Financing Activities Definition
Financing activities are the different transactions which involve movement of funds between the company and its investors, owners or creditors to achieve long term growth and economic goals and have effect on the equity and debt liabilities present on the balance sheet; Such activities are can be analyzed through the cash flow from finance section in the cash flow statement of the company.
In simple terms, Financing Activities refer to the act of raising money or returning this raised money by promoters or owners of the firm in order to grow and invest in assets like purchasing new machinery, open new offices, hiring more workforce, etc. These transactions are normally part of long term growth strategy and hence affect the long term assets and liabilities of the firm.
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 any obligation to pay any principal or interest but at the cost of ownership. It’s an inflow which at the face of it looks easy money but in the long term may prove very costly. As sometimes because of a growing business you might end up paying more interest than the prevailing market rates.
- Debt Financing: Another way of raising capital can be issuing long term debt such as bonds. This in contrast to equity financing does not dilute ownership but makes firm liable to pay fixed interest and return the money within promised timeframe normally for 10 or 20 years
- If the firm is a not for profit organization then donor contributions can also be part of the financing.
Outflows – Return Capital
- Repayment of Equity: When owners have got enough wealth in-store, they would like to buyback the company stock and once again increase their ownership. They can do so through 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 profit with them. 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 share.
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 firm, they can be simply 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:
- Financing activities provide much-needed fuel for the firms to grow and expand into new markets. Companies short of capital might lose out to new opportunities and new customers. 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.
- It provides valuable insight to the investors about the financial health of the firm. For example, financing activity like buyback of shares regularly indicates that promoters are very positive of the growth story and want to retain ownership. This is the reason 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 take a clue that the firm is going through financial distress and facing issues in raising capital from banks or other lenders.
- Financing activities are often 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 be an invitation for 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 the consideration of how this capital has been raised or returned to the investors. There is always a tax implication which accountants of these firms should take into consideration. For example, financing activities like paying dividends attract tax but share buyback does not. Though differing in the long term, both these mechanisms are similar in short term horizon i.e. rewarding stock owners.
- 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 takeover.
- 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 financial health of the firm and hence depends on a lot on the owner’s mindset. This can be detrimental to shareholders.
- There can be multiple ways to raise and return capital. The decision to do so depends a lot on the available opportunities, prevailing rate of interest, bargaining power of the owner, health of the firm, confidence of investors and past track record.
- Not only raising capital but also returning that capital with interest payments is equally an area of consideration. A mistake here and there can cost tax implications.
Companies across the globe use a combination of a different financing mechanism to raise capital. Instead of going along a single way they use both equity and debt to improve the weighted average cost of capital WACC making it as low as possible. How these activities are performed can determine the success or failure of a firm in the long term.
This has been a guide to what is Financing Activities and its definition. Here we discuss the example of financing activities including equity, debt, buyback, dividends, etc along with their advantages and disadvantages. You can learn more from the following articles –