Business Financing Sources: Types, Costs and Criteria

Business Financing Sources

Financing sources: Companies need financial resources to carry out their activities and investments. These resources can be classified according to three criteria:

A) According to the time horizon of the financing

• Short-term sources: financing sources maturing within the year.
• Long-term sources: financing exceeding one year.

B) According to their origin: internal or external to the company

• Internal financing: undistributed profits (reserves), depreciation quotas and amortization.
• External financing: capital, loans and credits for the company's operations.

C) According to whether the funds come from owners or from outside the company

• Own financing: capital and reserves.
• External financing: loans, bank credits and all types of debt, both short and long term.

Equity Financing: Capital

Capital is formed by the contributions of the members who form the company, and capital increases may occur in successive stages.

Reserves

Reserves are undistributed profits retained by the company and form part of its internal self-financing. Profits obtained over time are not distributed but kept as a consequence of the company's activity. They can be:

• Legal: required by law in a fixed percentage.
• Statutory: set out in the company's bylaws.
• Voluntary: determined by the decision of the company and extraordinary reserves, including subsidies from the state or private entities.

These profits are kept in the company to finance new investments, which enables growth. For this reason, this source is also known as self-financing. Self-financing does not represent the growth of the company, but it does maintain production capacity and comes from a part of the result not distributed outside the company.

Depreciation

Depreciation is the loss of value of fixed assets during their productive use. Assets lose value through physical wear and through obsolescence, both technical and functional, as new technologies appear. At the end of each financial year, the depreciation amount is calculated and recorded as an expense, reducing the taxable profit. Over the years, the accumulated depreciation funds are kept in the company, so that when the assets reach the end of their economic life, the company can replace them with the money accumulated.

Provisions

Provisions are also a part of the company's result. The company creates a fund to meet losses or expenses that are probable but not yet certain, for example, a fund to pay compensation or taxes.

External Resources

Long-term loans

Companies request loans from financial institutions to finance themselves through credit. Once approved, the loan money is available immediately, and it is repaid over time under the agreed conditions, including the corresponding interest.

Bonds

Bonds are credit instruments (obligations, promissory notes, etc.), including EMTN programs, issued by companies in order to obtain funds from investors. When companies need large amounts of money and their conditions do not allow them to obtain loans from financial intermediaries at acceptable costs, they can issue bonds. The company commits to repaying the money with interest under the agreed conditions. Only large companies can access this type of financing.

Leasing

Leasing is a financing system in which the company uses an asset without owning it, and can incorporate any change in the fixed fees paid. Three economic agents take part in the process:

• Client company: the company that needs a specific asset.
• Manufacturer company: the company that produces or sells the good.
• Leasing company: the financial institution that finances the purchase and delivers the good to the client company in exchange for a rental.

The leasing period usually coincides with the economic life of the asset. The leasing fee includes the amortization of the asset, the capital cost, interest, administrative expenses and a risk premium if the company fails. At the end of the leasing period, the company can keep the asset by paying the price set in the contract. Leasing contracts for movable assets have a minimum term of 2 years, and for real estate, 10 years.

Renting

Renting consists of the rental of goods, both movable and real estate. In a renting contract, the lessor commits to a fixed monthly payment in exchange for a series of services: maintenance of the good, comprehensive insurance, and options in the contract to replace it or renew the contract for a further period to be determined. The rental payment is 100% tax deductible. Unlike leasing, there is no purchase option at the end of the lessee's contract.

Short-term External Financing

External sources provide companies with funds to finance part of the operating cycle.

Short-term bank loans

• Overdraft: a normal financial source that consists of the bank allowing the company to use a checking account for an amount greater than the available balance.
• Credit account or credit policy: when a company wants a means to cover possible financing needs without knowing exactly when they will arise, it can request a credit line from the bank, which provides funds up to an authorized limit.

Trade credit

Trade credit is automatic financing that arises when the company does not pay its suppliers immediately. If the supplier does not offer a discount for paying in cash, this financing is free.

Discounting of bills

The company can discount its customers' bills before their maturity date, receiving the amount in advance.

Factoring

Factoring is the sale of the company's credit rights over its customers (invoices, bills) to a specialized company.

Spontaneous sources of financing

These are the amounts the company owes to its employees for wages or to the public administration for taxes, which are usually settled at the end of each month.

Financial Markets and Business Financing

Companies can cover their financing needs by issuing financial assets (promissory notes, bonds, shares, etc.). There are several types:

• Fixed-income financial assets: provide a predetermined return, such as bonds.
• Variable-income financial assets: returns depend on the company's profits, such as shares, whose value and dividends may vary.

The markets where financial assets are traded are called securities markets. They include all the markets where securities of both variable and fixed income are issued and traded. They are divided into:

Primary market

The primary market is where new securities are issued for the first time. Companies can sell new shares or issue bonds so that investors can finance them. Examples of primary market operations: capital increases and the issuance of bonds.

Secondary market

The secondary market is where securities already issued are bought and sold among investors. Owners can thus obtain liquidity. Examples: the purchase and sale of shares and bonds already in circulation.

Selection of Financing Sources

The criteria a company uses to choose its financing depend on several factors:

• Type of investment: if the funds are to finance long-term investments, the source should also be long-term. If the investment is to be linked to the company for more than one year, the financing should have a maturity exceeding one year. For goods that are obsolete or have a high degree of wear, funds should be recovered through depreciation.
• Level of debt: if the company wants to reduce its level of debt, it should seek own sources of financing. External sources are used if the company wants to increase its profitability or does not have sufficient equity.
• Cost: external sources usually have a higher cost, while spontaneous financing from suppliers and other sources may have zero cost.

Cost of Financing Sources

Cost of own funds

Contributions from partners and undistributed reserves imply that the company does not pay interest or a fixed dividend, so calculating their cost is difficult. For example, if the company does not distribute dividends in a year, the cost may be similar to zero. However, if the company assumes a high-risk shareholder, it must offer a return that compensates for that risk. The cost of own resources can therefore be equated with the return the shareholder expects.

Cost of external resources

To calculate the cost of external resources, the APR is determined by including all the expenses that may arise (commissions, interest, etc.). Sources such as spontaneous financing (wages owed to employees, taxes owed to the public administration, etc.) have a cost equal to zero. Other external resources involve a cost for the company.