Self-Financing and Commercial Credit: A Comprehensive Guide
Self-Financing
Self-financing refers to using undistributed retained earnings for expansion or maintenance. This allows firms to avoid resorting to financial institutions or soliciting new contributions from members.
Types of Self-Financing
Enrichment
Retained earnings held as reserves increase the company’s share capital. These reserves can be:
- Legal: Formed in accordance with applicable laws, typically a minimum percentage of profits.
- Statutory: Established by agreements outlined in the company’s statutes.
- Voluntary: Formed by voluntary agreement of the partners.
These reserves represent an increase in the company’s capital, providing resources for investment, growth, and expansion.
Maintenance
Funds allocated for the amortization of production equipment and future needs. This includes:
- Depreciation: Accounts for the loss of value over time, calculated as part of production costs.
- Provisions: Reserve funds to cover future risks and potential claims.
Advantages of Self-Financing
- Greater autonomy and independence.
- No explicit interest payments required.
Disadvantages of Self-Financing
- Limited capital available.
- Potential for less profitable investments.
- Possible conflicts between shareholders and directors.
Commercial Credit Providers
Commercial credit involves postponing payment to suppliers, effectively obtaining credit for the duration of the postponement. This common practice is often automatic, convenient, and free, making it a popular short-term credit option. While no explicit interest is paid, potential discounts for prompt payment are forgone, representing an implicit cost.
Bank Loans and Credits
Loan: The company receives the requested amount immediately and pays interest on the entire sum.
Credit: A credit account or line of credit provides the company with a pre-approved amount or limit. Interest is only paid on the amounts used and for the duration of their use, not on the total credit limit.
Trade Discount
Companies can convert receivables into cash before their collection date by offering them to a bank at a discount. The bank then collects the full amount upon maturity.
Calculation: E = N – DC – C
Interest Calculation: DC = NT / B
Factoring
Factoring companies specialize in collecting receivables for other businesses. Companies needing liquidity can sell their receivables (e.g., bills of exchange) to a factoring company before maturity. This offers the same advantage as trade discounts, plus it releases the company from the risk of default.
Borrowings
Large companies can issue bonds (or other debt securities) to raise capital. These bonds are offered to the public, and investors become creditors, entitled to interest payments and repayment of the principal at maturity.
Types of Interest
The price of a loan, expressed as an annual percentage of the amount borrowed.
- Issue Premium: Bonds offered below their nominal value.
- Redemption Premium: Return value exceeds the nominal value plus interest.
Interest is calculated on the nominal value.