2. How do firms raise the funding they
need?
■They borrow money (debt),
■sell ownership shares (equity),
■and retained earnings (profits).
■The financial manager must assess all
these sources and choose the one most
likely to help maximize the firm’s value.
3. Financing Decisions
■refer to the decisions that
companies need to take regarding
what proportion of equity and debt
capital to have in their capital
structure.
4. Topics Included:
■ 8.1 Short–Term Financing and Sources
■ 8.2 Trade Credits
■ 8.3 Short-Term Bank Loans
■ 8.4 Financial plans
■ 8.5 Business and Financial Risk
■ 8.6 Dividend Reinvestment Plans
■ 8.7 Sources of Long–Term Financing
■ 8.8 Equity Financing
■ 8.9Traditional Debts Instrument
5. 8.1 Short–Term Financing and
Sources
■ Short-term financing comes due within
one year.
■ The main sources of short-term
financing are
■ trade credit
■ bank loans
■ commercial paper
6.
7.
8.
9. What are the main disadvantages of
trade credit?
■ Need for credit management
■ Risk of late payment fees
■ Potential supply chain complications
■ May affect creditworthiness
■ Some suppliers may refuse credit to start-ups
■ Expensive if the payment date is missed
10. ■ Keynotes:
■ Benefits galore for
buyers, and not so
shabby for suppliers
either.
■ Trade credit helps
cement long-term
partnerships. It gives
both parties reason
to pull together.
■ The biggest downside to trade
credit is the potential knock-on
effect if things don't go to plan.
■ For buyers, the penalty of failing
to keep up your side of the deal
can add to your costs and sour
the relationship.
■ But for suppliers, it could be far
worse. If the customer business
goes under and debts remain
unpaid, suppliers can face an
uncertain future.
11.
12. ■ Cost of Trade Credit Calculator Formula
■ As an example of the use of the calculator, suppose a business offers 2/10 net 30 terms to customers
which means a 2% discount (d) is allowed if the customer pays within 10 days (discount days) otherwise
full payment is due within 30 days (normal days). If the customer takes the discount then the amount
less the discount is paid 20 days early, but a cost equal to the discount is incurred.
■ The cost of trade credit can then be calculated using the formula as follows:
■ d = 2%
■ Normal days = 30
■ Discount days = 10
■ Cost of trade credit = (1 + d /(1 - d)) (365 / (Normal days - Discount days)) - 1
■ Cost of trade credit = (1 + 2% /(1 - 2%)) ^(365 / (30 - 10)) - 1
■ Cost of trade credit = 44.59%
■ In this example, the cost of having the use of the funds for an additional 20 days is equivalent to an
annualized cost of trade credit of 44.59%. This means that if the business is able to borrow the funds at
less than 44.59% it should do so rather than offer the early payment discount
■ A similar calculation can be carried out to determine whether or not to take a discount offered by a
supplier. In this case if the business does not take the discount and pay early, then it has the use of the
funds for a further 20 days, however, this is done at the cost of not taking the discount of 2%. Using the
same formula the cost of not taking the discount will be the same as in the example above 44.59%. If
the business can borrow at a rate less then this then it should do so and take the early payment
13.
14.
15.
16.
17.
18.
19.
20. Commercial paper
■ is a money-market security issued by
large corporations to obtain funds to
meet short-term debt obligations
(for example, payroll) and is backed
only by an issuing bank or company
promise to pay the face amount on
the maturity date specified on the
note.
21. 8.5 FINANCIAL PLAN
■ A financial plan is a document containing a
person’s current money situation and long-term
monetary goals, as well as strategies to achieve
those goals. A financial plan begins with a
thorough evaluation of the person’s current
financial state and future expectations and may
be created independently or with the help of a
certified financial planner.
22. KEY TAKEAWAYS
■ A financial plan documents an individual’s long-term
financial goals and creates a strategy for achieving them.
■ The plan should be comprehensive but also highly
individualized, to reflect the individual’s personal and
family situations, risk tolerance, and future expectations.
■ The plan starts with a calculation of the person’s current
net worth and cash flow and ends with a strategy.
23. Understanding the Financial
Plan
■ Whether you’re going it alone or with a
financial planner, the first step in creating
a financial plan is gathering a lot of bits of
paper—or, more likely these days, cutting
and pasting numbers from various web-
based accounts into a document or
spreadsheet.
24. ■ 1.Calculating net worth
To figure out your current net worth, list all of the following:
Your assets: This may include a home and a car, some cash in
the bank, money invested in a 401(k) plan, and anything else of
value that you own.
Your liabilities: These may include credit card debt, student
debt, an outstanding mortgage, and a car loan. In some cases,
you may have access to a grace period or moratorium.
■ The formula for your current net worth is your total assets
minus your total liabilities.
25. 2. Determining cash flow
■ You can’t create a financial plan without knowing where your money is going—
and when. Documenting transactions—the flow of cash in and out—will help
you determine how much you need every month for necessities, how much
might be left for saving and investing, and even where you can cut back a
little—or a lot.
■ One way to get this done is to skim through your checking account and credit
card statements. Collectively, they should provide a fairly complete history of
your spending.
■ If your expenses vary a lot seasonally, then it’s best to go through an entire
year—counting up all the expenditures in each category and then dividing by
12 to get an average monthly estimate of your spending. This way, you won’t
underestimate or overestimate what you spend on utilities, nor will you forget
to account for holiday gifts or a vacation.
■ Don’t overlook cash withdrawals that may be used on sundries from shampoo
to sodas.
26. 3.Considering your priorities
■ The core of a financial plan is a person’s clearly defined goals.
These may include funding a college education for the children,
buying a larger home, starting a business, retiring on time, or
leaving a legacy.
■ No one can tell you how to prioritize these goals. However, a
professional financial planner may be able to help you choose a
detailed savings plan and specific investments that will help you
tick them off, one by one.
■ The main elements of a financial plan include a retirement
strategy, a risk management plan, a long-term investment plan,
a tax reduction strategy, and an estate plan.
27. Special Considerations of a Financial Plan
■ Financial plans don’t have a set template. A licensed financial planner will be
able to create one that fits you and your expectations. Once complete, it may
prompt you to make changes in the short term that will help ensure a smooth
transition through life’s financial phases.
■ The following elements should be addressed and revised as necessary:
■ Retirement strategy: No matter what your priorities are, the plan should
include a strategy for accumulating the retirement income that you need.
■ Comprehensive risk management plan: This includes a review of life and
disability insurance, personal liability coverage, property and casualty
coverage, and catastrophic coverage.
■ Long-term investment plan: A customized plan based on specific investment
objectives and a personal risk tolerance profile.
■ Tax reduction strategy: A strategy for minimizing taxes on personal income to
the extent allowed by the tax code.
■ Estate plan: Arrangements for the benefit and protection of your heirs.
28. ■ What is the Purpose of a Financial Plan?
A financial plan is designed to help you make the best use of your money and achieve long-
term financial goals, whether they are sending your children to college, buying a bigger home,
leaving a legacy, or enjoying a comfortable retirement.
■ How Do I Write a Financial Plan?
You can write a financial plan yourself or enlist the help of a professional financial planner. The
first step is to calculate your net worth and identify your spending habits. Once this has been
documented, you need to consider longer-term objectives and come up with ways to achieve
them.
■ What Are the Key Components of a Financial Plan?
Financial plans don’t have a set format, although the good ones do tend to focus more or less
on the same things. After calculating your net worth and spending habits, you’ll explore your
financial goals and figure out ways to make them achievable. Usually, this involves some form
of budgeting and creating a means to put money away each month. To ensure that you live
comfortably for the rest of your life, it’s generally advisable to devise a retirement, risk
management, and long-term investment strategy and keep tax expenses to a minimum.
33. 5 Financial Ratios Used To Measure Business Risk and How
To Use Them
■ Why measure business risk?
■ When you run a business, you typically know your destination and what you want to
achieve. And there will be financial and business roadblocks that detour your path to
success.
■ There are numerous instances where an in-depth view of your business finances can help
avoid risks. Everyday business events such as expansion projects, acquisitions, low cash on
hand, increased fixed expenses, increased borrowing, and even an increase in sales can be
signs that it’s time to reevaluate your business risk.
■ There’s no room for gut feelings and leaps of faith in business. Business owners and
managers must use financial ratios to manage business risk effectively and avoid financial
setbacks.
■ According to a study by author Steve Martin, the number one quality of successful business
people is resourcefulness. This list of financial ratios is an excellent resource for business
owners who are ready to take their organization to the next level.
34. What do financial ratios measure
■ Financial ratios are used to ensure that executives, financial institutions,
and stakeholders have an accurate picture of risks associated with an
organization. They measure different aspects of your company’s financial
health for financial management, market risks, and risks related to
investing in a company.
■ Financial ratios can also help navigate the risks of selling a particular
product or service for small business owners. According to a study, 60
percent of small business owners admit that they don’t feel knowledgeable
about their finances.
■ While financial ratios are primarily useful for those already in business, they
can benefit someone looking to start a business as well (such as using
benchmarks and hypotheticals to determine if an idea is viable or too risky)
35. ■ 1. Contribution margin ratio
■ The contribution margin ratio shows the contribution margin (sales – variable costs) as a
percentage of your total sales. This formula will tell you how much income there is to cover
fixed and variable costs and help your company set profit targets.
■ Contribution margin ratio = contribution margin / sales
■ For example, let’s say you have a product that costs $0 retail, and you have about 30,000 of
fixed expenses, including machinery, office expenses, and loan interest. It costs about 8 for
labor and manufacturing to make each unit.
■ 1. First, calculate your contribution margin:
■ (Sales – Variable Costs) = (20 – 8) = 12
■ 2. Now, calculate your contribution margin ratio:
■ (Contribution Margin/Sales) = (12/20) = 60 percent
■ The result of this contribution margin ratio in this example tells us that 60 percent of the
sales from each product is available to contribute to your 30,000 of fixed expenses. Now you
can quickly determine how many units you need to sell each month to keep your business up
and running.
■ In a perfect world, your contribution ratio would be 100 percent. But a good contribution
margin is subjective and depends on how much your fixed expenses cost and the number of
units you can sell in a given month.
36. ■ 2. Operating leverage effect (OLE) ratio
■ The operating leverage effect ratio can help you analyze your contribution margin ratio. Use
the OLE ratio to measure how your income increases or drops depending on the changes in
sales volume to show how much revenue is available to cover non-operating costs. This can
help you decide if you need to change your prices and get a glimpse into your company’s
future profitability.
■ OLE ratio = contribution margin ratio/operating margin
■ Let’s say that your organization earned 1 million in revenue last year, and it cost you about
300,000 to operate your business.
■ You already know your contribution margin ratio from the previous formula.
■ So let’s start by calculating your operating margin:
■ (Revenue – Operating Costs)/Revenue = (1 million – 300,000)/1 million = 70 percent
■ Calculating your operating leverage effect ratio can help you better understand how much of
your costs are going towards operations and how much you have to cover variable expenses. A
high OLE indicates a higher profit potential, while a low OLE shows low profitability potential.
37. ■ 3. Financial leverage ratio
■ The financial leverage ratio is used to measure overall financial risk. By measuring the
amount of debt held by your company against its income, you can glean a picture of how
investors see your business in terms of financial risk.
■ Financial leverage = operating income/net income
■ For example, if your gross income last year was 3 million, net income was 4 million, and your
operating expenses added up to 2 million, this is how you would calculate your financial
leverage ratio.
■ 1. First, let’s calculate your operating income:
■ (Gross Income – Operating Expenses) = 1 million
■ 2. Next, find your financial leverage:
■ (Operating Income)/(Net Income) = 1 million/4 million = 25 percent
■ This value shows that your business has financial obligations and may not be ready to take on
additional debt until your company can generate more income.
38. ■ 4. Degree of combined leverage ratio
■ Separately calculating operating and financial leverage is most common. Still, if you want to
see how the two ratios relate to each other, you should also calculate a combined leverage
ratio. This ratio measures business and financial risk in one balance to get an idea of your
total risk.
■ Combined leverage ratio = operating leverage ratio X financial leverage
ratio
■ To calculate your company’s combined leverage ratio, simply input your figures for your
operating leverage ratio and financial leverage ratio and multiply to get your result. For this
example, let’s say that your business has no debt and a financial leverage ratio of 80
percent:
■ (Operating Leverage Ratio) x (Financial Leverage Ratio) = (1) x
(0.8) = 80 percent
■ It doesn’t give the entire picture, but it does provide a simple at-a-glance look at your
business and financial risk.
39. 5.Debt-to-equity ratio
■ Banks, financial institutions, and investors typically use the debt-to-equity ratio to determine the
risk of loaning money to an organization. Knowing your debt to capital ratio is essential for a
business owner to see the distribution of resources and adjust spending and borrowing as needed.
■ Debt-to-equity ratio = (total liabilities)/(shareholders’
equity)
■ You can find these values on your corporate balance sheet, or you can calculate them on your
own. What’s more important than knowing how to calculate this ratio is interpreting it.
■ Let’s say your total liabilities, including current and long-term liabilities add up to
■ 1,865,000, and your shareholders’ equity adds up to 620,000. Now, let’s determine your debt-to-
capital ratio:
■ (Total Liabilities)/(Shareholders’ Equity) = 1,865,000/620,000 = 3.01
■ The goal isn’t necessarily to have a low debt-to-equity ratio. It can be a sign that your allocation
of resources isn’t optimized and could generate more revenue or spend less in certain areas. It
could also show investors that your business is not taking advantage of growth opportunities.
■ However, a significantly high debt-to-equity ratio can mean that your company is borrowing too
much and unable to keep pace with your spending.
40.
41.
42.
43.
44.
45.
46. Example of a DRIP
■ For a DRIP example, let's say an investor owns 100 shares of a company's
stock and has elected to have dividends reinvested. The company announces
a $0.20 per share quarterly dividend and the stock price is $20 per share at
the time of the dividend. Instead of receiving $20 in cash, the investor
receives 1 additional share of stock.
■ Here's the calculation for the DRIP stock example above
■ 100 shares x $.20 dividend = $20 reinvestment to buy 1 share at $20/share
■ Important: Investors should note that a DRIP reinvestment can result in the
purchase of fractional shares. Based upon the above example, if a
shareholder owned 100 shares of company stock, the dividend payout was
$.20 per share, and the share price at the time of the dividend was $22, the
dividend would buy 0.91 share, or slightly less than one additional share for
the investor.
47.
48. Long Term Financing
■ Long-term financing means financing by loan or borrowing for a
term of more than one year by issuing equity shares, a form of
debt financing, long-term loans, leases, or bonds. It is usually
done for big projects financing and expansion of the company;
such long-term financing is generally of high amount.
■ The fundamental principle of long-term finances is to finance
the strategic capital projects of the company or to expand the
company’s business operations.
■ These funds are normally used for investing in projects that will
generate synergies for the company in the future years.
■ E.g.: – A 10-year mortgage or a 20-year lease
49.
50. ■What Is Equity
Financing?
■ Equity financing refers to
the sale of company shares
in order to raise capital.
Investors who purchase the
shares are also purchasing
ownership rights to the
company.
51. Major Sources of
Equity Financing
■ When a company is still
private, equity
financing can be raised
from angel investors,
crowdfunding
platforms, venture
capital firms, or
corporate investors.
Ultimately, shares can
be sold to the public in
the form of an IPO.
52. 1. Angel investors
■ Angel investors are wealthy individuals who
purchase stakes in businesses that they believe
possess the potential to generate higher
returns in the future. The individuals usually
bring their business skills, experience, and
connections to the table, which helps the
company in the long term.
53. 2. Crowdfunding platforms
Crowdfunding platforms allow for a number of
people in the public to invest in the company in
small amounts. Members of the public decide to
invest in the companies because they believe in
their ideas and hope to earn their money back
with returns in the future. The contributions from
the public are summed up to reach a target total.
54. 3. Venture capital firms
■ Venture capital firms are a group of investors
who invest in businesses they think will grow at a
rapid pace and will appear on stock exchanges in
the future. They invest a larger sum of money
into businesses and receive a larger stake in the
company compared to angel investors. The
method is also referred to as private equity
financing.
55. 4. Corporate investors
■ Corporate investors are large companies that
invest in private companies to provide them
with the necessary funding. The investment
is usually created to establish a strategic
partnership between the two businesses.
56. 5. Initial public offerings (IPOs)
■ Companies that are more well-
established can raise funding with an
initial public offering (IPO). The IPO
allows companies to raise funds by
offering its shares to the public for
trading in the capital markets.
57. Advantages of Equity Financing
■ 1. Alternative funding source
■ The main advantage of equity financing is that it
offers companies an alternative funding source to
debt. Startups that may not qualify for large
bank loans can acquire funding from angel
investors, venture capitalists, or crowdfunding
platforms to cover their costs. In this case,
equity financing is viewed as less risky than debt
financing because the company does not have to
pay back its shareholders.
■ Investors typically focus on the long term without
expecting an immediate return on their
investment. It allows the company to reinvest
the cash flow from its operations to grow the
business rather than focusing on debt repayment
and interest.
■ 2. Access to business contacts,
management expertise, and
other sources of capital
■ Equity financing also provides certain
advantages to company management. Some
investors wish to be involved in company
operations and are personally motivated to
contribute to a company’s growth.
■ Their successful backgrounds allow them to
provide invaluable assistance in the form of
business contacts, management expertise,
and access to other sources of capital. Many
angel investors or venture capitalists will
assist companies in this manner. It is crucial
in the startup period of a company.
58. Disadvantages of Equity Financing
■
1. Dilution of ownership and
operational control
■ The main disadvantage to equity
financing is that company owners
must give up a portion of their
ownership and dilute their control.
If the company becomes profitable
and successful in the future, a
certain percentage of company
profits must also be given to
shareholders in the form of
dividends. Many venture capitalists
request an equity stake of 30%-50%,
especially for startups that lack a
strong financial background. Many
company founders and owners are
unwilling to dilute such an amount
of their corporate power, which
limits their options for equity
financing.
■ 2. Lack of tax shields
■ Compared to debt, equity
investments offer no tax shield.
Dividends distributed to
shareholders are not a tax-
deductible expense, whereas
interest payments are eligible
for tax benefits. It adds to the
cost of equity financing.
■ In the long term, equity
financing is considered to be a
more costly form of financing
than debt. It is because investors
require a higher rate of return
than lenders. Investors incur a
high risk when funding a
company, and therefore expect a
higher return.
59. What Is a Debt Instrument?
■ Debt instruments are fixed-income assets that
legally obligate the debtor to provide the lender
interest and principal payments.
■ When a company wants to raise capital, they can
opt to raise capital by using internally generated
funds, equity financing, and debt financing.
■ Debt financing can be a great source of risk for
businesses, primarily through increased liquidity
and solvency risk.
60. Types of Debt Instruments
■ There are two types of debts
instruments, which are as follows:
■Long-term
■Medium &
Short-term
61. Common Debt Instruments
■ 1 – Long-Term Debt Instruments
■ The company uses these instruments for its
growth, heavy investments, future planning.
These are those instrument which generally
has a period of financing of more than 5
years. These instruments have a charge on
the companies assets and also bears an
interest paid regularly.
62. 1 – Debentures
■ A debenture is the most used and most
accepted source of long-term financing by a
company. These carry a fixed Interest Rate on
the finance raised by the company through
this mode of the debt instrument. These are
raised for a minimum period of 5 years.
■ Debenture forms part of the capital structure
of the company but is not clubbed with
calculating share capital in the balance sheet.
63. 2 – Bonds
■ Bonds are just like debentures, but the main
difference is that bonds are used by the
government, central bank & large companies,
and also these are backed by securities, which
means these have a charge over the company’s
assets. These also have a fixed interest rate, and
the minimum period is also at least 5 years.
■ https://www.wikihow.com/Calculate-Bond-Value
64. 3 – Long-Term Loans
■ It is another method that is used by companies to
get loans from banks, financial institutions
■ . It is not as much a favorable option method of
financing as the companies have to mortgage their
assets to banks or financial institutions. And also,
the Interest rates are too high as compared to
Debentures.
65. 4 – Mortgage
■ Under this option, the company can raise funds by
mortgaging their assets with anyone either from
other companies, individuals, banks, financial
institutions. These have a higher rate of interest in
funding the companies. The interest of the party
providing funds is secured as they have a charge
over the asset being mortgaged.
66. 2 – Medium & Short-Term Debt
Instruments
■ These are those instruments which generally
used by the companies for their day to day
activities and working capital requirements
of the companies. The period of financing in
this case of Instruments are generally less
than 2-5 years. They don’t have any charge
over the companies assets and also don’t
have a high-interest liability on the
companies.
67. 1 – Working Capital Loans
■ Working capital loans are the loans that are
used by the companies for their day-to-day
activities like clearing of creditors
outstanding, payment for the rent of the
premises, purchase of raw material, and
repairs of machinery. These have interest
charges on the monthly limit used by the
company during the month from the limit
allowed by financial institutions.
68. 2 – Short-Term Loans
■ Banks and financial institutions also
finance these, but they do not charge
interest monthly; they have a fixed rate
of interest, but the period for funds
transferred is for less than 5 years.
69. 3– Treasury Bills
are short-term debt instruments that mature
within 12 months. They are redeemed at
maturity in full, and if sold before maturity,
then they can be sold at a discounted price. The
interest on these T-bills is covered in the issue
price as they were issued at a premium and
redeemed at par value.
70. Advantages
■ Tax Benefit for Interest Paid:- In
debt financing, the companies get
the benefit of interest deduction
from the profit before calculation
of tax liability.
■ Ownership of Company:- One of
the major advantages of debt
financing is that the company does
not lose its ownership to the new
shareholders as the debenture does
not form part of the share capital.
■ Flexibility in Raising Funds:-
Funds can be raised from debts
instruments more easily as
compared to equity funding as
there is a fixed rate of interest
payment to the debt holder at
■ Easier Planning for Cashflows:- The
companies know the payment schedule
of the funds raised from debt
instruments such as there is an annual
payment of interest and a fixed time
period for redemption of these
instruments, which helps companies to
plan well in advance regarding their
cashflow/funds flow status.
■ Periodic Meetings of Companies:- The
companies raising funds from such
instruments are not required to sent
notices, mails to debt holders for the
regular meetings, as in the case of
equity holders. Only those meeting
which affects the interest of the debt
holders would be sent to them.
71. Disadvantages
■ Repayment:- They come with
a repayment tag on them.
Once funds are raised from
debt instruments, these are to
be repaid on their maturity.
■ Interest Burden:- This
instrument carries an interest
payment at a regular interval,
which needs to be met for
which the company needs to
maintain sufficient cash flow
■ Interest payment reduces
the company profit by a
significant amount.
■ Cashflow Requirement:- The
company needs to pay interest as well
as the principal amount for the
company has kept the cashflows for
making these payments well in time.
■ Debt-Equity Ratio:- The companies
having a larger debt-equity Ratio are
considered risky by the lenders and
investors. It should be used up to such
an amount, which does not fall below
that risky debt financing
■ Charge Over the Assets:- It has a
charge over the companies assets,
many of which require the company
to pledge/mortgage their assets in
order to keep their interest/funds
safe for redemption.
