Funding operations provide governments and business entities an opportunity to consolidate short-term debt obligations into long-term debt instruments, such as bonds, that carry a fixed rate. Most investors consider debt instruments with repayment dates of a year or less to be short-term in nature, while long-term debt typically does not require full repayment for a year or more. While the interest rate on short-term debt typically runs lower than the interest rate on long-term debt, the variability of interest rates issued over the short term presents downside risk for companies or governments that need debt funding over the longer term.
When governments or businesses undertake funding operations, they look for a long-term debt vehicle that can provide appropriate funding for their expected operational expenses over the long term, while also replacing short-term debt currently on the balance sheet. Holding short-term obligations provides an opportunity to purchase long-term debt more strategically and less frequently, as the chances of large interest rate movements remain relatively low over the shorter term.
Short-term and Long-term Debt
While companies and governments can obtain short-term debt on fixed-rate or variable-rate terms, any funds that do not get repaid within a year become subject to rate changes by definition, as the companies or governments would need to refinance the debt in some way as it came due. The interest rate on variable-rate debt vehicles resets periodically, at an interval set by the debt issuer. Interest rates on short-term fixed-rate debt would effectively reset as companies or governments refinance into new instruments at prevailing rates.
Issuers offer higher interest rates on long-term debt to match the higher risk of default over a longer maturity period. At the same time, the fixed nature of the rates provides the entity taking the loan with greater stability, since interest accrues more predictably over the course of repayment. Fixed rates also provide protection in a rising interest rate environment, as short-term interest rates rise and floating rates reset to higher levels.
Funded Debt and Capitalization Ratios
Companies consider short-term debt on their balance sheet to be unfunded. Short-term debt may include both bank loans or corporate debt issuances with maturity dates under one year. Companies consider long-term debt to be funded debt for balance sheet purposes.
Investors use funded debt to calculate two important ratios that they use to determine the financial health of a company. The capitalization ratio looks at a company’s long-term debt as a proportion of its total capitalization. A company’s net working capital ratio looks at long-term debt as a proportion of the company’s existing capital. In most cases, investors prefer to see net working capital ratios under 1:1.
Funds from operations (FFO) is the term that investors use in order to describe the cash flow of a real estate company or a real estate investment trust (REIT).
What Exactly is Funding?
Funding is the act of providing financial resources, usually in the form of money, or other values such as effort or time, to finance a need, program, and project, usually by an organization or company. Generally, this word is used when a firm uses its internal reserves to satisfy its necessity for cash, while the term financing is used when the firm acquires capital from external sources.
Sources of funding include credit, venture capital, donations, grants, savings, subsidies, and taxes. Fundings such as donations, subsidies, and grants that have no direct requirement for return of investment are described as soft funding or crowdfunding. Funding that facilitates the exchange of equity ownership in a company for capital investment via an online funding portal as per the Jumpstart Our Business Startups Act (alternately, the JOBS Act of 2012) (U.S.) is known as equity crowdfunding. Funds can be allocated for either short-term or long-term purposes.
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