FINANCING
1. What is Financing?
Financing deals with raising the funds to finance the investments (both working capital and fixed capital investments). In other words, financing is finding money from different sources in order to finance the investments.
2. Types of Financing
- Types of financing (according to the source):
(1) Debt financing (borçla finansman)
(2) Equity financing (özkaynak ile finansman)
b. Types of financing (according to maturity):
(1) Short-term financing: Maturity is at most 12 months (at most 1 year)
(2) Long-term financing: Maturity is more than 12 months (more than 1 year)
c. Types of financing (according to the provider):
(1) Spontaneous sources of financing: This type of financing is provided by the suppliers and the government by delaying the payments and by the customers by making an advance payment.
(a) Trade credit: Suppliers provide financing to the business by deferring the payments for the goods and the services that they sold. Business receives the goods and benefits from the services but make the payment for them in the future. By deferring the payment suppliers provide financing to the business.
(b) Taxes and other duties payable: Government provides financing to the business by deferring the payment of accrued taxes.
(c) Advance payments: Customers provide financing to the business by making an advance payment. Customers provide financing by making the payment before receiving the goods and benefiting from the services.
d. Institutional-based financing: Businesses get the necessary funds from a financial institution. Provider of the funds is a financial institution such as a bank, factoring company or leasing company.
e. Market-based financing: Corporations get the necessary funds from the capital market by issuing securities. Providers are the investors. Only type of business that may get funds from the capital market is corporation.
3. Financial Structure, Capital Structure, and Asset Structure
a. Financial structure: The mix of short-term and long-term funds. Financial structure is related to the right-hand side of the balance sheet.
b. Capital structure: The mix of interest bearing debt and equity financing. Capital structure is also related to the right-hand side of the balance sheet.
c. Asset structure: The mix of current assets and non-current (fixed) assets. Asset structure is related to the left-hand side of the balance sheet.
4. Alternative Financial Structure Policies
Asset structure affects the financial structure.
As a rule of thumb, current assets should be financed by short-term funds and long-term funds. But the amount of short-term funds must be higher. If all the current assets are financed by only short-term funds (short-term liabilities) then the net working capital becomes zero, which is very risky. There is no safety margin. If the business cannot convert its receivables and inventories into cash (in other words if the business cannot collect its receivables and sell its inventories) then it cannot pay its short-term liabilities. If the percentage of long-term funds is higher that finance current assets, then it is costly. Because long-term funds are more expensive than short-term funds. This decision is a trade off between cost and risk. As the amount of short-term funds that finance current assets increases, the risk also increases but the cost decreases. As the amount of long-term funds that finance current assets increases, the risk decreases but the cost increases. The amount of short-term and long-term funds that are used to finance current assets depend on the risk attitudes of the managers. If the managers are willing to take risk they may increase the amount of short-term funds. If the managers avoid taking risk they increase the amount of long-term funds.
Fixed (non-current) assets must be financed by long-term funds. Financing fixed assets by short-term funds is risky because fixed assets cannot generate enough cash in a short period. If short-term funds are used to finance fixed assets a loan revewal becomes necessary. If the bank rejects loan renawal, then the business may go bankkrupt.
5. Types of Short-Term Financing
- Trade credit (accounts payable, notes payable)
- Advances from the customers
- Taxes and other duties payable
- Short-term bank loans
- Business credit cards
- Issuing short-term debt instruments (bills)
- Factoring
a. Types of Short-Term Bank Loans
(1) Overdraft (Kredili Mevduat Hesabı-KMH)
- Enables the firm to withdraw money from its bank account even if the balance is not adequate.
- Suitable for very short-term (overnight or two or three days) cash needs.
- Very expensive
- Very flexible and easy to use.
(2) Revolving Line of Credit (Borçlu Cari Hesap-BCH)
- Bank sets a line (limit) for the firm,
- The firm withdraws cash from the line whenever it needs money and repays it whenever it has cash.
- Interest is charged every three-month on the average balance of the withdrawals.
- Payment flexibility
- It must be closed once a year.
- Mainly used to finance working capital (short-term cash needs),
- Suitable for the firms whose cash flow turnovers are high but irregular.
- Suitable for the firms that have short-term receivables but unpredictable collection patterns.
- If the business does not know when to receive the money, it must use revolving line of credit.
- Interest is not fixed when the loan is taken out. Interest is determined at the end of each three-month period.
(3) Term (Spot) Loan (Spot Kredi)
- It has a fixed maturity,
- Interest and principal are paid at once at maturity.
- Interest is fixed when the loan is taken out.
- Less flexible
- Requires lumpsome payment
- Mainly used to finance working capital
- Suitable for the firms that have predictable collection patterns.
- If the business knows for sure when to receive the money it must use term (spot) loan.
(4) Factoring
The firm transfers its receivables to a factoring firm. Services provided by the factoring firms:
- Collection
- Bookkeeping of receivables
- Finance
- Guarantee
Discount (peÅŸin iskontosu): From the face value of the receivable, interest and other fees are deducted and the remaining amount is paid.
Advance payment (ön ödeme): Up to the 80 % of the face value is paid after deducting the fees. At the maturity of the receivables interest is deducted from the remaining 20 % and the balance is paid.
In Turkey 80 % of the domestic factorings are discount. But, 80 % of the export factorings are advance payment.
6. Factors that the Banks Consider When They Extent Credit or Loan to the Businesses
Banks collect information about a business that applies for a loan. Based on the analysis of the information banks accept or reject a loan application. If a bank accepts a loan application it sets a limit for the business. This limit is the maximum amount of money that a business can borrow from that bank.
Banks consider the same factors that we studied in receivables management. These factors are: character, capacity, capital, conditions, and collateral. When the banks examine the conditions banks take into consideration the economic conditions and effect of the economic conditions on the sector in which the business is operating. Banks generally demand colleteral in the form of mortgage on real estate or pledge on inventory, receivables, machinery and equipment, etc.
7. Types of Long-Term Financing
- Long-term bank loans
- Financial Lease
- Issuing long-term debt instruments (issuing bonds)
- Equity
a. Long-term Bank Loans (Loans payable in installments)
- It has a fixed maturity,
- Interest and principal are paid in installments (monthly, every three-month, every-six month)
- Interest is fixed when the loan is taken out.
- Less flexible
- It does not require a lumpsome payment
- It is used to finance fixed assets. The firm pays the loan as it uses the fixed assets.
- Some investment loans have grace period (six months, two years etc.).
b. Financial Lease
- The lessee (borrower) selects an asset,
- The lessor (leasing firm) purchases the asset,
- The lessee uses the asset during the lease term and bears all the responsibility (insurance, repair, maintenance etc.)
- The lessee pays series of payments in installments,
- The lessee acquires the asset at the end of the term at no cost or at a symbolic cost.
- Lease term must be at least 80 % of the economic life of the asset.
- Present value of the future lease payments must be at least 90 % the cost of the asset.
Advantages of leasing
- 100 % finance,
- Operational benefits
- No taxes except VAT
- Financial lease is a financing method. There are two very important points in financial lease. Lessee (the business that uses financial lease) must pay for the insurance, repair, and maintenance. The lessee must insure the asset. The second important point is that; the lease agreement must state that the asset will be transferred to lessee at no cost or at a symbolic cost at the end of the lease term. There is also another leasing method, which is operating lease. Operating is not a financing method. The main difference between the financial lease and operating lease is that: In operating lease lessor (the leasing firm) pays for the insurance, repair, and maintenance; and at the end of the lease term the lessee must return the asset to the lessor.A Special type of financial lease (sell and lease back)
- Business owns a real estate (building).
- Business sells this real estate to the leasing company and obtains financing.
- The ownership is transferred to the leasing company. Simultaneously leasing company leases this real estate to the business and the business continues to use the real estate.
- Business makes periodic lease payments.
- At the end of the lease term, leasing company sells back the property to the business at a symbolic price.
c. Long-Term Debt Instruments
- Bond (maturity is at least one year)
- Discounted
- With coupon payments
- Issue is the same as issuing stock
- Issuing debt securities ensure a large amount of borrowing as compared to bank loans,
- Large paper work, high issuing costs,
- Very inflexible
d. Equity Financing
(1) Types of equity finance
- Cash or in-kind contribution of existing owners (shareholders) or contribution of new shareholders. This type of equity has also two types. They are explained below:
(a) Private Equity: Private equity is provided by the individuals or instutions such as private equity funds or other corporations.
(b) Public equity: Public equity is raised by issuing stock to the general public in the capital market.
- Retained earnings (undistributed profit to the owners. Earnings not paid out as dividends. Firm’s own cash). Indirect contribution of the owners (shareholders).
(2) Types of Corporations
- Publicly held corporation: Corporation whose shares are offered to the public. Corporations whose shares are traded in an organized exchange.
- Privately held corporation: Corporations whose shares are not offered to the public. Corporations whose shares are not traded in an organized exchange.
(3) Equity Terminology
- Share capital (Esas sermaye): Amount of capital stated in the corporate charter. Share capital can be increased by the decision of the general assembly of share holders (ortak genel kurulu). The capital article of the corporate charter must be amended.
- Authorized capital (kayıtlı sermaye): Maximum amount of capital that can be increased by the decision of the board of directors.
- Paid-in capital (ÖdenmiÅŸ sermaye): Amount of capital paid by shareholders.
- Nominal value: Stated value of a share (1 KrÅŸ or 1 TL.) Paid-in capital is stated in terms of nominal value.
- Issue price (ihraç fiyatı) : Actual money paid by the investors to own the shares. Shares can be issued at nominal value or above the nominal value. Shares can be issued below nominal value under certain conditions.
- Additional paid-in capital (issue premium): Difference between the issue price and the nominal value.
- Market price: Price of a share in the secondary market.
(4) Issuing Stock
- Initial public offering (halka açılma): A privately held corporation is said to go public when it sells its shares in a general offering to investors for the first time. This first sale of shares is called an initial public offering.
- Types of initial public offering:
- Public offering of the already existing shares (ortak satışı): Existing shareholders sell their shares to the public. All cash goes to the shareholders who sell their shares. No cash enters the firm.
- Public offering of the shares issued by capital increase. New shares are sold. All the cash enters the firm.
- Secondary (seasoned) offering (Ä°kincil arz): After initial public offering a publicly held corporation from time to time will need to raise money by issuing stock through capital increase. An issue of additional shares by a corporation whose shares are already publicly traded is called secondary (seasoned) offering.
- Preemptive right (rüçhan hakkı): In a secondary (seasoned) offering existing shareholders has the priority to buy the shares. They may exercise their rights or sell their rights. Remaining shares after the shareholders exercise their preemptive rights are sold to general public.
- Private placement (tahsisli satış): Sale of shares to a limited number of investors without a public offering. The corporation with the help of the intermediary institution organizes roadshows to find the investors.
- Sale to qualified investors: Qualified investors are institutions and individuals whose cash and investment in securities are at least 1 million TL. A corporation may choose to sell the securities to qualified investors. Again roadshows must be organized to find the qualified investors.
8. Cost of the Funds
- Cost of trade credit: Given up cash discount (not taking the cash discount).
- Cost of advances from the customers: Advance payment discount.
- Cost of business credit cards: If the total payment is made within the specified perid no cost, otherwise interest.
- Cost of taxes and other duties period: If the payment is made within the specified perid no cost, otherwise late payment charge.
- Cost of bank loans and factoring: Interest, tax, and fees.
- Cost of leasing: Interest and fees.
- Cost of issuising debt instruments (bonds and bills): Interest and issue costs.
- Cost of issuing stock: Issue costs.