Business Financing and Capital Structure
In conducting their activities, all organizations need a sufficient amount of financial resources for covering expenses and ensuring the continuation of the organization’s life cycle. Cash and cash equivalents, capital and bank accounts, as well as other types of financial resources are used by companies for both short-term and long-term goals. That is why financial planning is one of the most important activities of businesses as it involves estimating future demand for financial resources within a company. The objective of financial planning is to forecast future revenues and costs, compare them, and plan activities of a company according to limited resources, facilities, and budgets. As finance is a very important part of each business, proper financial planning is vital in order to achieve the overall success of a company.
One of the major objectives of the financial planning is ensuring the presence of sufficient amount of financial resources that may be used for the functioning of a company. In order to achieve this objective, companies usually attract financial resources using different financial instruments. If a company increases its financial resources by attracting capital from investors, direct or indirect investment occurs. In other words, investment is putting money in a company with an expectation of getting more in the future. Investment and other types of financial resources involvement are beneficial for both companies and investors. They help companies to achieve their goals, as well as they help investors to increase their income.
Financial planning answers the question whether a company needs additional financial resources to expand its activities. If a company is going to increase the level of production, produce new products, or enter new markets, for example, there is a need in financing, and, as a result, in additional asset investment. However, if a company does not plan to make significant changes, additional investment is not required as it can finance expenses using undistributed profit.
However, there are situations when a company does not plan to expand its business, but it still needs additional financial resources. Working capital deficiency is one of these cases, and it is a situation when current assets of a company are lower than its current liabilities. In order to understand the issue of working capital deficiency, there is a need to understand the concept of working capital. The latter is a part of operating capital, which is normally used for short-term operations of a company. Companies use working capital, as well as long-term assets, to perform its normal activities and ensure providing goods or services (Kim & Shin, 2013).
Working capital management is aimed to ensure liquidity of company’s assets in order to avoid possible problems with working capital deficiency. In general, companies achieve this by managing their accounts payable and receivable, inventories and cash. Management of these current assets of a company can help a company to ensure sufficient short-term liquidity and perform all financial transactions in time. As a result, working capital management is a very significant activity of a company in a short-term period.
Working capital is usually managed by using different short-term financial instruments. Nowadays there are many types of financial instruments, which can be used for involvement of excess financial resources, especially cash. In general, there are instruments of debt and instruments of equity. Instruments of debt establish relations between economic subjects in terms of borrowing money for a specific time and with a specific interest. The most popular borrowing instruments are bonds and notes. The most popular instruments of equity are stocks, which are issued by companies and presuppose dividend payments for them.
The choice between instruments of either debt or equity depends on a specific situation of the corporation, terms of borrowing, namely time, sums and interest. If a company wants to involve additional financial resources without increasing the number of owners, it should use instruments of debt. However, it may be difficult for a company to serve its giant debts, and it is better for them to use instruments of equity, which do not include interest payments but presuppose dividends to the owners of stocks, for example. Furthermore, there are convertible bonds, which can be converted into a specific amount of stocks in a determined time and with a determined converting rate. Convertible bonds refer to financial innovations, and their popularity is growing from year to year.
However, the process of involving financial resources is usually costly. The initial phase is called underwriting, and it is performed by huge banks, which usually require high payments that cannot be avoided by corporations. Such payments are the cost of involving additional financial resources and can be referred to as transactional costs.
Nevertheless, different financial markets can suggest different transactional costs. On the international financial markets, which are regulated by states, transactional costs are higher. Tax, reserves and supervisory requirements increase transactional costs on the international financial markets. On contradiction to this, financial Euromarkets, which are not regulated by states, suggest much lower transactional costs. This is one of the most important factors of the ongoing popularity of financial Euromarkets. As a result, companies can choose either national or international investors, and this choice is very important. Interest rates in some countries may differ from interest rates in other countries, and that is why searching for sources of financing on foreign markets is quite a natural situation. There are opportunities of lower transactional costs and lower interest rates, and this creates incentives for companies to use foreign investment.
Nevertheless, foreign investment may be riskier as they involve crossing borders and national legislation systems. In general, the riskier a financial instrument is the more expensive it is for the borrower, and the more profitable it is for the investor. Such relationship is obvious. If an investor puts his money in a venture company, he faces high risks of losing his capital. As a result, such investment is not attractive for him. However, a venture company needs additional financial resources, and it increases its return on such investment in order to attract at least some investors. As a result, the higher the risk is the higher are returns on specific investments. On contradiction to this, companies with a good name can usually issue financial instruments with relatively lower interest rates. If an investor puts money in such company, he is confident in getting returns, and the interest rate is low. Treasury bills are another example. These are the least risky securities because the possibility of default is very high. As a result, interest rates on Treasury bills are much lower than average on the market.
The maturity of securities is also important. Securities, which are issued for many years, are riskier as nobody can foresee the far future. As a result, they usually have higher interest rates. However, three or six months Treasury bills have relatively low interest rates as they are not risky at all. As a result, the primary objective of all investors is finding an optimal investment portfolio with investment of different risks and returns. In other words, this is diversification.
If the investor’s portfolio is properly diversified, even in the worst-case scenario he will not lose everything due to different types and kinds of his investment (Statman, 1987). Furthermore, if the best comes to the best, such portfolio will have relatively high rate of return. As a result, diversification is the best option for reducing risks in the investor’s portfolio.