Financing Activities Definition Examples What Is Included

Financing Activities Definition

In simple terms, Financing Activities refer to the act of raising money or returning this raised money by promoters or owners of the firm to grow and invest in assets like purchasing new machinery, opening new offices, hiring more workforce, etc. These transactions are normally part of a long-term growth strategy and hence affect the long-term assets and liabilities of the firm.

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What is Included in Financing Activities Examples?

Inflows – Raising Capital

Equity Financing: This corresponds to selling your equity to raise capital. Here the money is raised without obligation to pay any principal or interest but at the cost of ownership. It’s an inflow that, on its face, looks like easy money but may prove very costly in the long term. Sometimes, because of a growing business, you might pay more interest than the prevailing market rates.Debt Financing: Another way to raise capital is by issuing long term debtLong Term DebtLong-term debt is the debt taken by the company that gets due or is payable after one year on the date of the balance sheet. It is recorded on the liabilities side of the company’s balance sheet as the non-current liability.read more bonds. This, in contrast to equity financingEquity FinancingEquity financing is the process of the sale of an ownership interest to various investors to raise funds for business objectives. The money raised from the market does not have to be repaid, unlike debt financing which has a definite repayment schedule.read more, does not dilute ownership but makes the firm liable to pay fixed interest and return the money within the promised timeframe, normally for 10 or 20 years.If the firm is a not-for-profit organization, donor contributions can also be part of the financing.

Outflows – Return Capital

Repayment of Equity: When owners have enough wealth in-store, they would like to buyback the company stockBuyback The Company StockShare buyback refers to the repurchase of the company’s own outstanding shares from the open market using the accumulated funds of the company to decrease the outstanding shares in the company’s balance sheet. This is done either to increase the value of the existing shares or to prevent various shareholders from controlling the company.read more and increase their ownership. They can do so in multiple ways like – buying stocks from an open market, bringing offer for sale, or proposing a buyback.Repayment of Debt: Like any fixed deposit, firms must repay the debt after a definite period as promised at the time of the issue.Dividend Payment: This is a mechanism by which firms reward their shareholders and share their profits. Since these are subject to tax, firms sometimes use the capital to buy back shares from the shareholders by bringing a buyback offer. This decreases the number of shares in the market and hence increases the earnings per shareEarnings Per ShareEarnings Per Share (EPS) is a key financial metric that investors use to assess a company’s performance and profitability before investing. It is calculated by dividing total earnings or total net income by the total number of outstanding shares. The higher the earnings per share (EPS), the more profitable the company is.read more.

How to Record Financing Activities?

The Financing activities examples listed above are recorded in the cash flow statement of the firm. Diagrammatically, it can be explained as:

Since financing activity is all about cash inflows and cash outflows recorded in the cash flow statement of the firmCash Flow Statement Of The FirmA Statement of Cash Flow is an accounting document that tracks the incoming and outgoing cash and cash equivalents from a business.read more, they can be calculated by adding all inflows and outflows individually and then taking an algebraic sum of the two derived terms.

Consider the following example of a firm that undergoes the following financing activities:

Advantages

Financing activities provide much-needed fuel for the firms to grow and expand into new markets. It is easy to imagine what would have happened to major internet giants of today like Facebook or Google, or even our homegrown OLA, had they not been able to raise money for their expansion plans. Companies short of capital might lose out on new opportunities and new customers.It provides valuable insight to the investors about the firm’s financial health. For example, financing activity like the buyback of shares regularly indicates that promoters are very positive about the growth story and want to retain ownership. This is why Indian IT majors like Infosys and TCS brought consecutive buybacks in 2 years, and the same was cheered by the investors. On the other hand, if a firm is readily diluting its equity, investors might assume that it is going through financial distressFinancial DistressFinancial Distress is a situation in which an organization or any individual is not capable enough to honor its financial obligations as a result of insufficient revenue. It is usually the result of high fixed costs, obsolete technology, high debt, improper planning and budgeting, and poor management, and it can eventually lead to insolvency or bankruptcy.read more and facing issues in raising capital from banks or other lenders.

Disadvantages

Financing activities are often in the interest of regulators as they are often attentive to how the money has been financed and what it is used for. Firms should be vigilant during these operations as a slight mistake can invite regulatory scrutiny leading to a long legal hassle. Walmart buying Flipkart stake was one such financing activity example. More than what amount of capital has been raised in consideration of how this capital has been raised or returned to the investors. There is always a tax implication that these firms’ accountants should consider. For example, financing activities like paying dividends attract tax, but share buyback does not. Though differing in the long term, these mechanisms are similar in the short term, i.e., rewarding stock owners.

Limitations

A firm can end up paying more interest than it has paid, had the money been raised from the bank.Diluting equity too much and not redeeming it back might become an example of a hostile takeoverExample Of A Hostile TakeoverA hostile takeover is a process where a company acquires another company against the will of its management.read more.Again, diluting equity can make it difficult to implement decisions as it will be difficult to please everyone and take a unanimous decision.Sometimes raising capital becomes more of a negotiating skill than the firm’s financial health and hence depends a lot on the owner’s mindset. This can be detrimental to shareholders.

Important Points

There can be multiple ways to raise and return capital. The decision to do so depends a lot on the available opportunities, prevailing interest rate, bargaining power of the owner, health of the firm, confidence of investors, and past track record.

Raising capital and returning that capital with interest payments is equally an area of consideration. A mistake here and there can cost tax implications.

Conclusion

Companies across the globe use a combination of different financing mechanisms to raise capital. Instead of going along a single way, they use both equity and debt to improve the weighted average cost of capital + [Cost of Debt * % of Debt * (1-Tax Rate)]” url=”https://www.wallstreetmojo.com/weighted-average-cost-capital-wacc/”]WACC”WACC””The making it as low as possible. How these activities are performed can determine the success or failure of a firm in the long term.