Financing activities covers business activities related to the company’s capital structure. These activities include transactions involving changes in owner’s equity, long-term liabilities, owner’s equity, and short-term loans. The transaction involves the flow of cash between the company and its investors, namely shareholders and creditors.
Capital structure
Capital sources of a company can come from equity or debt. To take debt, companies do it by taking loans from banks or issuing debt securities such as corporate bonds or medium-term notes. Liabilities increases. And, it raises regular payments, namely interest to creditors and coupons to bondholders.
However, when taking the equity route, the company issues shares to investors. Shareholders’ equity increased. The issuance of shares does not always result in regular payments. For example, a company might choose not to distribute dividends.
Cash flow from financing activities
In the cash flow statement, financing activities are one of three categories of cash flow in and out. The other two are cash flow from operating activities and cash flow from investing activities.
Cash flows from financing activities describe the flow of money between businesses and suppliers of capital (shareholders and creditors). From this section, you will see how businesses increase capital and repay creditors and shareholders.
Positive numbers indicate that the business receives cash. That increases the company’s capital, as well as its assets.
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Conversely, negative numbers indicate the business pays out capital. For example, companies pay dividends or pay off long-term debt.
Components of cash flow from financing activities
Both cash outflows and inflows from creditors and investors, it is part of financing activities. In other words, cash flow from financing activities contains transactions related to corporate debt and equity.
Examples of sources of cash inflows from this activity are:
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- Issuance of common stock and preferred stock
- Sale of treasury shares
- Issuance of debt securities
- Borrow money to the bank
These transactions add to the company’s cash. When issuing shares or debt securities, for example, cash flows from investors to companies.
In contrast, examples of sources of cash outflows include:
- Share buyback
- Repayment of debt securities
- Bank loan payment
- Payment of cash dividends to shareholders
Furthermore, some changes in capital structure might involve cash. Such activities are known as non-cash financing activities.
An example is the conversion of debt into ordinary shares. Although changing the capital structure, the conversion does not affect the cash reported in the cash flow statement. After conversion, the company’s liabilities decrease, and shareholder equity increases. As a result, the bondholders now become shareholders.
Why it is important
Business financing activities provide insight into the financial health and business objectives. In general, positive cash flow from funding activities can indicate the intention of business expansion and growth. Money flows more to the company, so assets increase. Companies can use it to finance the purchase of capital assets or build new production facilities.
Thus, financing activities show how companies finance operations and expansion externally. Internal cash funding is excluded. For example, a company buys capital goods using internal cash. Accordingly, there are no financing activities because the equity and liability accounts are unchanged by such expansion.
Both investors and creditors see how efficiently a business can use existing cash to fund operations. They also want to see how effectively they can raise capital for future projects.
When debt accounts for a more significant portion of the company’s capital, it has high financial leverage. High leverage limits the company to owe. The only way to increase cash inflows from financing activities is to issue shares. And, issuance of shares does not increase leverage because it is not a liability, but equity.
