M2L04 Internal financing and borrowing

  1. How companies generate money for further investment
  2. Distribution of money in the company
  3. Internally generated funds and the importance of depreciation
  4. Capital structure of the company
  5. Financing through banks
  6. Financial leverage
  7. Case study: financing through bank loans and leverage

Today we deal with internally generated funds and bank debt.
The first question is how companies generate money for further investments. Every company operates and generates income from sales and pays certain expenses and, in addition to paying certain expenses related to its business, invests in assets, invests in working capital. These are all the changes that occur in the profit and loss account and the balance sheet that reflect the changes that occurred in the company during the year. These changes represent the uses and sources of funds. We divide the funds, that is, the uses and sources of funds that take place in the company, into three different categories. The first category is operational activities, which include all those changes in working capital that you have in the company – that is, inflows and outflows of funds. We also have investment activities that, as a rule, are reflected in the changes that have occurred in investment assets, that is, in long-term assets. Examples are in front of you. There are again inflows from the sale of the plant or outflow of funds that we used for the purchase of a certain plant or equipment. Companies also have financial activities that take place within the company’s life cycle, especially during one year where I deliberately put examples for slightly larger companies because I expect you to become a slightly larger company in a relatively quick period. You can always reduce all examples for larger companies to examples for smaller companies. So, in financial activities, we have changes that occurred in loans obtained, we have repurchases of parts of ownership shares, we have outflows for repurchases, outflows for payments of part of the profits to owners and the like. These are all the activities that occur within the balance sheet and the income statement and these activities will be shown in something called the cash flow statement which is shown to you on the next slide. So, as I said, the company will have uses and sources of funds and these cash flows will create, as a rule, internally generated funds.

So companies always have two basic sources of cash. They can collect money from external investors or they can generate part of the money themselves, which will be used for reinvesting in the company, i.e. for increasing the business activity of the company itself. Shareholders or company owners who want to reinvest part of their money in the company, shareholders or company owners at the end of the period have the right to part of the net profit or even the entire net profit. If they want the company to do well in the coming periods and think that there are certain investment opportunities in the economic environment that the company should absolutely accept, then the owners of the company or the shareholders of the company decide to leave that money to the company so that the company can earn on that money. What should also be noted here is that when we talk about investing in a company, we are talking about those internally generated funds, where we have to take into account a special part of the funds, because we say that cash is reinvested all the time in the company, and that cash is used to make additions, to earn from the company’s operations. There is one item, and that item is not cash, but which greatly affects cash is depreciation as a non-monetary expense, i.e. an outflow of funds, i.e. an expense. Depreciation, if increased by profits, represents cash flow and internally generated or created funds that are later available to the owners of the company or the company itself to invest in profitable projects. When we talk about funds intended for reinvestment, as a rule, we will talk about the capital structure and we will look at the capital structure as something on the basis of which the company grows. So, a company can of course grow based on its assets, the assets it has at its disposal, but it also grows based on the debt it potentially takes from the capital market or the equity capital that is in the company. The capital structure is usually found on the right side of the balance sheet, in the capital and liabilities section. In the example in front of you, there is a company that has as much as 19.72% of loans in bank A, 14.08% of loans in bank B and as much as 66.2% of the owner’s capital. The relationship between debt and equity represents the capital structure. In the example in front of you, the values ​​found in the company are also given. The value of the capital that is in the company. When put into percentage terms, they show the percentage structure of the company’s capital. Thus, the company capital, the company’s capital structure shows the relationship between long-term assets, financing assets and ownership assets. Here, I mentioned bank loans as one of the company’s financing options. Companies are very often financed by banks, and in this segment, they approach banks when they do not have enough of their own funds. So, when the company does not have enough cash and has decided to borrow funds, pay a certain interest on them and invest that amount of money in the business.

How to approach banks in general?

Therefore, any approach of an entrepreneur to the bank will require the presentation of a business plan so that the bank can also ensure that it gives money for the right purposes. Of course, based on the register of loan obligations and their internal analyses, banks can determine whether you are the creditor for them who will pay them back, or return the loan on time. In the short term, banks offer business ventures typical credit lines, i.e. lending for working capital, but companies can take or borrow from the bank in the long term as well. Borrowing funds, for example, from banks at interest rates that are lower than the rate of return that you can achieve if you reinvest the borrowed money in the company, that is, use it for an investment in some specific part of a business venture that will bring you a high return, this is called financial leverage. In financial leverage, it is good to return to that capital structure. We said that the capital structure is the relationship between the company’s debt and equity capital. And financial leverage means that you will take on additional debt, that is, increase part of the debt in order to reinvest in the company. If you increase part of the debt, it turns out that you are changing the capital structure of the company. The capital structure of a company is most often measured by something called financial or business leverage. We have a special ratio called the debt to equity ratio and in the business sector and the financial sector in general that debt to equity ratio of less than 1 (debt/equity) should be considered solid by any industry’s standards. If companies have very large leverage, high leverage, which means that they are in debt, apart from the fact that they probably have an idea of ​​how they will place these debt funds in profitable projects, they are highly exposed to market risks. One of them is the financial risk, i.e. the risk that will arise for the company owners in the form of potential insolvency and which in the worst-case scenario can lead to the bankruptcy of the company itself or the reorganization of the company.

In general, a high degree of business leverage or financial leverage is good for the company if the company fulfils its obligations on time, but equally, from the mathematical side, it allows companies to earn much more on each incremental sale. Companies with a low degree of business offering that have very little debt in their ownership structure are likely to make profits more easily when faced with a low degree of sales revenue. We will look at financial leverage in the way that companies will always have a tendency to borrow at rates that are lower than the rate of return required by the owners on their funds. Of course, the first fundamental principle of financing business ventures is precisely through internally generated funds. Let’s go now to one example – a case study of financing through bank loans and financial leverage. Sandra is the owner of a small business that manufactures decorative lampshades and has been in business for ten years and has been doing solid business so far. However, in recent days she simply cannot sleep because a new idea came to her mind. What if she started making eyeshadows from a special kind of unwashed untreated rice paper? She has been thinking about this for days, but she is simply afraid, like all entrepreneurs, of entering a new sphere of business, especially considering the current state of the market. However, this year it was more and more difficult for her to sell the classic shades that she made, given the enormous competition, especially from manufacturers like Ikea and similar. And after researching in detail this new production of shades from unrefined unwashed rice paper, she decided to get a special cutter for such paper, considering that such paper is quite fragile, and she even decided to give added value to her customers by creating combinations of special graphics with watermarks on these eyeshadows and that will represent unique products. Unique. This will make Sandra stand out on the market. When she found this new equipment and saw its price, €13,000, how much additional investment in the business would cost her, at the moment it doesn’t really suit her, but she still can’t stop thinking that she should really do something, change your business. And she went to the bank. After much deliberation, the bank decided to grant her a loan of €13,000, with the understanding that I would borrow at an interest rate of 5%, where she would have to repay the loan within 3 years. The whole time he is thinking “well, was it even worth doing it for me”. The first thing that Sandra did wrong in this process was that before she made the financing decision, she went into financing. That is, Sandra made an investment decision. The investment decision stated that they will invest in a new machine for the development of an additional device or business reorganization. A financial decision, or a capital budgeting decision, was to follow, where Sandra had to see in advance how much potential sales revenue she could expect and ultimately how this would affect her cash flows and, of course, the changes in the balance sheet that she would generate. Based on that, Sandra should have budgeted for this project for at least the next 3-5 years, given that she could have known in advance that entrepreneurs are granted such amounts of loans for a period of 3 years. Sandra did not do this, her calculations were simple. Today I take €13,000, which means that in the coming periods I should also earn €13,000 from the sale of eyeshadows. Every such decision – this is a decision about financial leverage – the leverage we take from the bank, the money that Sandra took €13,000 and which costs her 5% on an annual basis, as a rule, based on the theory of financial leverage, should create an annual return on investment for Sandra’s business into new shades at a minimum of 5% + opportunity cost of capital. Sandra could just as well have closed the company and gone to the Bahamas. But then she is no longer an entrepreneur. Sandra could equally try to continue her business or she could take financial leverage and invest in something completely different. But Sandra, by investing the money lent by the bank in her own business or developing her own business, generates something called financial leverage. Sandra might look at it this way: if the cost of the equipment is €13,000, the annuity repayment takes 3 years, the annual interest rate is 5%, this means that Sandra will repay around €390 per month based on the time value of money and the annuity calculation. This means that Sandra should earn at least €380 per month, but this amount does not cover the opportunity cost of capital, or even the amount of potential inflation on Sandra’s fixed assets. Which means Sandra wasn’t far wrong at this point – she did a micro-calculation and said how much minimum she would need to earn to break even. But Sandra did not make the first basic principle: budgeted her capital, made a budget for the new part of the business venture and the foundation. I have just decided to take financing from the bank. Be careful in that part. Every time you are going to change the capital structure, you must carefully weigh and calculate based on the basic financial profitability criteria whether changing the capital structure in your company is something you strive for and whether it will bring added value to the company.

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