Business needs funding which comes from owners as capital and from lenders as loans
Which one takes place at the first stage – finance or cash inflow?
The answer is the same as relates to old issues – egg or hen.
Business needs funding which comes from owners as capital and from lenders as loans.
The owner is paid back by way of dividend or profit, lender by interest along with principal. These two items comprise sources of funds for running business with expenses incurred in connection with operational expenses and with purchase of capital goods.
Meeting operational expenses is termed as working capital. Purchase of capital goods is,on the other hand, as term financing.
Working capital is like exchange finance which is used for production of goods and services, payment of which is settled out of current cash flows.
Settlement of working capital financing depends on the operating cycle from production process to sales realization.
Delay in realization of sales proceeds within stipulated time and unsold output may create problems to wash out working capital loans.
This finance is normally accounted for while on calculation of cost of goods/services produced.
Loan for purchase of capital goods needs a long time to be repaid with interest.
In this case borrowers need to have satisfactory profitability to accommodate interest payment with sound liquidity through a stream of cash inflows for regular repayment during the tenure of loan. Volatility in the cash stream leads to hamper repayment.
Repayment of loan installment and interest out of current operations is known as hedge finance. It will be speculative finance if only interest is possible to be settled from current operations.
For settlement of instalment, fresh loan is required. Both installment and interest are not possible to be settled from current operations under ponzi finance.
In this case, a new loan is required for repayment and running business operations.
Loan on account of working capital is inevitable for procurement of goods and services including wages to produce output before sales. Smooth sales and cash inflows ensure repayment of working capital loans since such loan is recorded in the daily operations of business as expenses along with interest as non-operating expenses.
Loan for capital goods is payable for periods more than one year.
The cost of loan is presented in the regular operations as non-operating expenses but such is not allowed for installment payment which depends on cash flows accumulated by way of depreciation and after tax portion of profit retained without disbursement as dividend/profit. Smooth repayment depends on the size of installment compatible with depreciation allowances loaded in business operation expenses.
Otherwise, it is only possible to make instalment payment. Nonpayment of instalment results in default.
Excess of income over expenses including depreciation brings operating surplus in a business entity.
Surplus does not represent a sound position to wash out repayment. Liquidity position needs to be measured by adjustment of surplus in consideration of cash sales/payment, net flows from receivables/payables, non-cash outflows on account of depreciation and relevant provisions. Sound bottom line after payment of acceptable dividend ensures smooth repayment of principal of loans.
Business entities are run through uncertainty due to technology change, substitute products in the market, external demand shock, taste change and so forth.
Such a situation results in survival questions for the business entity. Consequently, liquidity surplus may face pressure due to sales squeeze.
So term borrowing based on future cash flow expectation does not work to wash out liabilities. Prudential regulations for extending loans at the end of lenders or regulators are ineffective in the situation.
Ultimate effect to call back collateral to realize loan proceeds remaining outstanding.
Prudential regulations for loans are formulated by central banks of nation states.
Central banks formulate regulations but they do not have practical experiences in business operations or lending activities.
They deal with secured instruments like treasury bills/bonds. In addition, they have some unique experiences in lending activities.
They extend loan facilities to their staff based on internal regulations. In this case, they consider the present value of their retirement entitlements of staff.
Such loans are settled till their retirement depending on retirement benefits.
During their service life, current cash flows are not enough to pay off the loans. Such secured loan operations are not enough to accommodate practical situations in loan markets.
As stated earlier, term loan is used for purchase of capital goods. It means that a loan helps to get current benefits at the cost of future cash flows.
Banking staff take advances with capitalization of future benefits out of money creation out of nothing or through a so-called fractional reserve system.
Individuals utilizing future income at present can lead quality life, others without having such opportunities cannot.
Such opportunities to some people are an effective tool for inequality in society!
But these fortunate people are few in society.
Major employment in the society is being generated by private business entities for which long term capital is needed to procure capital goods.
Banks’ raw materials are deposits ranging from short term to medium term. But they sell products having a long maturity.
It is said they are facing maturity mismatch for operating such capital market products.
As found in the foregoing paragraphs, business entities are under uncertainty in future, their term funding is also in a risky path.
Capitalization of future cash flows for current use is a way to move from low income to middle income, to upper income, to high income range.
Loan is a way by which individuals can move forward. At the individual level, we see such progress of a few classes of people working with the financial system and few organized corporations.
Employment itself creates the right to have loans in millions for big ticket purchases like home.
Whole tenure of their fixed length of service is capitalized through granting loans out of thin air. Beneficiaries become fortunate to move to the upper level in respect of wealth. The calculation of loans is arranged in such a way so that monthly earnings remain unfettered, future flows are focused for adjustment at the end of services.
Such fixed income flows are rarely possible for real sector individuals. Their income depends on smooth operations of the entity in which they work.
In a real life situation of uncertainty, term loans are always at risk.
Loans for capital goods should be negotiated for such periods for which capital goods are capable of generating expected income flows to serve repayment of principals and interests.
The repayment size for the principal amount needs to be set in such a way so that a fund retained out of concerned capital goods is able to make such payment.
Otherwise principal payment is rarely possible.
Consequently, loans become a case of default.
But a fund of depreciation does not ensure repayment if sales are not as same as expected due to different shocks.
In such a case, does collateral need to be called? Reality!
But we see in the previous discussion, that individual loans granted by banking sectors are cleaned through the terminal benefits of individuals.
So why raise questions to call collaterals to come to the cases of nonpayment in real sectors. Should it not be bailed out?
In real life situations, sales flow is not as same as expected. So, term loans are rarely repayable. So, is there any alternative without bailing out?
Share this post: