Financing Activities

Financing activities are the different transactions that involve the movement of funds between the company and its investors, owners, or creditors to achieve long-term growth and economic goals and have an effect on the equity and debt liabilities present on the balance sheet; Such activities can be analyzed through the cash flow from finance section in the cash flow statement of the company.

Financing activities cash flow refers 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.

Financial activities primarily involve transactions with investors and creditors, influencing the overall financial health and stability of the organization.

One facet of financing activities is equity financing, where a company raises funds by issuing shares of its stock. This can occur through initial public offerings (IPOs) or subsequent stock offerings. Investors, in return, become shareholders and have ownership stakes in the company, sharing in its profits and losses.

On the other hand, debt financing involves raising capital by borrowing funds. This can take the form of loans, bonds, or other debt instruments. The company commits to repaying the borrowed amount along with interest over a specified period. Bond issuances, for example, are a typical means of long-term debt financing.

Financing activities also encompass the distribution of profits to shareholders through dividends. Additionally, companies may engage in share repurchases, buying back their stock from the market. These actions impact the company's equity structure and can signal confidence in its financial standing.

Understanding and effectively managing financing activities accounting are paramount for businesses to optimize their capital structure, strike a balance between debt and equity, and ensure sustainable growth while meeting financial obligations. It is a delicate dance that financial managers must navigate to secure the necessary resources for operations and strategic initiatives.

Let us understand the different types of investments that lead to financing activities cash flow through the detailed discussion below.

Inflows – Raising Capital

1. 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.
2. Debt Financing: Another way to raise capital is by issuing long term debt bonds. This, in contrast to equity financing, 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.
3. If the firm is a not-for-profit organization, donor contributions can also be part of the financing.

Outflows – Return Capital

1. Repayment of Equity: When owners have enough wealth in-store, they would like to buyback the company stock 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.
2. Repayment of Debt: Like any fixed deposit, firms must repay the debt after a definite period as promised at the time of the issue.
3. 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 share.

The Financing activities accounting 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 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:

Let us understand the advantages of financial activities cash flow through the explanation below.

• 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 optimistic 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 distress and facing issues in raising capital from banks or other lenders.

Despite the various advantages listed in the section above and throughout the article, there are a few factors that prove to be a disadvantage. Let us understand them through the points below.

• Financing activities accounting is 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 lengthy 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.
• Diluting equity too much and not redeeming it back might become an example of a hostile takeover.

Let us understand the differences between financing activities accounting and investing activities through the comparison below.

Financing Activities

• Financing activities involve transactions related to obtaining funds to support the company's operations and growth.
• Companies engage in financing activities to shape their capital structure, balancing debt and equity to meet financial obligations and optimize growth.
• Includes equity financing through stock issuances and debt financing through loans or bond issuances.
• Payment of dividends to shareholders is considered a financing activity, as it involves using a portion of profits to reward investors.
• Buying back company shares from the market is a financing activity, impacting the company's equity structure.

Investing Activities

• Investing activities involve the acquisition and disposal of long-term assets, such as property, equipment, and investments.
• Companies make investment decisions to enhance their operational capabilities, expand into new markets, or generate returns on investments.
• Capital expenditures, such as purchasing machinery or building facilities, are considered investing activities.
• Selling assets, whether it's real estate or investments, is part of investing activities and can generate cash inflows.
• Investing activities are focused on generating long-term value for the company by strategically deploying resources in ventures that contribute to its growth and profitability.