Updated July 10, 2023
Definition of Financing Activities
Financing Activities are the activities that result in cash inflows and outflows between the company and its investors, and owners who fund the company’s long-term growth and expansion. As these transactions are for the long-term strategy of the business, they majorly impact long-term liabilities, assets, and owner’s equity.
Explanation
It is a detail of how the company is managing its long-term finances from external sources. Internal financing activities are not included in these; for example, if a company purchases machinery from its funds without the help of an external source of finance, it would not be included in the financing activities because the transaction did not affect long-term liability or equity.
It is an important aspect of the business because stakeholders, investors, and creditors always keep an eye on the business as to how it is managing its long-term finance to fund capital expenditure and how efficiently the company is using its funds as a source before reaching for external finance.
Examples of Financing Activities
Now let us take an example where we can identify and calculate the cash flow from financing activities for the business:
XYZ company provides the following information regarding its cash inflow and outflow. But first, we need to calculate the cash flow from financing activities.
| Items | Amounts (In $) |
| Repurchase of company’s stock (A) | 85,000 |
| Long-term loan (inflow) (B) | 6,00,000 |
| Payment of old long-term debt (C) | 4,00,000 |
| Dividend payout (D) | 1,00,000 |
| Payment to short-term creditors (E) | 40,000 |
| Rent, salaries, and wages paid (F) | 60,000 |
| Cash sales (G) | 3,00,000 |
Solution:
We must focus on long-term liabilities and equity to calculate cash flow from financing activity. Therefore, cash flows from financing activities can be calculated as follows:
- Financing Activity = B – (A + C + D)
- = [6,00,000 – (85,00 + 400,000 + 100,000)]
- = $15,000
The cash flow from financing activities is $ 15,000.
Analyzing
Financing activity is one of the important sources or an indicator of the company’s financial health. It serves as a criterion for the investors and the shareholders to analyze the company’s policy, its efficiency in managing long-term financing activities, and its overall sound financial health.
So, suppose cash inflows exceed outflows from financing activities. In that case, the company is laying down a strategy for expansion and growth since increased cash inflow denotes increased business assets.
On the other hand, if the cash outflow from financing activities exceeds cash inflow, it can indicate that the company is using funds from financing activities to improve its liquidity position; it also suggests its dividend policy.
Financing Activities and the Cash Flow
Financing activity is one of the three headings on the company’s cash flow statement under which cash flow from financing activities, i.e., transactions that impact long-term liability and equity, are recorded.
It can be divided into two parts, i.e., cash inflow and cash outflow. Any transaction which would lead to an increase in the cash due to these activities in the business would be included under inflow, and any transaction that would lead to a decrease of cash due to these transactions would be included under outflow:
- Cash Inflow: Cash inflow arises from issuing shares and initial public offering, debt financing like long-term loans, bonds, etc.
- Cash Outflow: Cash outflow arises due to repurchasing stocks from shareholders, paying out dividends, repayment of long-term debt, etc.
Financing Activities vs Investing Activities
There is only one major difference between both of them.
It includes transactions that impact long-term liability and owner’s equity. Therefore, it includes long-term debt repayment, the new sanction of loans, repurchase of stock, dividend payouts, etc.
While investing activities include transactions that impact non-current assets. Therefore, these activities include long-term investments, property purchases, plants, equipment, loans given to other entities, etc.
On the whole, we can say that cash flow from financing activities relates to transactions made regarding long-term or non-current liabilities, and owner’s equity and cash flow from investing activities relate to non-current assets.
Advantages
Some of the advantages are as follows:
- Helps arrange capital for the company for its long-term strategy for growth and expansion.
- Serves as an indicator of the company’s financial health and helps investors make investing decisions.
- Helps creditors analyze the company’s creditworthiness as the loans are raised and paid periodically.
Disadvantages
Some of the Disadvantages are as follows:
- Regulators are mostly interested in how the money is financed and its usage; any small error in these decisions can lead to regulatory scrutiny and legal hassle.
- Some financial activities, such as issuing shares, can dilute the equity.
Conclusion
It is an important part of the cash flow statement of the company. They are the indicator of the company’s financial position. They help investors and shareholders analyze the company’s worth and base their investment decisions on it. The company’s efficiency in financing decisions will decide its success or failure in the long term.
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