Short-Term and Long-Term Financing PDF

BMSH2201 SHORT-TERM AND LONG-TERM FINANCING Equity Financing Overview The owner’s investment in the company is referred to as owner’s equity or simply equity. The mix of the debt and equity that a company uses is known as its capital structure. The decision on how the...

BMSH2201 SHORT-TERM AND LONG-TERM FINANCING Equity Financing Overview The owner’s investment in the company is referred to as owner’s equity or simply equity. The mix of the debt and equity that a company uses is known as its capital structure. The decision on how the firm should be financed, whether with debt or with equity, is referred to as the capital structure decision. The best capital structure depends on several factors. If a company finances its activities using debt, the creditors expect the business to pay back the loan as promised. If the company chooses to finance its activities using equity, the owners expect a return in terms of cash. If a company has a lot of profit, the owners can receive a significant portion of income after the expenses. If earnings are low and the company still has to pay its creditors, the owners will receive almost nothing after expenses. Failure to pay interest or principal as promised may result in financial distress. Financial distress is when a company makes decisions under pressure to satisfy its legal obligations to its creditors. With equity financing, there is no obligation. Though the company may choose to distribute funds to the owners in cash dividends, there is no legal requirement to do so. Additionally, interests paid on debt are tax-deductible, while dividend payments are not. Sources of Equity Financing Personal savings / Personal funds – This is the least expensive form of acquiring business funds because it will not require the owner to pay anyone back. It can include profit sharing, early retirement funds, or cash value insurance policies. Friends and relatives – Business owners can also request funding from family or friends. Because of their relationship with the owner, they are more likely to invest in the business. Often, they are more patient about being paid back than other business sources. Venture Capital – This refers to financing that comes from companies or individuals in the business of investing in young, privately-held companies. They provide capital to young companies in exchange for an ownership share of the business. These firms usually do not invest in a company unless it has a proven track record. They also prefer firms with a competitive advantage and/or a proven demand for the product. Angel investors – These are individuals and businesses interested in helping small businesses survive and grow. In many cases, angel investors help businesses for more than profit reasons – for example, they have a personal interest or experience in a particular industry. They may also be interested in the economic development of a specific geographic area. Government grants – Local and national government institutions often offer financial assistance in the form of grants and/or tax credits for start-up or expanding businesses. Equity offerings – In this situation, the business sells stocks directly to the public. Depending on the type of shares, equity offerings can raise significant funds for the company. 07 Handout 1 *Property of STI  [email protected] Page 1 of 5  BMSH2201 Debt Financing Bank and Nonbank Institutions Debt financing involves borrowing bank funds from creditors with the stipulation of repaying the borrowed funds plus interest at a specified future time. For the creditors, the reward for providing the debt financing is the interest on the amount lent to the borrower. Debt financing may be secured or unsecured. Secured debt has collateral or a valuable asset that the lender can include to satisfy the loan if the debt is not paid. Debt financing can also be short-term or long-term. Generally, short-term debt is used to finance current activities, such as operations, while long-term debt is used to finance assets such as buildings and equipment. Banks and nonbanks are two (2) sources of long-term funds. Banks are financial intermediaries that bring together depositors and borrowers. They are regulated by the Bangko Sentral ng Pilipinas (BSP). There are several types of banks: Commercial banks – These banks have mostly retail customers. Its main business is lending. Many transactions take place in a commercial bank, and it is usually not very large in size. To reach more clients, a commercial bank puts up many branches in different locations. They want to be closer to their market to serve them better and faster. Universal banks – These banks are similar to commercial banks but are licensed to do more sophisticated banking services than commercial banks. Their clients are the top corporations of the country and global businesses. They lend to other companies, manage their corporate funds, invest their portfolio, and advise these companies on financial market movements and directions. Their transactions are usually larger than commercial banks. Investment banks – These banks offer sophisticated banking services but are more specialized. They focus on trading, fund management, and portfolio management. Nonbanks are financial intermediaries supervised and regulated by the Securities Exchange Commission (SEC). Investment companies – These companies pool together their customers' money and invest these in financial instruments – stocks, bonds, currencies, commodities, and financial derivatives. These investments are collectively known as mutual funds. Their investment services include portfolio management, recordkeeping, custodial, legal, accounting, and tax management services. Insurance companies – These companies sell coverage or protection from events such as the death of a loved one, fire, accidents, or natural calamities. Insurance premiums are paid by the buyer over a time period, in exchange for coverage of the events mentioned. In return, the insurance companies manage the premiums by investing in the same financial instruments that offer good returns. If any insured events occur, the insurance owner is compensated through the insurance claim. 07 Handout 1 *Property of STI  [email protected] Page 2 of 5  BMSH2201 Loan Application Introduction to Loan Application Bank credit is the banking system's borrowing capacity provided to an individual/business. A company or an individual’s bank credit depends on the borrower’s ability to repay and the total amount of credit available in the banking institution. Lenders use the 5Cs of credit to gauge whether to approve a loan. Conditions – These refer to the intended purpose of the loan. The loan size in relation to the specific use will help the lender evaluate your loan request. Conditions also include the national, industry, and local economic situation. An unstable economic situation may negatively affect a loan application. Capacity – Lenders need to determine if borrowers can comfortably afford the payments. The borrower’s income and employment history are good indicators of the borrower’s ability to pay outstanding debt. Income amount, job stability, and type of income may also be considered. The debt to income ratio of the borrower may be evaluated. This particular ratio compares debts to the before-tax-income. Collateral – Secured loans require collateral, which the borrower owns that will guarantee payment. It assures the lender that the lender can obtain the collateral if the borrower does not pay the loan. The value of the collateral will be evaluated, and any existing debt secured by the collateral will be subtracted from the value. Character – This is sometimes known as credit history. It refers to the borrower’s reputation or track record for repaying debts. A person’s character can be seen in the credit history and the lenders that have extended credit to them, the amount of credit they have, and their payment history. Capital – It is the money invested in the business and indicates how much is at risk if the business fails. Capital also represents the savings, investments, and other assets that can help repay the loan. Precautions when Borrowing Insolvency is the inability to pay debts on time. It is the temporary insufficiency of cash. On the other hand, bankruptcy is a legal process wherein the assets of a debtor are distributed to the creditors to pay his/her debts. The personal net worth is the value of an individual’s assets, cash, savings, real estate, cars, stocks, bonds, or jewelry, less all debts, such as credit card debts, monthly bills, and loans. A personal balance sheet will allow an individual to identify his/her short-term and long-term assets. Credit can also be stolen. Identity theft is a crime in which impostors deceive others by using their personal or financial information (name, Social Security System (SSS) number, credit cards) for their own purposes. If an individual suspects that another person is using their information, it must be immediately reported to the proper credit bureau or creditor. To prevent identity theft, the following measures must be taken: Shredding papers that contain personal and/or financial information Making sure that credit cards are returned after purchase Keeping a record of credit card numbers 07 Handout 1 *Property of STI  [email protected] Page 3 of 5  BMSH2201 The Loan Application Process As soon as all required information is available, the bank's loan officer will forward the loan application to the loan manager. The loan application will then be handed over to the credit officer, assessing debt-paying ability and requesting loan approval from the credit committee. A credit committee is a group of officers responsible for assessing a potential borrower's credit standing and debt-paying ability. Credit ratings estimate the ability of a person or organization to fulfill their financial commitments based on previous dealings. A credit analyst is someone who evaluates the borrower’s financial standing by reviewing his/her financial statements. A credit analyst is usually needed for corporate or business clients. The credit analyst evaluates statistics and analyzes corporate records, including payment plans, savings data, payment history, and purchase activity. Based on these, the credit analyst will recommend the lending officer on whether to approve the loan or not. The loan application process starts when the borrower fills out the loan application form and hands it to the financial institution (bank or nonbank). Then, the financial institution would evaluate the credit history/ information of the borrower. The loan officer, who receives the loan application, will review the documents submitted and determine if any additional documentation is required. Then he/she will pass it on to the credit committee. Credit processing is then done by the credit committee, which will approve or deny the loan. The bank will also submit a letter of intent to ensure that all parties involved understand the circumstances and conditions of the loan. The letter of intent will provide details about the loan amount, interest rate, collateral required, capital required, and other important terms and conditions of the loan. The letter of intent may include the name of the involved parties, the amount of financing, type of collateral, and other key terms. If the loan is approved, the crediting bank/nonbank may ask the borrower to verify that the information given at the beginning is still true, and no new debt has been acquired. After the documentation fulfillment, the bank/nonbank will send the closing documentation, which contains arrangements for payments, transferring and filing of deed transfers, and the borrower’s signature. If credit is denied, the borrower may find out the reason why and appeal to the creditor or another company. However, the requirements for loan application may differ in other companies, or according to the amount and purpose of the loan. Loan Application Requirements Most sole proprietorships are first-time business owners or have few assets that can be used as collateral. They also rarely have audited financial records. Some of the requirements for a sole proprietorship business loan are: Valid identification, such as government IDs with picture and signature Bureau of Internal Revenue (BIR) registration certificate and Department of Trade and Industry (DTI) certificate – These documents ensure that the business has gone through the proper procedures and complied with the BIR and DTI. Certificates must be updated and not expired. Business permit – Also referred to as the mayor’s permit, this document shows that the business is safe to operate within a given city’s ordinances. It needs to be updated annually. When applying for a business loan, the business permits must be updated. 07 Handout 1 *Property of STI  [email protected] Page 4 of 5  BMSH2201 Settlement bank account – Having a bank account (if the owner is borrowing from a bank) will facilitate the processing and payment of the loan. Banks and nonbanks follow extensive loan procedures to guarantee payment on their loans. In the case of businesses, bad credit may happen. Bad credit occurs when the company is unlikely to pay its debts, perhaps because the business did not grow over time or because the company expenses increased faster than sales. Duties of Borrowers towards Creditors When a business owner uses bank loans, the financial institution funds the business and helps it grow. In exchange, the company must provide the following: Continuous submission of financial reports to ensure regular and prompt payments of his/her obligations Yearly walkthrough of business operations to review, assess, and improve Annual corporate planning to determine what must be done to increase sales Annual strategic planning to identify growth areas in the business and to assess where innovation can help business efficiency Regular discussions on cost and operating controls Financial management – identifying where to source funds, how to raise funds quickly, how to keep costs down, and paying debts on time Managing debts, avoiding delayed payments, avoiding bankruptcy. During bankruptcy, the orderly liquidation of assets and payment to creditors. Businesses need funds for several reasons. For working capital – Funds can be used for the business's day-to-day operations. Working capital refers to the current assets and current liabilities of the business. For capital expenditures – Long-term funds can be used for capital expenditures or long-term investment opportunities, such as investing in real estate or new equipment and technology. Some government regulations, such as anti-pollution ordinances or health laws, may require additional investments for the changes in the business operations. For debt servicing – Funds can also be used to pay for debts. References Mayo, H. B. (2017). Business Finance: Theory and Practice. Quezon City: Abiva Publishing House, Inc. Titman, S., Keown, A. J., & Martin, J. D. (2018). Financial Management: Principles and Applications (13th ed.). New York: Pearson Education Inc. 07 Handout 1 *Property of STI  [email protected] Page 5 of 5