Financing instruments. The financing needs of a company
Category: Corporate Banking
This chapter will focus on loans as a means of financing a company. Financing instruments like leasing or factoring , in effect, pose similar risks as loans. It is mainly for tax-driven reasons that companies resort to leasing. Since tax laws are very different even within Western countries, this chapter will only give a brief overview of leasing and related instruments. Topics like raising equity or issuing bonds are not covered here.
A. The financing needs of a company
One of the most common criteria for classifying the financial needs of a company is to discern whether they are short-term, medium-term or long-term needs.
1. Short-term loans
Short-term loans are needed to enable a company to pay its current debt, mainly trade payables as they fall due. Short-term loans help to balance the different terms between the time ,when current assets can be realized and be transferred into cash, and when short-term liabilities fall due. Short-term loans are most often used to finance accounts receivables and inventories. Their purpose should be to finance one business cycle, or a temporary seasonal need.
The source of repayment is the completion of the business cycle, that is when all business activities have, hopefully, been converted into cash. Risk assessment must focus on the liquidity of the assets of the company and on management’s ability to mitigate risks.
Short-term loans are granted in a revolving manner. They are normally due on one day’s notice. In most cases, however, they are needed time and again, which is why banks allow a company to utilize a certain credit line for a period of up to 12 months. If a borrower exceeds his overdraft facility , the bank will charge a premium for this.
2. Medium and long-term loans
Medium and long-term loans are normally needed to finance substantial investments or long-term capital expenditure. The life of the loan should not be longer than the useful economic life of the financed asset.
The funds for repayment should be generated by the cash flow that is derived from the output or production from the financed investment. The financial effects of such investments have to be taken into account when undertaking financial planning. A company must disclose its financial planning showing if the future cash flow is enough to service the additional debt.
The longer the life of the loan, the more difficult is it to predict the future of the borrowing company. This is why medium and long-term loans are often accompanied by covenants. These covenants are part of the loan contract and oblige the company, e.g., to observe certain financial ratios, or not to sell any substantial assets without prior consent of the bank, and so on. Collateral, like mortgages, can safeguard a bank against the risk that the loan cannot be eventually repaid. In theory, the collateral should be valuable enough to recover principal and outstanding interest payments, but often this is not the case, for example as the market value of land and buildings fell dramatically.
3. Leasing and factoring
Leasing means that assets, that would otherwise be financed by credit, are bought by the leasing company, which is normally a subsidiary of a bank. The leasing company then leases the asset back to the corporate client, who pays a rent (instead of installments for principal and interest) and can use the asset in the same manner as if it had been bought by himself.
Most medium and long-term assets can be leased. So, many corporate buildings are leased. All kinds of equipment is leased, often by specialized leasing companies. A large proportion of new car sales is financed via leasing. The leasing contract can even contain a clause obliging the leasing company to «buy back» the financed asset at a fixed price. This is of interest for clients who lease assets which will probably be technically obsolete, like computer systems, in a couple of years.
The credit risk is the same as with lending: the leasing company must properly assess the corporate client’s ability to pay the rent. Leasing may in some cases be cheaper than borrowing, but in most countries the reasons why companies resort to leasing instead of lending are mainly tax-driven.
Corporations can sell their accounts receivables to a factoring company, which will pay them a price for the receivables. The advantage for the corporate client is, that the receivables are immediately converted into cash, and that he does not have to waste too many resources on bookkeeping, controlling and recovering of the receivables.
The factoring contract can even stipulate that the risk that some of the corporation’s debtors fail to pay, lies with the factoring company, which charges appropriate premiums for its business. The risks associated with factoring are similar to credit risks. The factoring company has to analyze whether its corporate client’s receivables are good enough to be bought. It has to consider everything that has been said about a corporation‘s industry, its products and its customers.