Financial resources

The operating and investment cycles give rise to a timing difference in cash flows. Employees and suppliers have to be paid before customers settle up. Likewise, investments have to be completed before they generate any receipts. Naturally, this cash flow deficit needs to be filled. This is the role of financial resources. The purpose of financial resources is simple: they must cover the shortfalls resulting from these timing differences by providing the company with sufficient funds to balance its cash flow.

These financial resources are provided by investors: shareholders, debtholders, lenders, etc. These financial resources are not provided ‘‘no strings attached’’. In return for providing the funds, investors expect to be subsequently ‘‘rewarded’’ by receiving dividends or interest payments, registering capital gains, etc. This can happen only if the operating and investment cycles generate positive cash flows.

To the extent that the financial investors have made the investment and operating activities possible, they expect to receive, in various different forms, their fair share of the surplus cash flows generated by these cycles. The financing cycle is therefore the ‘‘flip side’’ of the investment and operating cycles.

At its most basic, the principle would be to finance these shortfalls solely using capital that incurs the risk of the business. Such capital is known as shareholders’ equity. This type of financial resource forms the cornerstone of the entire financial system. Its importance is such that shareholders providing it are granted decisionmaking powers and control over the business in various different ways.

From a cash flow standpoint, the equity cycle comprises inflows from capital increases and outflows in the form of dividend payments to the shareholders.

Without casting any doubt on their managerial capabilities, all our readers have probably had to cope with cash flow shortfalls, if only as part of their personal financial affairs. The usual approach in such circumstances is to talk to a banker. Your banker will only give you a loan if he believes that you will be able to repay the loan with interest. Bank loans may be short-term (overdraft facilities) or longterm (e.g., a loan to buy an apartment).

Like individuals, a business may decide to ask lenders rather than shareholders to help it cover a cash flow shortage. Bankers will lend funds only after they have carefully analysed the company’s financial health. They want to be nearly certain of being repaid and do not want exposure to the company’s business risk. These cash flow shortages may be short-term, long-term or even permanent, but lenders do not want to take on business risk. The capital they provide represents the company’s debt capital.

The debt cycle is the following: the business arranges borrowings in return for a commitment to repay the capital and make interest payments regardless of trends in its operating and investment cycles. These undertakings represent firm commitments ensuring that the lender is certain of recovering its funds provided that the commitments are met. This definition applies to both:

• financing for the investment cycle, with the increase in future net receipts set to cover capital repayments and interest payments on borrowings; and
• financing for the operating cycle, with credit making it possible to bring forward certain inflows or to defer certain outflows.

From a cash flow standpoint, the life of a business comprises an operating and an investment cycle, leading to a positive or negative free cash flow. If free cash flow is negative, the financing cycle covers the funding shortfall.

The risk incurred by the lender is that this commitment will not be met. Theoretically speaking, debt may be regarded as an advance on future cash flows generated by the investments made and guaranteed by the company’s shareholders’ equity.

Although a business needs to raise funds to finance investments, it may also find at a given point in time that it has a cash surplus, i.e., the funds available exceed cash requirements.

These surplus funds are then invested in short-term investments and marketable securities that generate revenue, called financial income.

Although at first sight short-term financial investments (marketable securities) may be regarded as investments since they generate a rate of return, we advise readers to consider them instead as the opposite of debt. As we will see, company treasurers often have to raise additional debt just to reinvest those funds in short-term investments without speculating in any way.

These investments are generally realised with a view to ensuring the possibility of a very quick exit without any risk of losses.

Debt and short-term financial investments or marketable securities should not be considered independently of each other, but as inextricably linked. We suggest that readers reason in terms of debt net of short-term financial investments and financial expense net of financial income.

The cash flows of a company can be divided into four categories, i.e., operating and investment flows, which are generated as part of its business activities, and debt and equity flows, which finance these activities. The operating cycle is characterised by a time lag between the positive and negative cash flows deriving from the length of the production process (which varies from business to business) and the commercial policy (customer and supplier credit). Operating cash flow, the balance of funds generated by the various operating cycles in progress, comprises the cash flows generated by a company’s operations during a given period. It represents the (usually positive) difference between operating receipts and payments.

From a cash flow standpoint, capital expenditures must alter the operating cycle in such a way as to generate higher operating inflows going forward than would otherwise have been the case. Capital expenditures are intended to enhance the operating cycle by enabling it to achieve a higher level of profitability in the long term. This profitability can be measured only over several operating cycles, unlike operating payments, which belong to a single cycle. As a result, investors forgo immediate use of their funds in return for higher cash flows over several operating cycles. Free cash flow (before tax) can be defined as operating cash flow less capital expenditure (investment outlays).

When a company’s free cash flow is negative, it covers its funding shortfall through its financing cycle by raising equity and debt capital. Since shareholders’ equity is exposed to business risk, the returns paid on it are unpredictable and depend on the success of the venture. Where a business rounds out its financing with debt capital, it undertakes to make capital repayments and interest payments (financial expense) to its lenders regardless of the success of the venture. Accordingly, debt represents an advance on the operating receipts generated by the investment that is guaranteed by the company’s shareholders’ equity.

Short-term financial investment, the rationale for which differs from investment, and cash should be considered in conjunction with debt. We will always reason in terms of net debt (i.e., net of cash and of marketable securities, which are short-term financial investments) and net financial expense (i.e., net of financial income).