What is the difference between self-financing and debt financing?

There are basically two types of financing for SMEs: self-financing and debt financing. In the case of self-financing, as the name suggests, the money is provided from your “own funds,” i.e., from the company’s liquidity. This is made up of the annual cash flows – i.e., profits plus depreciation and amortization – or possible capital contributions from existing or new company owners. In the case of debt financing, on the other hand, debt capital is provided by third parties, must be repaid over a certain period of time and usually involves interest charges.

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Is there such thing as an ideal mix of self-financing and debt financing?

The ideal mix of equity and debt capital differs from company to company. A company’s business model and strategy are key to the ideal financing ratio. That’s why we meet with the company to discuss its needs and analyze both the current and future financial situation. All this information is then incorporated into a possible financing structure. Two aspects are to be highlighted here:

  1. Equity must finance profitable projects.
  2. The financing mix must maximize the profitability of the projects.

When is self-financing preferable to a bank loan?

  • Self-financing: If a company has a large amount of cash and cash equivalents that are not directly earmarked for operational use or distribution to shareholders, it may be worth making planned investments using its own capital. However, this is on condition that such a project is aligned with the strategy of the company and the owner.
  • Financing with a bank loan or leasing: If this is not specifically specified in the strategy, it is advisable to pay for part of the investment through a loan or a leasing arrangement. This has the advantage that you, as the owner, remain in control of your own remaining funds.

On the other hand, debt financing is almost always preferable when there is a market opportunity for growth projects and growth capital is needed in the short term. There are several reasons for choosing this form of financing:

  1. Short-term opportunities are seldom considered in financial planning, which is why large sums of equity for short-term use are usually not available.
  2. Companies at the growth stage are usually not profitable and therefore require external capital.

The leverage effect can be clearly seen in growth companies. It occurs when the return on total assets is greater than the interest rate paid on borrowed capital.

Plan your liquidity: with the UBS planning template

Careful liquidity planning will help you make the best possible decisions for your company, especially in uncertain times.

How many Swiss SMEs use debt capital?

According to a SECO study, around one third of SMEs finance using a bank loan. If these results are broken down by company size, it is evident that the proportion of companies with bank financing is significantly lower for micro-enterprises than for SMEs with more than ten employees. Smaller companies often finance their investments with equity capital and are generally less investment-savvy simply because they are smaller. They usually have only a small amount of machinery and do not own their own premises.

Crises, such as the Coronavirus pandemic in 2020, can lead to companies in certain industries with a weak equity base being dependent on emergency loans. During the pandemic, companies in the construction and catering industries were the most likely to apply for a COVID-19 loan. Companies with a strong equity base or almost complete self-financing are also prepared for times of crisis.

What do I need to be aware of when applying for a corporate loan from UBS?

In addition to the equity ratio, we as a lender focus primarily on the company’s current and expected long-term earnings. The company should be able to use current cash flows to meet short-term liabilities and use future cash flows to repay the loan and the interest on it. Equity holdings are what cushion the company against risk. The ideal mix is therefore the product of two elements:

  1. The profitability of the company. This also includes the maximum debt derived from this.
  2. The future strategy and upcoming investments.

The part of a financing not provided by a bank must be backed by equity. Or you can opt for lower levels of investment, which in turn can impact your earnings. As can be seen, the two are inter-related.

Is a certain equity ratio essential for a corporate loan?

No, there is no specific quota that specifies how high the equity capital must be for financing. The amount depends on the industry. For example, for a service company with only limited fixed assets, a relatively low equity ratio of around 25 percent is sufficient. By contrast, a construction company with a lot of machinery and a depot will need a significantly higher equity ratio of around 40 percent. With regard to the financing of a certain part of the balance sheet – such as accounts receivable, inventories, machinery, real estate – experience shows that the proportion of equity is based on how quickly the assets in question can be sold or converted into cash. Financing a production building will therefore require more equity than an “advance” on current assets.

Yves Felder

Head Corporate & Real Estate Banking Romandie

Yves Felder and his teams support companies in the French-speaking part of Switzerland in all strategic and operational aspects of their finances. Over more than 10 years at UBS, he has held further management positions in Switzerland and New York. Yves Felder studied Finance and Risk Management in Zurich, holds an Executive MBA from HEC Lausanne and a Diploma from the Chartered Alternative Investment Analyst Association (CAIA).