Basically, financing means equipping a so-called economic entity with the capital it needs to achieve its goals. This sounds bulky at first, but means nothing else than the provision of needed money or other financial resources, for example, to found a business, to buy a house or – in the economic context – for the economies of States.
The term economic entity generally refers to economic agents, be they individuals, companies or whole economies. Financing is thus a key element of the economic cycle and is crucial for businesses, households and governments, as it enables them to spend and invest. There is a difference in terms of financing, especially in the business context of companies, the source of funds (internal or external financing) and the legal position of the investor (equity or debt financing).
As with sovereigns and households, financing is used to cover capital needs to meet specific goals. From a business point of view, a distinction is made between purely monetary financing, which serves to secure liquidity, and the capital-economic financing with which companies provide their capital. Both forms of financing are reflected on the liabilities side of the balance sheet, while the funds acquired with them (machinery, land or similar) are recorded on the assets side.
All processes used to provide funds for investment or the production process fall under the concept of funding, as well as the related repayments and, more broadly, related consequences such as changes in voting rights.
The terms finance and investment go hand in hand in business administration, as the financing resources are the necessary basis for investments to be made and vice versa planned investments are usually the reason for seeking funding. If goods such as rights or real estate are directly supplied to the company instead of funds, financing and investment come together.
About the external and internal financing
On the one hand, a distinction is made between the type of source of funds (external or internal financing) and, secondly, the types of capital:
In addition, there are other relevant criteria for accounting, such as the distinction between short, medium and long-term financing. Overall, there are four possible combinations:
In external financing, the funds come from an external source. The two main forms are equity financing (financing of equity with the associated rights and obligations) or financing by credit. The funds can be paid in the form of money, securities or even commodities. External financing via equity financing is self-financing, as the funds used to generate / increase equity capital are used. External financing via loans and loans is a debt financing.
In contrast, internal financing uses funds from the company itself for investments, such as cash flow, the reversal of long-term provisions or depreciation. A reduction of the retained liquidity reserve is also a form of internal financing. Internal financing from asset reallocations is counted as self-financing, while internal financing from the reversal of provisions is attributable to external financing.
In summary, capital is supplied to the company in the case of self-financing and thus participations are created. The investor acquires rights, but is also liable and disadvantaged in the event of insolvency. Self-financing can be provided from external sources (external financing) or by using the company’s own resources (internal financing from funds generated in the company’s sales process).
In the case of debt financing, it is not a participation but a credit relationship that is established. The investor does not acquire any participation or profit participation rights, but is not a subordinated creditor in the event of insolvency. For internal financing, for example, funds from provisions are used, and external financing is lending and lending.
Another criterion is the distinction between ordinary (or on-going) financing and extraordinary financing. The latter serves special purposes such as start-up or reorganization financing, while ordinary financing finances day-to-day operations.
In addition, there are special forms of corporate financing. These include, for example, leasing, factoring (ie, the sale of a company’s receivables to a factoring company for immediate payment of the agreed purchase price) or mezzanine capital (a hybrid form in which equity capital is contributed without the corresponding voting rights – and profit rights are acquired).
The financing plan should work as well as possible
A wrong financing plan is one of the most frequent insolvency reasons (in addition to too low equity and entrepreneurial failure). It is no coincidence that corporate governance generally lays down financial principles that determine the long-term procurement and structuring of corporate capital. This includes, for example, the golden accounting rule, which states that fixed assets should be covered by equity, while borrowed capital may be used to cover current assets.
The Golden Rule, on the other hand, requires that all long-term fixed assets (such as land) must also be secured by long-term capital (equity or long-term loans) to avoid liquidity problems. Financial planning deals in detail with ensuring the liquidity of the company, identifying future capital needs for investments or the like, and identifying the ideal funding methodology.
It is planned whether and when equity or borrowed capital is needed, in which way the equity is increased, which maturities should ideally have the debt and much more. The aim is not only to secure the company’s liquidity, but at the same time to minimize the capital costs to be expended. Long-term financial planning addresses the need for capital for several years, while liquidity planning schedules cash flows on a weekly or monthly basis, up to one year ahead.
Financing in the economic sense
Even states use the means of financing. Classical sources here are government bonds or bonds. Risks of the system became apparent during the financial crisis as banks, which traditionally had a very low equity ratio, invested in risky government bonds and were then unable to cover the shortfalls with equity.
To safeguard monetary stability, central banks are prohibited under EU treaties from printing money for the purpose of financing state budgets. This would lead to high inflation and endanger the stability of the euro. The Bucklebank and the EurCen Bank have the mandate to control this and to ensure the stability of the monetary value.
It is in the interest of economies that economic agents be financed as much as possible with needed capital, as this will benefit the economy as a whole, that is to say: consumption and investment will be boosted and the community will benefit. A positive financing climate with favorable interest rates is also good for the overall economy as investment incentives are set and start-ups are facilitated.
Households and Financing
Financing also plays a major role in the private sector, as it allows private households to buy consumer goods or assets and thus boost the economy. For households, of course, the financing must be covered by appropriate collateral, whether small-scale instant loans or large loans for the acquisition of real estate (keyword: real estate financing) and house building.
The word finance is a loanword from Latin (from finantia for due payment or termination). At that time, the term was used to settle a dispute by paying a fine – so “ending” financing through repayment is a meaning that has survived into our modern day. In the Middle Ages, however, the word “financies” was used negatively and synonymous with usury. It was only at the beginning of the 17th century that today’s value-neutral use of public money or state funds prevailed.