A company, just like any person, needs to be able to raise extra funds for itself to build new plants, buy inventory, etc. But a firm, unlike a person, has many more options to choose from when it comes to borrowing money. People either get a loan from a bank, or use a credit card, but a firm can raise capital by issuing stock, selling debt, borrowing from the bank, and even from other corporations.
A corporation has two different broad types of financing available; short and long-term. Equity and debt financing are the most commonly referred to, but both are forms of long-term financing.
There are numerous ways a firm can borrow funds to satisfy its short-term needs, but the most common ways are through unsecured and secured loans, commercial paper, and banker’s acceptance.
There are two types of bank loans – Secured and Unsecured. While the main difference is collateral, there are some other important distinctions as well.
Unsecured Bank Loans
An unsecured bank loan is a loan in which the borrowing firm does not provide any assets as collateral. Therefore, the bank is taking on default risk if the borrowing firm doesn’t repay the interest or principal. These are loans provided by a bank that can be either committed or non-committed.
With a committed bank loan, usually used if the firm is borrowing from a bank for the first time, the firm must file legal paperwork with the bank that determines the amount the firm can borrow. A non-committed loan allows the firm the ability to borrow up to a certain amount of funds, usually up to the amount previously borrowed, without having to file the legal paperwork.
Secured Bank Loans
A secured loan is a loan in which the borrowing firm provides assets as collateral. This way the bank is assured that it will be repaid if the firm defaults on the loan. Common forms of security, or collateral, may be inventory, accounts receivable, or other liquid assets.
A firm would choose a secured loan over an unsecured loan because the bank will provide a lower interest rate if the loan has collateral attached to it. That being said, the firm runs the risk of having its assets provided as collateral seized in the case of a loan default.
Commercial Paper and Banker’s Acceptance
Other forms of short-term financing include commercial paper and banker’s acceptance.
Commercial paper is a debt instrument in which a firm issues an IOU to a bank, company, or wealthy individual, which provides funds to the firm. It typically makes up notes payable in current liabilities. Commercial paper has a maturity of 270 days or less, which exempts it from being registered with the SEC, providing an easy transference of funds.
A less common way for firms to receive short-term funds is through banker’s acceptance. This occurs when a seller sends a bill to the customer’s bank, which agrees to pay that bill. Of course, the firm will eventually need to pay the bank back with interest.
Both types of loans provide the firm with quick, easy cash that doesn’t require the type of legal contracts that come with bank loans. Commercial loans are relatively safe investments since firms with high credit ratings issue the loans, and due to the short period of time the loan is outstanding, the financial health of the firm is easily predictable. Banker’s acceptance is an easy way to “borrow” funds since the firm doesn’t have to repay the bank immediately. Both options are used due to their ease.
Long-term financing is comprised of debt and equity financing. Equity can be broken down into two different forms; common and preferred.
The most common type of long-term financing used by corporation is by issuing stock. Stock has two types – Common and Preferred, both types have advantages and disadvantages.
The most common of these two is common stock. Common stock represents a partial stake in the corporation. A buyer of common stock provides funds to the firm in exchange for ownership and voting rights in the firm. It is important to note that a firm only receives the funds from the initial sale of stock, not from any transactions that occur when a person sells stock to another person. With equity, once issued, the firm has an immediate inflow of cash that requires no future payment. The downside here is that the equity holders have ownership in the firm, and can vote on issues pertaining to management and the future of the company.
Common stock is what is normally trading on stock exchanges.
Preferred stock has components of debt and equity in that is pays a fixed dividend regularly, has priority over stockholders, and trades like stock. The payments are predictable and can be written off the tax statement. Why is preferred stock less popular among investors? It is less popular than equity because the rate of return is lower than that of stock, and less popular than bonds because bonds typically have a higher coupon rate.
Debt is a fixed income security that pays periodic interest, but doesn’t represent ownership in the company. As a brief overview, a firm issues a bond to individuals with varying maturity dates, quoted above, below, or at a fixed value called par. The firm receives money from the investors in the amount of principal paid at the time for the bond. Debt is attractive to corporations because the interest payments made can be deducted from the company’s taxes, lowering the amount it pays. Plus, the payments made are easily predictable and fixed. However, issuing debt increases the number of people who must be paid regularly, regardless of the company’s financial performance. One of the most important reasons a firm chooses debt over equity, though, is that debt provides a firm with financial leverage.
The biggest reason companies use debt is for financial leverage. Financial leverage is simply the use of debt to purchase assets. A firm that borrows funds by issuing debt will, in effect, have extra cash that it can use as it wishes. This is akin to a credit card. For example, a firm can use $200,000 to buy equipment by using its cash, or it can multiply that $200,000 by borrowing additional $400,000 to buy $600,000 worth of equipment. While this allows firms the ability to use more cash than it has on hand, it comes with significant risk. The more the firm borrows, the more interest it will owe on outstanding debt. While this will lower the amount of taxes the firm must pay, the firm cannot neglect interest payments, which needs to be paid out regularly. The firm must strike a good balance between using cash on hand and leverage so that it benefits without too much added risk.
The Short and Long-term Financial Needs of a Business
A firm has two different ways it can finance itself; short and long-term financing. How does the firm decide which to use? Is one better than the other? The answer is found on the balance sheet.
Current assets are financed with short-term borrowing (current liabilities), and noncurrent assets with long-term borrowing (noncurrent liabilities). For example, accounts receivable needs to be financed because when a firm sells from inventory on credit, it will not actually receive the funds immediately. There is a stretch of time between the date of the sale, and the date the funds are received. Therefore, the firm needs to cover this temporary deficit with money.
Short-term financing is used in this case because it is relatively simple to borrow on the short term, and it is received by the firm quickly. Also, it is relatively easy to pay off debt in the short term. On the other hand, if a firm is building a new factory, this requires long-term financing. Long term financing is more attractive for very big investments that take a long time to pay off.
For example, Ford recently announced plans to build two new factories, costing a total of 2.6 billion dollars. There are not very many banks that have enough cash on hand to make a loan that large, even if they really liked Ford’s business plan, but there are millions of investors who each might be willing to buy some Ford bonds and earn interest.