Akash Dubey
05 Sep, 2019
Financing activities represent the transactions of the business that are used to fund business operations and expansion. These activities refer to the inducement of funds by way of long term debts or sale of equity in the business. These transactions are a part of the long term vision of the company and hence, affect the long term assets and liabilities of the company.
Financing activities reveal the characteristics of the funding structure of the company. It showcases how the business is procuring funds for its operations and scalability. However, the they do not include internal financing on only includes external sources of funds procurement. It does not include retained earnings or profits from business operations used to finance business expansion or purchases of assets.
Forexample:
Case 1: If a company ABC Private Limited buys a boiler with retained earnings from previous years
Case 2: If ABC Private Limited buys a boiler by taking an external loan from Bank and buys a machine by transfer of equity in favor of XYZ Private Limited.
In case 1, the company is financing its procurement of assets internally. Hence, the transaction will not be representing in financing activities. Here, there is no change in the debt or equity structure of the company.
In case 2, the company procures assets by taking financing from a bank and by transfer of equity. Hence, this is included in the financing activities as it changes the debt or equity structure of the company.
Table of Contents
Importance of Financing Activities
Details of financing activities are crucial for both investors and debt providers for the company. The reflection of the these activities accounts for determining the fund efficiency of the enterprise. It shows the ability of the organization to raise funds and manage funds. The liquidity[1] of the enterprise is concluded by this head.
Representation of Financing Activities
Financing activities are represented in the Cash Flow statement under the head of “Cash from Financing Activities.” The cash flow statement is a part of the financial statements of the company. The head contains transactions that influenced the fund inflow or outflow for the enterprise by way of equity or debt.
For example cash increases if someone provides long term funds to the company by way of debt or equity.
Cash decreases, if payment is made to the debtors or equity buyback takes place by the company,
Items of Financing Activities
Following are the items that represent the financing activities in an organization
- Borrowing of short term loans
- Borrowing of long term loans
- Payment of short term loans
- Payment of long term liabilities
- Issue of shares
- Issue of bonds
- Buyback of shares
- Payment of dividends to shareholders
- Payment of interest on finance or lease
Recommended Article: Comprehensive Guide to Cash Flow Analysis.
Effect on Financing Activities on Cash Flow
The financing activities affect the cash flow in two ways- positive effect and negative effect. The activities that increase the amount of cash are deemed as positive cash flow. The financing transaction, which reduces the amount of cash, is termed as negative cash flow. Read the following examples to understand better.
- Sale of stocks (positive cash flow)
- Loan from a bank or financial institution (positive cash flow)
- Payment of dividends to shareholders (negative cash flow)
- Cash from the issue of new stocks (positive cash flow)
- Redemption of bonds (negative cash flow)
- Purchase of treasury stock (negative cash flow)
- Repayment of existing loans (negative cash flow)
- Repurchase of existing stock (negative cash flow)
- Issuing bonds (positive cash flow)
Advantages and Disadvantages of Financing activities
The management uses a combination of equity as well as debt funding information of capital for the company. Both of them should be in a healthy proportion to run the affairs of the company in a smooth manner without compromising with its future growth. There are certain advantages and disadvantages of financing activities.
Advantages of financing activities:
Financing activities provide the essential funds which are required to excel in the growth of the company. Companies lacking in capital availability have to limit their marketing activities and cannot plunge to expansion or diversification of business. So many successful business entities of the present would not have been growing on a scalable pace if they were not raising funds via financing activities.
Additionally, these activities provide a report about the financial state of the firm. These activities represent the source of business funds and how they are employed. They also represent the pattern of the growth of the organization. For example, if the company is taking debt at regular intervals, it means that it is not able to generate enough funds for financing its assets, operations, and expansion.
At the same time, if the creditors are giving debt at regular intervals and are paid at the due interval, this describes the creditworthiness of the firm. Additionally, if the company exercises buyback of shares, this represents the positive growth of the company as the management is confident about the growth of the entity at the same time selling off equity at regular.
Disadvantages of Financing Activities
Financing activities are also having certain disadvantages if they are not recorded in a proper manner. For example, any event not represented properly under the financing activities head under cash flow statement can attract penalty implications form regulators. Therefore, the enterprise should utmost care that these transactions are properly recorded with taking reference from current laws and provisions.
Additionally, it should also not be ignored that the manner of raising funds is the most important factor for investors, creditors, and regulatory authorities. It should take with utmost care so that a firm may not end up having a negative finance ratio.
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