From Chapter 6: Financing Activities, I have studied about the financial activities of a firm. In general, this chapter covers equity financing, debt financing, leases and other aspects of financial activities. Several important points from the chapter can be outlined. They are described below.
Aspects of Financial Activities
- The shareholder’s equity can be changed by three events: investments made by shareholders, usually net cash received by a firm; distributions to shareholders, usually in a form of dividends; profitable operating and investment activities. Shareholders usually make cash investments in order to secure their equity interests in a company. In exchange, the company can issue preferred stock, options, stock rights etc. Dividends are usually paid to shareholders in a form of cash, sometimes as property dividends, stock splits or additional shares. Companies can also repurchase shares from shareholders for cash to decrease their equity. For shares, market price and book value are usually calculated.
- For debt financing, liability recognition and valuation principles are important. The liability requires economic benefits in the future. The obligation for the firm is present, and the event that gives rise to it has occurred. Liabilities that report future payments are shown at the present value; discount rate is used. If liabilities require the future delivery of goods or services, they are represented at the basis of estimated cost of goods or services. Cash advances are shown in the amount of the advance. Obligations are divided in to six groups: obligations with fixed payment dates and amounts, obligations with fixed payment amounts but estimated payment dates, obligations with estimated payment dates and amounts, obligations arising from advances from customers on unexecuted contracts and agreements, obligations under mutually unexecuted contracts, and contingent obligations. There are special rules for establishing fair value of debt, reducing debt, and accounting for troubled debt. Use of hybrid securities (or compound financial instruments) provides additional issues to long-term liability reporting. Preferred stock is an example of hybrid securities. Convertible preferred stock enables the holder to exchange it for the common stock. Convertible debt may be converted into common stock. If bonds are issued with detachable warrants, they provide an example of where debt and equity features may be quite easily separated. There are also off-balance-sheet financial agreements. A firm may use an existing asset as collateral for a loan. If it sells this asset, it receives cash, but liabilities will not be shown in the balance sheet. A firm can also use another entity to obtain financing. It is an example of off-balance-sheet financing, too. Sometimes, firms sell their receivables to obtain financing. Product financing arrangements occur if a firm sells inventory to another firm or arranges for another firm to purchase inventory.
- Many firms use leases. They provide many benefits to lessees. Tax benefits and other deductions can be shifted to lessors. In exchange, lessors can allow lower lease payments. Lessees are able to change capacity without purchasing or selling assets. Lessees can reduce the risk of technological obsolescence and finance their needs when alternative methods of financing are more costly or unavailable. In an operating lease, a lessor transfers to a lessee only the rights to use property for a certain period. Capital lease method is different. A lessee assumes the risks and enjoys the benefits of assets ownership. However, under such conditions, the lessee should depreciate the leased asset itself. An operating lease can be converted into capital lease.