Introduction

We can finance the company from internal or external sources and we encounter both types in practice. In today’s article, we take a closer look at financing options from outside the company.

Why is external financing used? What types of this kind of financing exist? What are its advantages and disadvantages?

Why not only internal financing, but also external financing?

Companies nowadays often use external financing for several reasons. One of the most common reasons companies choose this method is to finance a long-term investment – such as the purchase of machinery, buildings, licenses, etc. Other reasons include increasing working capital or ensuring competitiveness.  

External financing, what do we mean by that?

As the name suggests, it is the financing that a business (company) obtains from outside, from other entities such as other businesses, banks, insurance companies, owners (shareholders/partners), government institutions, etc.

The general main advantages of external financing definitely include obtaining a larger volume of financial resources for an “unlimited” period of time and often on more favourable terms than would be the case from internal sources. However, it is also necessary to realize that these are foreign resources, and this entails an increased level of indebtedness of the company, which may cause a decrease in its financial stability. For the company, this option also means higher costs in the form of interest rates or various fees and, in extreme cases, it can cause the loss of control of the company. Below, we introduce some types of external financing. The most common methods of this type of financing include:

• Contributions and ownership interests of founders (owners)
• Loans and bank credits
• Overdraft facility
• Lease
• Factoring

Contributions and ownership interests of the founders

The first type of external funding we have chosen is the founders’ contributions and ownership interests, where we raise funds directly from our owners. The founders’ contributions can be divided into monetary and non-monetary. Cash resources (direct payment to the company’s bank accounts from the owner) do not need to be specified any further. Non-cash resources are considered as values that are not cash but can be converted into cash or have the potential to be used to settle liabilities. Non-cash contributions are more challenging for the company from a practical point of view, especially due to their valuation by the depositor, which, among other things, raises tax issues to be assessed. The inherent advantages of this type of financing include the “cost saving” as there is usually no obligation to pay interest or fees and these deposits are generally not time limited. In this way, the owner tries to support the company’s activities or stabilize it. On the other hand, it should be noted that the resources of the owner that can be invested in the company are not infinite and the financing needs of the company may be higher.   

The legal regulation for partners’/shareholders’ deposits can be found in particular in Act No. 90/2012 Coll., the Business Corporations Act (hereinafter the “BCA”) and Act No. 89/2012 Coll., the Civil Code (hereinafter the “Civil Code”). This defines the various obligations and requirements that need to be met if a company decides to take this step. When using this option, it is recommended to ensure that all parties are present in the assessment of the potential impact of the transaction – accounting/tax/legal perspective. 

Loans and bank credits

Loans and bank credits are probably the best known and most used source of external financing. In terms of maturity, they can be divided into short-term, which have a maturity of up to one year, and long-term, which have a duration of more than one year, with the proviso that even for long-term loans and borrowings, the portion maturing within one year is recognised as a current liability in the financial statements. Each bank or other financial institution sets its own conditions, under which it is willing to lend funds to clients. Generally speaking, banks require a loan application to be accompanied by financial statements for the most recently completed period (if the company is audited, an auditor’s report), a corporate income tax return, current financial reports, and future plans including how the loan/loan will be repaid.  The advantage of loans and credits is their availability and relatively quick processing, but the amount each company can access is up to the discretion of each bank/financial institution. However, loans are inherently associated with interest and various fees (e.g. for processing applications), for which banks lend funds and which must be taken into account in the profit or loss for the individual accounting periods, among other things. At the same time, it is also very common for the company (borrower) to establish security for the loan/borrowing against the bank (lender) in various forms – for example, security over movable/immovable assets, bank accounts, receivables, etc. Furthermore, during the “credit” period, the company is obliged to submit to the bank individual documents, not only accounting documents, which are used to continuously evaluate the financial condition (health) of the company.  

In accounting regulations, bank loans and borrowings can be found mainly in the Czech Accounting Standard No. 016 and No. 018 and in Decree No. 500/2002 Coll. for entrepreneurs. Here, you will learn, among other things, how and when to recognise loans/borrowings received; how to treat interest/fees etc. – expense vs. incidental cost of non-current assets.

Overdraft facility

This is the possibility of drawing money from a current bank account in case there are not enough funds in our business account, so called “we can go into red numbers”. This service is not a one-off and can be repeated over and over again. This is usually a short-term form of financing. The advantages of an overdraft facility include, in particular, quick accessibility (banks usually do not require you to submit all the documents as in the case of a bank loan). On the other hand, as with a bank loan, there are interest costs associated with the use of an overdraft, and the interest rate tends to be higher than for “standard” bank loans. 

The accounting rules are the same as those recorded for bank loans and credits.

Lease

Another widely used form of financing in practice. Through lease (or in other words, “renting”), a company can secure the assets it needs without having to spend the money all at once. It spreads its funds over the lease periods (lease installments). Most often, companies lease cars, machinery or other production equipment through leases. Leases can be divided into two most well-known types – operating leases and financial leases.

Operating lease is more widely used in practice, the contract is made for a period that is noticeably shorter than in the case of financial lease. It has the advantage of not transferring risks from the lessor to the lessee, for example, in the form of risk of damage, or costs of maintenance and repairs, insurance, etc. During the entire period of use, the leased property is fully owned by the lessor and the lessee pays regular rent. Upon termination of the contract, the property does not become the property of the client (lessee), but is returned to the owner.

In contrast, in a finance lease, the lessee takes care of the leased asset, as if it were his own, i.e. pays for repairs and operation. It is usually entered into for a longer period of time. In addition, there is a one-off down payment at the beginning of the lease, which is usually between 20% and 30% of the price of the leased item, i.e. a higher expense must be expected at the beginning of this business relationship. However, unlike an operating lease, the client has the option (obligation) to buy the property and become the new owner after all agreed repayments have been made. 

The disadvantage of both leases is the amount of rent, which is higher than the actual purchase price of the leased item. The rent already includes all the fees associated with the use of the asset, so for the agreed lease period we will pay not only the price of the leased asset itself, but also the associated costs. Another disadvantage is the fact that the company is not the owner from the beginning of use, i.e. it has at its disposal “someone else’s” property, which it takes care of according to the agreed conditions.

Leases, as such, must be dealt with by the company both from an accounting perspective (in particular from the point of view of the temporal relationship of costs and revenues) and from a tax perspective (meeting the statutory conditions for tax deductibility of costs in individual tax periods). At the same time, operating lease as such is treated (in terms of contractual type) in the Civil Code, whereas no contractual type is defined for financial lease and therefore it is entered into as unnamed.

More information about leases can be found in our previously published article.

Factoring

It is the purchase of receivables before their maturity on the basis of a factoring agreement. We send invoices to the customer and also to the factoring company (factor), which usually finances 80-90% of the value of the receivables “assigned” in this way.

Factoring is of two types, recourse factoring, so called false factoring, which is a service where in case of non-payment of the receivable by the customer, the risk remains with the client (supplier). The contract contains a so-called recourse period, which is a protection period during which the factoring company takes steps to collect the receivable. With this factoring, the receivable remains the property of the supplier. Another type is non-recourse factoring, where the factor assumes the rights and risks in the assignment of receivables and the cost of this service by the factor is therefore higher than in the case of recourse factoring. Here, however, ownership of the receivable passes from the supplier to the factor.

The advantage of factoring is that we receive the money basically immediately and can use it immediately, while on the other hand, it is necessary to keep in mind that the factoring company does not provide these services for free, i.e. it is always necessary to take into account interest and fees.

There is no statutory definition of factoring as it is a contractual relationship. In general, the Civil Code and generally applicable accounting regulations are always used. Factoring was also one of the topics of the interpretations of the National Accounting Standards Board, namely Interpretation I-12.  At the same time, in our GT Newsletter we have discussed this topic in depth in the past.

Impacts in state reporting

Each type of external source of financing needs to be properly reflected in the financial statements of the company (accounting entity). Financing from external sources is usually shown in the balance sheet in the area of liabilities (mainly borrowings and loans, overdraft) – current/non-current, and in the area of profit and loss statement (mainly interest, fees). The lease area is continuously recorded in the profit and loss account (rent and other charges) and in the balance sheet (liabilities – lease payments). Factoring is recorded both on the balance sheet (receivables) and in the income statement (mainly fees, interest and assignment of receivables). 

Conclusion

There are countless types of external financing that are not mentioned in our article, such as grant financing, bond financing, asset sales, etc. In our article we wanted to present the most commonly used forms of external financing, however, it is always up to each company to make a detailed analysis of what kind of financing would be the most suitable for it not only in terms of current needs, but also with regard to future periods and expected obligations.

If you have questions (or are unsure) not only about the impact of external financing on financial reporting, please do not hesitate to contact us. We will be happy to answer your questions.

Author: Michal Kováč, Kateřina Hubičková, Petra Stys