In my first article on financing I aimed to present the most important external financing opportunities available. However, we cannot forget that some companies carry out their activity based on internal financing, or self-financing, i.e. they fund their own operations without external assistance.
Internal financing opportunities
With internal financing, much like external financing, it is important to match the financing term with the recovery period for the financed project or asset. Attention must also be paid to the interest rate of the financing as well as to the repayment instalments or any loss of earnings. Upon examining these aspects, in certain cases a company may conclude that internal financing is more expensive than sourcing the necessary funds on the money market. Below I look at the most typical self-financing models.
Although this form of financing would traditionally come under external financing, companies that have this option generally find it much easier to gain access to such funding than is the case with a bank loan for instance. Furthermore, borrowing from a related entity means they normally enjoy significantly looser conditions in terms of collateral required, the interest rate or the term of the loan. Of course, related-party loans can also be granted under conditions that are worse than market terms, but here there are usually factors in the background that are not related to just financing.
With related-entity financing that differs from market financing it is important to note that both the lender and the borrower may have to adjust their tax bases, which can ultimately impact on the cost of financing. This can all be avoided if the lending takes place at arm’s length between the related parties.
This method of internal financing is essentially reserved for prosperous companies. Yet even for profitable companies it is questionable whether the owners will decide to distribute profit as a dividend or reinvest it into the business. These decisions are largely influenced by the additional profit that can be earned from the activity to be financed. Current interest rates in Hungary encourage owners to opt for reinvesting profit, at least to some extent. However, this leads to an interesting contradiction because they do so in the hope of generating a greater return from their “reinvested” money. The external financing options presently on the table along with interest rates of virtually zero can often offer even better financing conditions for companies though.
Early payment discount
If we want to encourage our customers to pay their invoices before the payment deadline, meaning we do not have to finance the cost of the sold product or service for as long, and we can reinvest this income more quickly into our activity, then one method is to offer customers a discounted payment option. Not everyone will take advantage of this of course, but depending on their current liquidity position many partners may find a discount of a few percent appealing. However, we also need to be aware that there is a cost side to this, as with all types of financing – in this case it is the part of the invoice that we waive in exchange for a faster settlement. Choosing this system is only worthwhile if the expected benefit (cost of financing with bank loan, extra time and administration, no late payment interest on account of our liquidity problem) exceeds or is at least the same as the amount of the discount.