Question

Discuss your understanding of the role of financial analysis in capital financial decisions. Outline how you might approach funding decisions regarding capital projects. (Steps are ok for this answer).

Answer 1

Modes of Financing:

For any business, financing is a key aspect to support its operations or key strategic aspects from time to time. These business requirements shall vary in terms of value size, time frame, payback period, risk factors etc. Hence, choosing the right financing choice for the requirement is always necessary. Otherwise, it shall result in the liquidity or excess liquidity related issues.

Short term requirements generally include the operational working capital funding, small capital investments etc

Long term requirements include major capex investments, long term strategic aspects like business expansion plans, business acquisitions, etc

Based on the above, the companies scout for option for funding sources as below:

Equity Financing:

This is the method of raising funds through the issue of equity shares by giving the respective share of ownership on the firm. Generally, financing through this source is opted in case of fund requirement for major strategic activities, like Business expansions, business acquisitions, etc. The key advantages and disadvantages as below:

Advantages:

- Long Term: The equity shareholders doesn’t expect an immediate return on/of their investment. They look at long term perspective of the business growth and value addition to their investment. Hence, for the start-up, there is no immediate obligation to return this money back to shareholder in terms of value or dividends.

- Less risk: The equity shares doesn’t hold any coupon rate or any monthly interest obligations to be paid. The only expectation would be the annual dividend payouts based on the earnings. Hence, the startup doesn’t have to worry about the financing cost obligations.

- Cash Flows: To club up the above two, this sourcing provides good support to the Cash Flows of the firm with no immediate obligations to pay out;

Disadvantages:

- Loss of control: Equity share effectively mean that ownership is shared; Hence there shall be dilution in the ownership on the Start-up. This could be a case of concern for the founder of the startup;

- Decision Making: Since equity shareholders are the owners of the company, certain strategic decisions (as per the requirement of the local laws / regulations) need to be taken by the shareholders; This sometimes causes significant delays in decision making and also chances on the conflicts between the shareholders and the management of the company on the vision / strategic plans etc;

Debt Financing:

This is the method of raising funds / borrowing funds through various channels like Term loans from financial institutions, issuance of Bonds, Debentures, etc. Generally, financing through this source is opted in both the cases of long term and short term. Various debt instruments available in the market to suit the requirements of the firm, The key advantages and disadvantages as below:

Advantages:

- Term: In this case, the term is generally fixed upfront and hence the startup shall have complete clarity interms of monitoring the liquidity and further to satisfy debt obligations.

- No control: Unlike equity shares, debt instruments are temporary on the Balance Sheet of the firm and they doesn’t own any ownership in the start-up.To the best, they can have control on certain fixed/current assets of the company which are mortgaged with them.

- Cash Flows: The coupon rates are prefixed in terms of debt and the time frame as well known in advance; This helps in easy monitoring of the funds.

- Tax benefits: The cost of debt can be admitted for tax benefits unlike dividends, which are not tax admissible, for certain entry firms like the Startups.

Disadvantages:

- Creditworthiness: This is a very crucial aspect for any Startup to have Credit score, ratings and Drawing Power, for it to approach for debt financing. This is the biggest challenge and hidrance for any startup, as they shall not have any documentary evidence to showcase their thoughts and business of the startup.

- Collaterals for the Mortgage: Generally, debt financing need to be supported with a mortgage on the assets of the company. There can be cases, where there shall be requirement of Corporate Guarantees / Personal Guarantees (of Promoters). This is the second biggest challenge and hidrance for any startup, as they shall not have any property or assets to provide for mortgage.

- Cost Flows: While one way it is good that the debt obligations are known upfront, any defaults of the payments will have serious repercussions on the debt profile / ratings of the firm The regulatory norms are very strict on these terms.

While there are pros and cons, now a days even, certain banks and other financial institutions are coming up with various structured loans to small scale enterprises, Startups with no collateral offer. However, they too have stringent norms and other compliances to be followed for offering a loan