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TOPIC 7 — FINANCING AND INVESTMENT IN THE FIRM - Coggle Diagram
TOPIC 7 — FINANCING AND INVESTMENT IN THE FIRM
7.1. The Financial Function:
Firms need financial resources to acquire:
Capital goods
Buildings
Merchandise
Equipment, supplies
Company = a series of financing and investment projects over time.
Financial function = link between obtaining resources (financing) and using them (investment).
Objective (financial perspective): maximize the firm’s value considering:
Risk
Expected future returns
Value created for:
Capital providers (dividends, capital gains)
Employees (job stability, salary)
Suppliers (secured payments)
Financial area tasks:
a) Obtain financing:
Best conditions in:
Amount
Cost
Maturity
Combine financing alternatives to reach optimal financial structure.
b) Decide investments:
Select viable projects (profit/risk)
Use NPV, IRR
Include liquidity criteria (Payback Period)
Plan, analyze, and control investments
Finance interacts with all other subsystems (multifunctional role).
7.2. Economic–Financial Structure of the Firm
7.2.1. Balance Sheet:
Shows economic structure (assets) and financial structure (equity + liabilities).
Accounting equation:
Assets = Liabilities + Shareholders’ Equity
Assets = uses of funds / investments
Non-current assets (>1 year):
Intangible fixed assets (patents, trademarks)
Tangible fixed assets (buildings, equipment)
Long-term financial investments
Current assets (<12 months):
Inventories
Cash
Trade receivables
Other receivables
Ordered by liquidity
Equity and Liabilities = sources of financing
Ordered by enforceability (repayment term).
Equity:
Non-repayable long-term resources
Share capital, share premium, reserves (retained earnings)
Liabilities = financing with repayment
Non-current liabilities (NCL): >1 year
Current liabilities (CL): <1 year
Supplier credit
Short-term loans
Credit lines
Permanent capital:
Equity + Non-current liabilities
Long-term financing → reduces liquidity risk
7.2.2. Financial Equilibrium:
Assets liquidity< -> liability enforceability must match.
Minimum financial equilibrium rule:
Non-current assets must be financed with permanent capital
Only current assets should be financed with short-term liabilities.
To reduce risk:
Part of current assets should also be financed with permanent capital.
Leads to the concept of Working Capital.
7.3. Working Capital (Net Working Capital / Operating Capital)
Definition:
Working Capital = Current Assets – Current Liabilities
OR
Working Capital = Permanent Capital – Non-current Assets
Must give the same result.
Represents:
Permanent resources financing part of current assets
Financial “cushion” to prevent liquidity problems
Interpretation:
Positive WC → financially healthy
Zero WC → meets minimum equilibrium but risky
Negative WC → part of non-current assets financed with short-term liabilities (dangerous)
No universal ideal WC:
Depends on sector, activity level, treasury policy
Firms with:
Fast collection + long supplier credit → may sustain low/negative WC (e.g., Mercadona, Lidl)
High inventory turnover or JIT → need less WC.
7.4. Business Activity Cycles & Average Maturity Period (AMP):
Two cycles
Long cycle (fixed asset renewal cycle)
Recovery of non-current asset investments
Duration = useful life
Recovered gradually through amortization (included in production costs)
Short cycle (operating cycle)
Starts with acquiring raw materials
Production → storage → sales → collection
Recovers cash invested in operations
Duration usually <1 year
Measured through Average Maturity Period (AMP)
Sub-periods of AMP
m1 = Average storage period (raw materials)
m2 = Average production period
m3 = Average sales period (finished goods)
m4 = Average collection period
m5 = Average payment period (suppliers)
Two types of AMP
Economic AMP = m1 + m2 + m3 + m4
Time from investment → final collection
Financial AMP = m1 + m2 + m3 + m4 – m5
Net financing period
Measures the time between paying and recovering the funds
Impact of AMP length
Long AMP:
Funds “frozen” longer
Higher working capital needs
Higher risk
Short AMP:
Faster recovery
Lower investment needed
More flexibility
7.5. Economic–Financial Analysis: Structure Ratios:
Ratios = relationship between two meaningful variables.
Used for comparison:
Industry standards
Past values
Competitors
Single-year ratios may be misleading → trend analysis preferred.
7.5.1. Solvency Ratios:
Debt-to-Equity (D/E) Ratio
D/E = Total Liabilities / Equity
Indicates financial autonomy
Too much debt → loss of independence
Long-Term Solvency Ratio
\= Total Assets / Total Liabilities
≥ 2 → considered solvent
High ratio:
Easier access to credit
But too high → underusing borrowing potential
Liquidity Ratio
\= Current Assets / Current Liabilities
Should be >1
Alternative expression of working capital
Immediate Liquidity Ratio
\= Cash / Current Liabilities
Measures ability to meet very short-term obligations
more or less-> 0.1 is acceptable (industry-dependent)
7.5.2. Performance Ratios
Absolute metrics: EBIT, EBT, EBITDA
Cannot compare companies of different sizes → use profitability ratios.
7.5.2.1. Economic Profitability (ROA):
ROA = (EBI / Total Assets) × 100
Measures profit generated per 100 units of assets.
Can be decomposed:ROA = Margin × Asset Turnover × 100
Margin = EBI / Sales
Asset turnover = Sales / Total Assets
ROA increases via:
Higher margin
Higher asset efficiency
Or both
7.5.2.2. Financial Profitability (ROE):
ROE = (Net Income / Equity) × 100
Return to shareholders
Uses net income (after interest and taxes)
7.5.2.3. Financial Leverage:
If ROA > cost of debt → leverage increases ROE
Example:
Cost of debt 10% → pay 10 interest per 100 of debt
Higher leverage = higher ROE only if ROA stays above debt cost
If ROA < cost of debt → leverage reduces ROE (dangerous)