Self-financing or 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.

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.

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.

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.

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.