4.3 Financing activities

Financing activities are crucial for companies to support operations, investments, and growth. This topic explores various sources of financing, including debt and equity, and their impact on a company's financial position and performance.

The chapter delves into the specifics of debt and equity financing, examining bonds, notes, mortgages, and stock issuances. It also covers how financing activities are reported on financial statements and the importance of ratio analysis in assessing a company's financial health.

Sources of financing

• Financing involves obtaining funds to support a company's operations, investments, and growth
• Selecting appropriate financing sources is crucial for effective financial management and achieving the company's objectives
• Financing decisions impact a company's capital structure, risk profile, and long-term financial stability

Short-term vs long-term financing

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• Short-term financing provides funds for a period of one year or less (accounts payable, short-term loans)
• Long-term financing involves obtaining funds for a period exceeding one year (bonds, long-term loans, leases)
• The choice between short-term and long-term financing depends on factors such as the purpose of funds, cash flow stability, and interest rates
• Short-term financing is often used for working capital needs, while long-term financing supports capital investments and expansion

Debt vs equity financing

• Debt financing involves borrowing funds that must be repaid with interest (bonds, loans, leases)
• Equity financing involves raising funds by selling ownership interests in the company (common stock, preferred stock)
• Debt financing allows companies to maintain ownership control but requires regular interest payments and principal repayment
• Equity financing does not create a repayment obligation but dilutes ownership and requires sharing profits with investors

Internal vs external financing

• Internal financing refers to funds generated from within the company (retained earnings, cash reserves)
• External financing involves obtaining funds from outside sources (debt or equity financing)
• Internal financing is often the preferred choice as it avoids the costs and requirements associated with external financing
• External financing becomes necessary when internal funds are insufficient to meet the company's financing needs

Debt financing

• Debt financing involves borrowing funds from lenders with the obligation to repay the principal and interest
• Debt financing provides companies with access to funds without diluting ownership
• The cost of debt financing is generally lower than equity financing due to tax deductibility of interest expenses

Bonds payable

• Bonds are long-term debt securities issued by companies to raise funds from investors
• Bonds have a face value (par value), coupon rate, and maturity date
• Companies make regular interest payments (coupon payments) to bondholders and repay the face value at maturity
• Bonds can be traded on secondary markets, and their prices fluctuate based on market conditions and the company's creditworthiness

Notes payable

• Notes payable are written promises to pay a specific amount at a future date, typically within one year
• Notes payable are often used for short-term financing needs, such as inventory purchases or temporary cash shortages
• Interest is charged on notes payable, and the borrower must repay the principal and interest at maturity
• Notes payable are generally unsecured and may require a higher interest rate compared to secured debt

Mortgages payable

• Mortgages are long-term loans secured by real estate properties
• Companies may use mortgages to finance the purchase or construction of buildings, land, or other real estate assets
• Mortgages require regular payments of principal and interest over an extended period (15-30 years)
• The mortgaged property serves as collateral, and the lender has the right to foreclose on the property if the borrower defaults

Leases as debt financing

• Leases are contracts that allow companies to use an asset for a specified period in exchange for periodic payments
• Finance leases (capital leases) are treated as a form of debt financing, as they effectively transfer the risks and rewards of ownership to the lessee
• Finance leases are recorded as assets and liabilities on the balance sheet, similar to a loan
• Operating leases are not considered debt financing and are treated as off-balance-sheet transactions

Cost of debt financing

• The cost of debt financing is the effective interest rate a company pays on its debt
• The cost of debt is influenced by factors such as the company's creditworthiness, prevailing market interest rates, and the debt's terms and conditions
• The after-tax cost of debt is lower than the pre-tax cost due to the tax deductibility of interest expenses
• Companies aim to minimize their cost of debt financing to optimize their capital structure and financial performance

Equity financing

• Equity financing involves raising funds by selling ownership interests in the company to investors
• Equity financing does not create a repayment obligation but requires sharing profits and control with investors
• The cost of equity financing is generally higher than debt financing due to the higher risk borne by equity investors

Common stock issuance

• Common stock represents the residual ownership interest in a company
• Companies can raise funds by issuing new shares of common stock to investors through an initial public offering (IPO) or secondary offering
• Common stockholders have voting rights and are entitled to a share of the company's profits through dividends and capital appreciation
• Issuing common stock dilutes the ownership percentage of existing shareholders

Preferred stock issuance

• Preferred stock is a hybrid security that combines features of both debt and equity
• Preferred stockholders have priority over common stockholders in receiving dividends and assets in the event of liquidation
• Preferred stock dividends are generally fixed and must be paid before any dividends to common stockholders
• Preferred stockholders typically do not have voting rights, unless specified in the stock's terms

Retained earnings

• Retained earnings represent the portion of a company's net income that is not distributed to shareholders as dividends
• Retained earnings are a form of internal equity financing, as they can be reinvested in the company's operations or used for future growth
• Using retained earnings for financing avoids the costs and dilution associated with issuing new shares
• The decision to retain or distribute earnings depends on factors such as the company's growth opportunities, capital requirements, and dividend policy

Cost of equity financing

• The cost of equity financing is the required rate of return that equity investors expect to earn on their investment
• The cost of equity is influenced by factors such as the company's risk profile, growth prospects, and investor expectations
• The cost of equity is typically estimated using models such as the Capital Asset Pricing Model (CAPM) or the Dividend Discount Model (DDM)
• Companies aim to minimize their cost of equity financing by managing investor expectations and maintaining a strong financial performance

Financing activities on cash flow statement

• The cash flow statement reports the cash inflows and outflows from a company's operating, investing, and financing activities
• Financing activities involve transactions related to obtaining or repaying capital, such as issuing stock, borrowing funds, or paying dividends
• The financing section of the cash flow statement provides insights into a company's financing strategies and capital structure management

Cash inflows from financing

• Cash inflows from financing activities include proceeds from issuing stock, bonds, or other debt securities
• Proceeds from borrowings, such as bank loans or mortgages, are also reported as cash inflows from financing
• Cash inflows from financing indicate the company's ability to raise capital and support its operations and growth

Cash outflows from financing

• Cash outflows from financing activities include repayments of debt principal, such as bonds, notes, or loans
• Dividend payments to shareholders are also reported as cash outflows from financing
• Stock repurchases, where the company buys back its own shares, are considered cash outflows from financing
• Cash outflows from financing reflect the company's obligations and commitments to its capital providers

Net cash from financing activities

• Net cash from financing activities is the difference between the cash inflows and outflows from financing activities
• A positive net cash from financing indicates that the company raised more capital than it repaid during the period
• A negative net cash from financing suggests that the company repaid more capital than it raised
• The net cash from financing activities, along with the cash flows from operating and investing activities, determines the overall change in the company's cash balance

Disclosure of financing activities

• Companies are required to provide disclosures related to their financing activities in the financial statements and accompanying notes
• Disclosures help stakeholders understand the company's financing strategies, debt obligations, and equity transactions
• Proper disclosure of financing activities is crucial for transparency, comparability, and informed decision-making by investors and creditors

Notes to financial statements

• Notes to the financial statements provide additional information and explanations related to financing activities
• Notes may include details on the terms and conditions of debt agreements, such as interest rates, maturity dates, and collateral
• Equity-related disclosures in the notes may include the number of shares issued, par value, and any restrictions on dividends or share transfers
• Notes also disclose information on leases, including the classification of leases and the associated assets and liabilities

Supplementary schedules

• Supplementary schedules provide more granular information on financing activities
• Debt schedules may include a breakdown of the company's debt obligations by type, interest rate, and maturity
• Equity schedules may present the changes in the company's equity accounts, such as common stock, preferred stock, and retained earnings
• Supplementary schedules enhance the understanding of the company's financing activities and help users assess the company's financial position and risk profile

Management discussion and analysis

• Management discussion and analysis (MD&A) is a narrative section that provides management's perspective on the company's financial performance and condition
• In the MD&A, management may discuss the company's financing strategies, capital allocation decisions, and plans for future financing activities
• Management may also provide insights into the company's debt covenants, credit ratings, and liquidity position
• The MD&A complements the quantitative disclosures and helps stakeholders understand the company's financing activities in the context of its overall business strategy

Ratio analysis of financing

• Ratio analysis involves calculating and interpreting financial ratios to assess a company's financing activities and capital structure
• Financing ratios provide insights into a company's leverage, solvency, and ability to meet its debt obligations
• Ratio analysis helps stakeholders evaluate the company's financial risk, compare its performance to industry peers, and make informed decisions

Debt-to-equity ratio

• The debt-to-equity ratio measures the proportion of debt financing relative to equity financing in a company's capital structure
• It is calculated as total debt divided by total equity
• A higher debt-to-equity ratio indicates higher financial leverage and potentially higher risk
• The optimal debt-to-equity ratio varies by industry and company-specific factors, such as growth stage and cash flow stability

Times interest earned ratio

• The times interest earned ratio, also known as the interest coverage ratio, measures a company's ability to meet its interest obligations
• It is calculated as earnings before interest and taxes (EBIT) divided by interest expense
• A higher times interest earned ratio indicates a greater ability to cover interest payments and lower financial risk
• Lenders and investors use this ratio to assess the company's creditworthiness and debt servicing capacity

Fixed charge coverage ratio

• The fixed charge coverage ratio measures a company's ability to cover its fixed financial obligations, including interest and lease payments
• It is calculated as (EBIT + lease payments) divided by (interest expense + lease payments)
• A higher fixed charge coverage ratio indicates a greater ability to meet fixed financial obligations and lower financial risk
• This ratio is particularly relevant for companies with significant lease obligations or other fixed charges

Impact of financing on financial statements

• Financing activities have a direct impact on a company's financial statements, including the balance sheet, income statement, and statement of changes in equity
• Understanding the effects of financing activities on the financial statements is crucial for assessing a company's financial position, performance, and cash flows

Balance sheet effects

• Debt financing increases liabilities on the balance sheet, such as bonds payable, notes payable, or mortgages payable
• Equity financing increases shareholders' equity on the balance sheet, through the issuance of common stock or preferred stock
• Financing activities can also impact the cash and cash equivalents balance, depending on the timing of cash inflows and outflows
• The balance sheet provides a snapshot of a company's financial position and capital structure at a given point in time

Income statement effects

• Interest expense from debt financing is reported on the income statement, reducing the company's net income
• Dividend payments to preferred stockholders are also reported on the income statement, as a deduction from net income
• The tax deductibility of interest expense can provide a tax shield, reducing the company's effective tax rate
• Financing activities can indirectly impact the income statement through their effect on the company's operations and investments

Statement of changes in equity

• The statement of changes in equity reports the changes in a company's equity accounts during a specific period
• Equity financing activities, such as the issuance of common or preferred stock, are reported as increases in the respective equity accounts
• Dividend payments to common stockholders are reported as a reduction in retained earnings
• The statement of changes in equity provides insights into the company's equity transactions and the impact of financing activities on shareholders' equity