Financial management
Economic and financial structure of the company and classification of the main sources of financing
The financial department is responsible for obtaining and managing the resources (money) of the company.
When we buy something we need money, which we can take out of our pocket, from a current account we have, we can ask for a loan, etc. We therefore have different ways of getting this money that we need or, what is the same thing, we have different ways of financing our purchase.
Companies need money to carry out their activity. The ways it gets this money are called sources of financing.
In the balance sheet, the assets of a company represent the investments and the net assets and liabilities represent the sources of financing.
Sources of own financing: capital, reserves, depreciation and provisions
Source of financing means the liquid resources or means of payment available to the company to meet its financial needs. As it has been said before, the different sources of financing that the company has are in the net assets and liabilities of the balance sheet.
Sources of external financing: loans, borrowings, leasing, credit policy, commercial or supplier credit, effect discount, invoicing and renting
CLASSIFICATION OF FINANCING SOURCES
ACCORDING TO THE OWNERSHIP OF THE RESOURCES:
- OWN FINANCING: Resources belonging to the owners (not required). They are the capital, reserves, depreciation and provisions.
- OTHER FINANCING: Resources obtained from third parties (required). These are loans, borrowings, leasing or financial leasing, credit policies, commercial or supplier credits, effect discounts, invoicing and renting.
The formation of reserves presents advantages for business management, given that it ensures the development or expansion of the company, especially in those cases where external financing is impossible, or very difficult. It is particularly interesting in small and medium-sized companies, due to the fact that they have more difficulty accessing the capital markets, and also in those other cases where the risk of new investments is excessive to entrust them to external financing, due to their high cost
But own financing is also the one with the most risk, since in the event of bankruptcy the partners are the last to receive the corresponding part of the liquidation of the company. Therefore, it is the type of financing that should pay better.
ACCORDING TO THE ORIGIN OF THE RESOURCES:
- Internal financing (or self-financing): these are the resources generated by the company itself. There are two types: enrichment self-financing (reserves) and maintenance self-financing (depreciation and provisions). The first are to make new investments and the second to maintain the company's productive capacity.
- External financing: these are resources obtained outside the company, that is to say, that come from outside and that are captured through the financial markets, whether they are demandable (that must return) as if not. They are all sources of foreign financing and capital.
ACCORDING TO THE DURATION OF THE RESOURCES:
- PERMANENT RESOURCES, NON-CURRENT OR LONG-TERM LIABILITIES: Funds that do not have to be returned or that must be returned in more than one year.
- CURRENT OR SHORT-TERM LIABILITIES: Funds that must be returned at the latest after one year.
VOCABULARY :
SELF-FUNDING:
1) CAPITAL: Contributions of the partners (owners) of the company represented in shares (SA) or participations (the other legal forms).
2) RESERVES: Undistributed profits. part of the result of the exercise that is not distributed among the owners of the company. The part of the profits that are distributed among the partners of the company is called dividends.
3) DEPRECIATION: Estimate of the value that the fixed asset is losing; Accounting expression of the distribution (periodization) of the acquisition cost of the fixed asset in successive years that reflects the loss of value of the asset.
4) PROVISIONS: Funds reserved to cover insolvency and other risks.
FOREIGN FINANCING:
1) LOANS: Resources that must be returned and remunerated at agreed terms.
Contract by which a credit institution generally delivers a pre-agreed amount to a company or individual, with an established maturity and amortization plan, and with agreed interest rates.
2) LOANS: Issuance of debt securities (bonds, bonds, promissory notes, etc.) that are amortized and repaid at agreed terms.
It is a debt issue (bonds, bonds, promissory notes, bills...) issued by companies and bought by individuals or other companies in exchange for interest. On the date that has been determined, the company will have to return the money invested by the buyers in accordance with the conditions that have been agreed.
Only large companies can use loans as a source of financing, since this involves asking individuals and companies for money, which must find profitability attractive and acceptable risk.
3) LEASING OR FINANCIAL LEASE: Rental of fixed assets with purchase option.
Leasing concept. Financing instrument for movable or immovable property consisting of the assignment, by the company that owns the asset (leasing company), of the rights to use this asset to the leasing company, for a period of agreed time in exchange for a rental fee. The leasing contract obligatorily includes an option to purchase the asset, which the company can exercise at the end of the established lease period. If you are not interested in acquiring ownership of the property, you will not exercise the purchase option and will return it to the leasing entity or renew the rental contract. Usually, when a lease is entered into, the objective is to acquire the asset by exercising the purchase option. That is why the main purpose is usually to obtain financing in order to acquire the asset.
Advantages:
- Leasing is an effective and flexible instrument for obtaining financing intended for the use of goods intended for the development of an economic activity, since it allows financing 100% of the investments made. It allows us to enjoy greater liquidity than if we bought the asset using our own resources, because the entire price of the asset does not have to be paid from the beginning.
- The special tax regime it has allows you to deduct practically all of the financial lease payments and, therefore, pay less tax.
Disadvantages:
- As a disadvantage, we must highlight the financial burden that we have to bear and that would not occur if we bought the good in cash. On the other hand, it should also be noted that interest rates tend to be higher than those applied to mortgage loans.
- The duration of the financial lease contract is irrevocable, and the termination of the contract for reasons attributable to our company may have serious consequences.
- Although the asset is owned by the leasing company, the company that is paying for it uses it and is responsible for its maintenance and good use.
There are two types of leasing: the financial one, in which the operation is irrevocable by the lessee, since it can only be canceled by the purchase of the asset or by the end of the contract; and operating leasing, which can be revoked at any time, thus becoming a typical leasing operation.
This figure is part of the company's sources of financing as a non-current liability, since the company can incorporate operational fixed assets in its operating process without having to pay them at the initial moment.
4) CREDIT POLICY: Contract where a limit of resources that the company can dispose of is agreed upon. The company will pay interest (on what it has) and commissions.
The credit policy contract consists of the opening of a current account credit. It is the one by which the bank grants credit to the customer for a certain term and up to a certain sum of money. The bank undertakes, in exchange for a commission, to make available to the customer and within the established limits the amounts that he claims within the set period.
The expenses that are taxed:
• The amount of the policy itself.
• An opening Commission.
• The Brokerage (Trade corridor)
• A Commission on the unpaid balance.
• The interest on the amount arranged.
Credit policy: Financing method by which the company signs a contract with the bank, which makes available a credit account with a limit. The company uses this method when it does not know exactly when or how much it will need this money. The company pays the interest and a commission for the amount that it has not used for the amounts arranged.
The credit instrumented in the policy is a financial operation through which an amount of money is made available to a natural person or company for a term, using the amount that that person deems appropriate at each moment, as long as it does not exceed the established limit. Interest is paid on the amount used and a fee on the unused amount.
The differences between loans and credits are:
- In the case of the loan, the amount is delivered at the beginning of the operation, while in the case of the credit, the amount is available to be used as needed by the company.
− In the case of the loan, the interest is calculated on the balance of the outstanding debt at each moment, while in the credit, the interest is calculated based on the amount used and the time of use, in addition to having to pay a fee on undrawn amounts.
A loan is recommended when you want to finance something specific whose cost is already known. On the other hand, when you don't know what you might need, the most suitable is a credit policy and in this way you will only pay interest for the amount of money you use and for the time you have it. Although you will also pay a commission for the total available amount.
5) COMMERCIAL OR SUPPLIERS' CREDIT: Automatic financing when purchases made from suppliers are owed. If the supplier does not offer a cash discount, this financing is free.
Commercial credit is the amount of financing that the company obtains from the suppliers of the goods and services that it uses in its operation. All those deferrals of payments, usually with the acceptance of 30, 60 or 90 day trade effects, that the company must make to its suppliers, are part of this source of short-term financing.
If this financing is done without deferral fees or advance payment discounts, it has no cost, meaning that the financing would be free and would amount to a price reduction. But if the suppliers apply discounts to us for advance payment, then this credit would have a cost (opportunity cost), since if we didn't make the postponement (we didn't have credit) we would get a discount that we lose by doing the credit
Operating or commercial credits are intended to finance current assets.
6) ACCOUNT OVERDRAWN: Funds available in excess of the available balance (known as “red numbers”). It turns out very expensive.
The use of a current bank account for an amount greater than the available balance is called overdraft.
7) BILL DISCOUNT: When the banks pay us the amount of bills of exchange before their maturity (charging interest and fees).
The effect discount consists in anticipating, on the part of a financial institution, the amount of credit granted to customers. To make this possible, the company provides the bank with the credit documents (receipts, letters, promissory notes) and the latter deducts a management fee for the collection of the effect and interest for the period remaining until maturity of the effect. This figure is considered a source of financing because it represents an inflow of money for the company before the maturity date agreed with the customers is met.
8) INVOICING ("factoring"): Sale of all credit rights on customers (invoices, letters, etc.) to a company ("factor") in exchange for interest and commissions.
Invoicing is a type of contract whereby one company cedes to another, called a factoring company, the collection of its customers' debts.
The advantages of using invoicing are:
The saving of administrative tasks to collect debts.
○ Provide immediate financial resources that would not be obtained until after one
longer period.
Eliminate the risk of defaulters.
The downside is that it has a high cost.
This figure is a source of short-term financial resources for the company, since the factor entity anticipates the customer's collection.
9) RENTING: Rental of fixed assets without purchase option.
It is a modality that consists of the medium and long-term rental of movable property. In the rental contract, the tenant undertakes to pay a monthly rent during
a specific term and the rental company undertakes to keep the asset in question in working condition. Unlike leasing, this contract does not have a purchase option at its maturity. You can replace the equipment or renew the contract.
Depending on what you want to finance, it is appropriate to use one source of financing or another. For example, to finance a new machine, which is an item of fixed assets (long term) it would be necessary to finance it also in the long term. The most common possibilities are:
Own sources:
- capital increase
Alien source:
- long-term loan from a financial institution
- credit (direct) from the supplier of the machinery
- leasing
To finance the purchase of raw materials, being therefore a short-term element, which would also need to be financed in the short term. The most common possibilities are:
own sources:
- there is no appropriate short-term funding source from external sources:
- short-term loan from a financial institution
- commercial credit, obtained from suppliers of raw materials
Generic calculation of the cost of financing
The cost of financing (APR or K) is calculated the same as the IRR.
It is considered exactly the same as an investment, with net cash flows each year.
FNCn = net cash flow of year “n” = collections of year “n” – payments of year “n”.
Then the current value of all FNCn is taken and set to zero. The update rate (which in the case of an investment we call TRI or IRR) will be called APR (Annual Effective Rate).
In the case of loans, borrowings, de-accounting of effects and credits, the cost of financing will be the interest and commissions charged by the financial institution. On the other hand, in the case of invoicing, renting and leasing, the cost of financing can be calculated by subtracting from the sum of the installments the initial cost of fixed assets or trade credits.
The effective cost of debt is determined by calculating the discount rate that equates the present value of the funds received by the company with the present value of the expected outflows of funds to meet the interest payment and repayment of capital
The financing cost will be that rate that updates the flows in such a way that it equalizes the derived treasury income, valued in initial €, with the set of linked payments, also valued in initial €.
INVESTMENT PROJECTS
Concept and types of investment
Investment: Application of resources to increase the asset (non-current or current).
Investment: Unconsumed purchase or unsold production.
Investment: Act by which the immediate and certain satisfaction of resources is given up in the hope of obtaining a higher future income. It therefore involves the immobilization of resources for a period of time in the hope of obtaining a higher income in the future.
Classification of investments:
1) According to your objective:
According to the purpose of the investments within the company, these can be classified into:
replacement or renewal, expansion, modernization or innovation and strategic.
a) Replacement or renewal investments seek to replace those investments that are aging. It's about exchanging an old asset for a new one.
b) Expansion investments aim at expanding the size of
the company and the increase in the company's productive capacity.
c) Modernization investments are made to maintain and improve the company's production and market situation.
d) Strategic investments are those whose objective is to reduce risks for a
the company and can be: defensive, offensive and social.
Substitute investment: Investment that limits the realization of others. It should be noted that no
be confused with that of replacement or renewal, which is the one that replaces an old asset with a new one. Example of substitute investment: Buy a model A machine instead of model B.
In another way:
· Replacement or renewal investments: When we exchange an old asset for a new one.
· Expansive investments: To increase the productive capacity of the company.
· Strategic or modernization investments: To increase the competitiveness of the company with new technology or new products.
· Security investments: To ensure the surplus liquidity of the company. For example, buying public debt.
· Profitable investments: To make profitable the excess liquidity of the company. For example, buying tech stocks on the stock market.
2) According to the type of good purchased:
· Real investments: When we acquire tangible or intangible assets, or some element of current assets (raw materials, merchandise, etc.).
· Financial investments: When we acquire short- or long-term financial assets (shares, shares, bonds, bonds, treasury bills, etc.).
3) According to the permanence:
· Long-term, non-current or structural investments: When we acquire fixed assets.
· Short-term, operating or current investments: When we increase current assets.
4) According to the flows of collections and payments:
· Investments with a payment and a collection.
· Investments with one payment and several payments.
· Investments with several payments and a collection.
· Investments with several payments and several collections.
Types of investments according to their reasons for making them (or purpose)
a) Replacement or renewal investments seek to replace those investments that are aging. It's about exchanging an old asset for a new one.
b) Expansion investments are aimed at expanding the size of the company and increasing the company's productive capacity.
c) Modernization investments are made to maintain and improve the company's production and market situation.
d) Strategic investments are those aimed at reducing risks for the company and can be: defensive, offensive and social.
Financial elements used in the calculation of investment selection criteria
- Initial disbursement: It is the cost that is paid when acquiring the asset element.
- Duration of the investment: It is the time in which inflows and outflows of money occur.
- Net cash flows: It is the difference between collections and payments.
- Residual value: It is the value of the asset at the end of the life of the investment.
Static investment selection methods. Calculation and interpretation of the payback period
Investment analysis methods are ways of knowing whether or not a particular investment is profitable.
Investment selection methods are ways of knowing which investment, among those available to us, is better than others.
There are two types of investment analysis and selection methods: static methods , which do not take into account the passage of time, and dynamic methods , where they do take into account the passage of time.
The most used static methods are the total cash flow method and the pay back method and the most used among the dynamic methods are the NPV (or Capital Value) and the IRR or TRI (Internal Rate of Return).
Static reasoning is based on the fact that the value of money is constant over time. It works as if the money collected at different times has the same value.
Dynamic reasoning, on the other hand, takes into account the different value of money depending on when the cash flow occurs (either positive or negative).
Dynamic investment selection methods
Dynamic investment selection methods are used to evaluate and select different investment projects, considering the principle of financial equivalence (that is, cash flows do not have the same value if they occur at different times). Among the dynamic investment selection methods, the VAN (Net Present Value) and the TRI (Internal Rate of Return) stand out.
Static investment selection methods
Static methods are based on the fact that the value of money is constant over time. Therefore, two equal cash flows but referred to different points in time are considered to have the same value.
1. Calculation and interpretation of the NPV (Net Present Value) and interpretation of the IRR (Internal Rate of Return)
VAN = -D0 + FNC1/(1+i) + FNC2/(1+i)2 + ... + + (FNCn + VR)/(i+i)n
VR is the Residual Value of the investment, if any. It is what can be recovered from the investment once it is finished.
NPV or Capital Value : The NPV of an investment is the difference between the updated value of the net inflows it generates and the initial outlay. It consists of updating all net cash flows to the current time and obtaining the capital value at that time. The amounts must be added or subtracted according to whether they represent monetary inflows or outflows caused by the investment.
VAN = - Do + F1 / (1+ i1) + ... + Fn / [(1+i1) (1+i2) ... (1+in)]
If the NPV = 60,000 it will mean that the set of cash flows derived from the investment project, updated at the cost of capital rate exceeds the total cost of the investment by 60,000 units and that, therefore, the project will take term
The Net Present Value (NPV) is the difference between the "cash-flows" updated at a discount rate and the values, also updated, of the disbursements of an investment.
NPV criteria :
If the VAN > 0 the investment project is advisable; If the NPV < 0 the investment project will be rejected.
If the NPV = 0 the investment project is indifferent; The criterion for selecting an investment according to the NPV is to choose, among those that have a positive value, that investment that has the highest value.
NPV consists of updating all net cash flows to the current time (time 0) and obtaining the capital value at that time. The amounts must be added or subtracted according to whether they represent monetary inflows or outflows caused by the investment.
If the NPV is negative, it means that the total sum of the outflows caused by the investment project is greater than the sum of the inflows, valued at the current moment. In this case, it is not appropriate to make the investment.
If the NPV result is positive, it means that the updated sum of all monetary inflows caused by the investment is greater than the updated sum of the outflows and that, therefore, the investment can be made.
The criterion for selecting an investment according to the NPV is to choose, among those with a positive value, the one with the highest value. If the NPV gives the result of 0 the investment is indifferent. Among different investments, we will choose the one with the highest NPV.
2. INTERNAL RATE OF RETURN (IRR or TRI)
The IRR is the discount or discount rate, called “r”, that makes the NPV value zero.
The IRR value provides a measure of the return on investment. To select an investment, this rate of return must be compared with the rate of discount or discount in the market (i).
If r > i it is appropriate to make the investment, since a return higher than that of the market is obtained. The NPV will give a positive value and the company will get a profit on its investment.
If r = i the investment is indifferent and the company will neither become richer nor poorer, it will remain the same, since the returns obtained allow the investment to be amortized.
If r < i the investment will not be made, since the value of the NPV will give a negative result and the company will obtain losses with this investment.
Among the investment projects for which the value of “r” is higher than “i”, the one with a higher value of “r” will be chosen.
0 = -D0 + FNC1/(1+r) + FNC2/(1+r)2 + ... + FNCn/(i+r)n
r = TIR = TRI
As can be seen from the formula, obtaining the IRR is not a trivial calculation when more than two cash flows occur. When there are one or two cash flows, the calculation is done directly by solving the equation of first or second degree that is reached. If there are more than two cash flows, it results in an equation of degree higher than two that can be solved using computer programs, financial tables, or by trial and error, also called trial and error, which can be used of help the graph of the NPV for the different values of "r".
The IRR value (expressed as a percentage) provides a measure of the return on investment. To select an investment it is necessary to compare this rate of return with the type of update or discount in the market
The Internal Rate of Return or IRR would be the maximum cost of the liability that the investment can support. In other words, i' would be the return on the asset.
IT .R. provides a measure of return on investment.
The IRR (r) is the discount rate at which the NPV of the project would be equal to 0. It measures the real profitability of the project.
The IRR is an easier parameter to visualize than the capital value. The fact that it is expressed in percentages provides a relative measure of the profitability of the investment. To select an investment you need to compare this rate of return with the rate of discount or market discount.
According to the IRR criterion, investments are profitable if an internal rate of return is obtained that is greater than the discount rate applicable in the market. Therefore, project 3 will be viable if 7% is higher than the market interest rate.
The Internal Rate of Return (IRR), also called the rate of return or the rate of internal return, is the discount rate that allows the initial investment to be recovered, that is to say it equates the updated "cash-flow" with the value, also updated , of the disbursements of an investment. Therefore, it can also be defined as the discount rate that gives a zero value to the Net Present Value (NAV) of an investment and as the limit value, from which an investment starts to be profitable.
If an investment project has an IRR of 6% it means that if the forecasts are met and we execute the project, it would provide us with an annual return of 6%. This rate updates the cash flows derived from the project in such a way that the NPV = 0, this being the maximum acceptable level of the cost of capital, meaning that we will only accept those projects that have an IRR higher than the cost of capital rate . If the NPV of the project is negative, it means that the set of updated cash flows according to the cost of capital rate is not sufficient to finance the investment. That is why we will have to reject the project. Obviously if the NPV is negative the IRR will be lower than the cost of capital rate.
The IRR indicates the maximum return generated by an investment. IT .R. provides a measure of return on investment.
As a criterion for selecting an investment, it is necessary to compare its value with the rate of market update (i).
If r > i, the investment is recommended. The NPV would be positive.
If r = i, it is indifferent.
If r < i, the investment is not recommended. In this case, the NPV would be negative.
If it is necessary to compare between different investment projects, it would be necessary to choose the one that had a higher IRR value.
COMPARISON OF THE VAN AND THE TRI
The application of the Net Present Value (NPV) or the Internal Rate of Return (IRR) entails the adoption of the same investment project, as long as the NPV is positive. In this case the TR .I. is always higher than the preset discount rate, so both criteria coincide in the selection of the investment project to be carried out.
However, it may happen that the two criteria give them a different priority. Each selection method employs a different reinvestment rate: while NPV assumes that intermediate cash flows are reinvested at the discount rate, TR .I., given its own definition, is based on the assumption that the reinvestment is carried out at the same resulting rate, that of the TR .I.
Thus, the use of the NPV criterion represents a more conservative option, as it does not presuppose - as does TR .I. - that at all times it can be reinvested at the same internal rate of return, especially when it reaches a particularly high value.
INVESTMENTS AND RISK
None of the criteria we have seen takes risk into account explicitly, but it is clear that it has its importance when selecting investments. Dynamic criteria can take this into account simply by adding an extra interest rate (the “risk premium”) that will be added to the capitalization rate.
Risk is the probability of losing money. Riskier investments must have higher returns to compensate for this risk. Between two investments with the same return, we will choose the one with less risk. And between two investments with the same risk, we will choose the one with the highest return.
Sometimes it is better to select a less profitable investment if the risk rate is not so high. It will depend on the willingness to take risks.
Using the NPV criterion, we can calculate it by discounting the FNCs at a “k + p” rate (that is, the market capitalization rate plus a risk premium).
With the IRR criterion , we can compare the return on the investment (IRR or TRI) with the sum of the nominal market interest (i) or capitalization rate (k) plus the risk premium (p). Then, to consider an investment profitable with the IRR criterion , the TRI must be greater than "i + p" or "k + p".
