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Financing Policies
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Let us take a moment now to look at some financing policies which will assist you to compile your balance sheet projections.
An organisation will be financed using either debt or equity. The finance may be short-term, medium-term or long term. When projecting financial requirements, you would need to relate back to your sales forecasts and cost estimates in order to determine whether or not you need to finance your operation and how you should finance your operation.
Let us look at some examples of sources of each type of finance:
Short-Term Finance
- Trade credit (buying “on account”)
- Bank overdraft or bank loans: banks will usually require some form of security for this.
Medium-Term Finance
- Leasing: monthly payments for purchase or rent of plant, property and equipment.
- Hire purchase: Similar to leasing, done through Finance Company.
- Medium-term loans: will usually also incur interest and security will need to be provided.
Long-Term Finance
Long-term loans: will probably be needed to be secured by land or property and will incur interest.
Corporate bonds: Borrowing by a company which is a “paper” traded on secondary financial markets at a fixed interest rate. The borrowing may be secured against specific assets. A debenture is essentially an unsecured bond.
Equity: Shares issued by a company. (Shareholders are owners or part owners of the company)
An organisation needs to choose how much financing will come from equity and how much financing will come from debt. The following table gives a comparison between the two:
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Equity |
Debt |
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Investors accept higher risk |
Lenders do not like risk |
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Some ownership and control will need to be given up |
Ownership and control is not lost |
|
Dividend payments are optional and are a distribution of equity |
Interest has to be repaid and is an expense |
|
Equity can end up costing more than debt, equity investors are looking for a return on equity that is greater than the rate of interest they could earn on a lower-risk investment |
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A ratio that can be used to analyse debt is called the gearing ratio:
Gearing ratio = Debt ÷ Equity
How to interpret this ratio:
This ratio indicates the extent to which an organisation is dependent on debt or equity. A low gearing indicates a low reliance on debt; a high gearing indicates a high reliance on debt and a possible cash-flow problem.
Click here to view a video that explains financing and specifically the Gearing Ratio.