.
Bonds can be offered to both institutional and private customers.
The issue of bonds is rather conducted by a bank than by the company itself because banks have experience,
information on the market environment, and distributions channels at their disposal.
Whether the capital costs of corporate bonds are high or low depends on the external rating provided by
agencies like Moody’s or Standard & Poors. That means that there is no general statement whether capital costs
are an advantageous or disadvantageous characteristic of this instrument.
Advantages:
There are several advantages of raising capital via corporate bonds. At first, the (mostly) long-term alignment of
bonds ensures a lasting and stable liquidity and thereby improves the quality of the balance sheet’s structure.
At the same time the need for a high amount of capital can be covered with a single transaction and the long-
term agreement provides a high degree of certainty.
Secondly, the issue of corporate bonds is not addressed to banks but to institutional and/or private investors.
Thus there is no additional burden on the credit lines with banks.
Thirdly, in most cases there is no collateral demanded for the bonds. Nevertheless, the issuing company agrees
via the negative-pledge-clause that all subsequent capital market debts are equally ranked regarding the liability.
Last but not least the issue of corporate bonds on financial markets provides access to a broad range of investors
and thereby increases the public awareness and can even help to improve the image of the company.
Disadvantages :
However, the disadvantages of issuing corporate bonds also have to be named. The debt acquisition with
corporate bonds decreases the equity ratio which makes it more difficult to acquire additional debt from banks.
Furthermore the preparations necessary to issue bonds are very time consuming causing that the capital is not
quickly available.
Investors call for detailed information before investing money, so the company has to provide information about
the intended investments.
Low flexibility and availability underline the fact that corporate bonds are typical long-term financing
instruments.
Application:
Due to the high demands of financial markets regarding corporate bonds (i.e. reputation, company size,
preferably external rating, transparency, due diligence, regular information and reporting, ability to pay interest
installments) this source of capital is only suitable for LSEs and upper ranged medium-sized companies.
Advantages:
Trade credits have a positive effect on cash management / liquidity.
Fast and easy access to this financing instrument due to the fact that there is no formalism.
Trade credits disburden the existing credit line of the company with its bank(s).
Furthermore trade credits are granted even though the credit lines with banks are already exhausted.
Disadvantages :
The by far biggest disadvantage of this financing instrument are the high capital costs. Trade credits commonly
have effective interest rates between 20 and 50%.
Beside this there is always the danger of being highly dependable on the supplier.
And last but not least trade credits cause a high degree of uncertainty related to this instrument
because the credit can be withdrawn quickly in case of financial difficulties of the supplier.
Application:
Trade credits are suitable for SMEs as a source of short-term financing.
Due to the easy and fast access it is already used by many European companies, especially micro and small
enterprises. The reason for that can be found within the convenience of borrowing money this way.
Nevertheless, caused by the high costs and the high degree of uncertainty related to this financing instrument,
SMEs should not make extensive use of it.
2 Internal Financing
Funds (coming from current business activity like turnover, interest or extraordinary
income) that are flowing back to the company or are retained in the company are the
source of internal financing capital.
Internal financing instruments are suitable for all kinds and sizes of companies. For
limited the volume of this sub-chapter, only the financing methods of retained
earnings, of sale of assets, and of spontaneous financing will be introduced in this
chapter.
Characteristics :
The major prerequisite for corporate financing with retained earnings is profit. If the company has made profit a
decision has to be made which amount is to be paid to the investors and which amount is to be kept inside the
company.
Advantages:
One advantage of retained earning is the increase of the equity ratio. Retained earning increase the company’s
liquidity and improve the balance sheet’s quality.
Furthermore, no information about the company has to be provided and no investor’s influence is attached to
this financing instrument.
Disadvantages :
Two major disadvantages come along with retained earnings. First, the high tax burden, especially in Germany,
make retained earnings a rather expensive financing instrument.
Secondly, there is a high level of uncertainty attached to retained earnings because a company cannot ensure to
be profitable. Furthermore this financing instrument lacks availability.
Application:
Retained earning are suitable for all kind of enterprises. However, the high degree of uncertainty of this
instrument calls for additional financing options.
Assets are sold and the generated cash flow is used for financing purposes. One
popular form is “Sale and lease back”, where ownership of assets is transfered, yet the
assets stays at disposal of the company, which pays leasing rates for its formerly owned
asset.
Sell of obsolete assets and levying of hidden reserves are methods to generate
financing sources as well
2.3 Spontaneous
Financing
Financing by altering the cash flow maturities. Financing and interest advantages are
generated if the ratio of average receivable collection period in days (DSO) decreases to
average liability payment period. The lower this ratio, the higher internal financing. The
overall spontaneous financing volume depends on the total volume generated by a
company, and general market conditions regarding payment terms.
3 Financing Surrogates
Financing surrogates are instruments which spare or even improve the liquidity of a
company without further acquiring capital from outside or inside the company. A
discussion whether some of these surrogates fall within the area of internal financing
or the external financing would go beyond the scope of this wrap-up. For that reason
financing surrogates are introduced in a separate sub-chapter.
3.1 Leasing
Characteristics :
With leasing contracts the lessee pays a frequent and regular installment over a beforehand
agreed period of time to get transferred the rights of usage for a certain asset.
However, the title of ownership to the asset remains with the lessor.
The lessee has only a temporary right to use the particular object.
Additional services can be attached to the product, e.g. full service leasing to vehicles.
3.1 Leasing
Advantages:
The main advantage of leasing is that there is no tie-up of capital what increases liquidity and
financial scope.
+ Leasing also provides the possibility to finance 100% of the investment, meaning that no
investment on the part of the leaseholder is required.
Furthermore there is no need for additional collateral.
Beside this, leasing provides easy and fast access to capital.
Finally, leasing may not have an effect on the balance sheet. This means that in most cases the total
sum of leased assets is not part of assets in the balance sheet.
3.1 Leasing
Disadvantages :
The main disadvantage to mention in this context is the high effective interest rate, that is usually
higher compared to bank credits.
- The lack of ownership of a leased objects means, that the investment cannot be used
as collateral.
Application:
Leasing as financing instrument is suitable for companies of all sizes because there is no minimum
size required.
Leasing is mostly used for financing of company cars, IT equipment and machines. Heavy users are
retailers and the construction business.
3.2 Factoring
Characteristics :
Factoring is a financing method for working capital and refers to the sale of book debts by a company to a factor
institution on a continuous basis.
The enterprise receives the cash immediately and not only if the obligor (i.e. the customer) has paid his bill.
Factoring is usually established on an ongoing basis, meaning that receivables are regularly sold to factoring
companies.
3.2 Factoring
Advantages:
Factoring optimizes a company’s cash management / liquidity because receivables are cashed-in much earlier.
This results in better liquidity ratios.
Depending on the contract the collection management is transferred to a bank or factoring provider and thereby
disburdens its own staff.
+
Furthermore, the credit default risk can be completely transferred to the factoring company.
Outsourcing these tasks to a factoring provider ensures professional handling of receivables.
If the company uses the cash coming from factoring to repay some of its debts, it can further increase the quality
of its balance sheet. This leads to better ratings and to better payment terms.
With turnover growth, financing growth as well.
3.2 Factoring
Disadvantages :
Factoring, however, comes along with some disadvantages. First, the receivables are usually sold below
par (an amount smaller than 100%). Furthermore factoring institutions charge expensive fees (i.e. 0.8 –
2.5% of the receivables’ volume, fixed fee for evaluating the creditworthiness of a debtor). It is thus a cost
intensive financing instrument.
-
Secondly, the factoring company requires information about the company’s obligors, what results in
additional administration workload. But this time consuming process can be disregarded because
factoring is usually used on a continuous basis and therefore the information is just provided in full detail
once, and the updates are less time consuming.
Ending Factoring might be difficult.
Appearance to the customers might not be appreciated.
Risk of losing control of customers and markets.
3.2 Factoring
Application:
Factoring as financing instrument mainly remunerates for medium-sized companies due to the demanded
minimum volume of receivables.
Because factoring is offered as a whole service package it is economically applicable at a total volume of
receivables of 500,000 € or above.
Medium-sized companies mainly profit from the fast and easy access to capital as well as from the risk
reduction referred to factoring.
4. Mezzanine Capital
If traditional financing instruments reach their limits and the increasing demand for
capital cannot be covered with either equity or debt, Mezzanine capital can be used to
close this gap.
4. Mezzanine Capital
Characteristics :
Mezzanine can neither be assigned to equity nor to debt.
It has both characteristics and is therefore also called hybrid financing instrument.
Equity characteristics for instance is the low-ranking of the capital and the opportunity to participate in an
increase of the company value (equity kicker).
Debt characteristics is the ongoing interest payment that is independent from the company’s profit.
Furthermore Mezzanine capital is to be paid back after the upon agreed period and the interest payments are
tax deductible.
The range of Mezzanine capital goes from preferred stock, junior debt without collateral, hidden participation in
a company to convertible bonds or option loans.
The expectations of investors regarding the profitability of their investment are positioned between senior debt
and equity.
4. Mezzanine Capital
As can be seen from the paragraphs above, Mezzanine capital combines the advantages of equity and of debt.
Advantages:
Mezzanine capital is commonly relinquished for a long period of about 6–10 years and therefore provides a high
degree of certainty to the borrowing company.
Voting rights of investors (if any) are kept at a minimum level.
Disadvantages :
Nevertheless there is one disadvantage. Depending on the (external) rating of the company the capital costs to
cover the investor’s risk can be up to 10% p.a. or even above.
Application:
Mezzanine is usually not considered in early stages of a company. Due to the complexity a minimum company
size as well as necessary financing know-how is demanded. It is therefore suitable for medium-sized companies
in order to supplement existing equity and debt financing instruments.
Financing Methods
5. Modern Financing
Instruments
If traditional financing instruments reach their limits and the increasing demand for
capital cannot be covered with either equity or debt, and even Mezzanine capital is not
an option, some of the latest developed instruments from financing can be used to
close this gap.
Most of these instruments have in common, that their existence is closely linked to the
development of securitization tools.
CDO ABS
MBS