FINANCIAL

MANAGEMENT

8. SELF-FINANCING OF THE COMPANY & DIVIDEND

POLICY

So far we have seen the external financing of the company, i.e., financing not originating
within the company. In contrast, shareholders contribute share capital.

In this section we will deal with the self-financing of the company, understood as the
financing that arises within it.

Likewise, we will address the dividend policy: a set of guidelines used by a company to
decide how much of its earnings will be paid to shareholders, or how these earnings are
accumulated in the form of fund reserves. It is worth noting that for shareholders a
dividend is an indicator of the company’s situation, and it allows checking the
profitability of the company and alternative investments.

Page 150

 FINANCIAL MANAGEMENT

8.1. OBJECTIVES

ü Self-financing of the company

ü Cost of self-financing and self-financing ratios

ü Dividend policy

As previously described, self-financing or internal financing of the company consists of

resources generated by itself, unlike other financial resources coming from the outside.

We can distinguish between actual self-financing in which funds come from revenues
and which is constituted by retained benefits, i.e., by an increase of the shareholder’s
equity of the company; and maintenance self-financing, which consists of depreciation,
forecasts and provisions. These funds or financial resources, insofar as they do not apply
to the specific purpose for which they were first devised, may be arranged by the
company to finance its assets.

§ Reserve Funds:

They are savings accounts or other highly liquid assets set aside by an individual or
company to meet any future costs or financial obligations, especially those arising
unexpectedly. Furthermore, they are accounted away from the operating load, by
extraction or reduction on profits.

According to Professor Ribero, they are described as "[...] benefits that are not
distributed and remain in the bosom of the company, constituting a fund to prevent
possible risks". Accordingly, it is necessary that there are profits so they can be
accumulated.

Page 151

 FINANCIAL MANAGEMENT

§ General Provisions:

General provisions are balance sheet items representing funds set aside by a company
as assets to pay for anticipated future losses. They provide coverage against default from
insolvent clients or other debtors, or they are used to pay future liabilities whatever the
origin or cause of the liability. From an accounting perspective, they are booked to
operating expenses (before the balance).

To illustrate, let us look at depreciation. Since a good begins to depreciate until the
moment of its replacement at the end of its useful life, a considerable period of time
usually elapses. During this time, the company, in order to finance its assets, may use
resources generated by the provision for depreciation until the moment it is deployed.

Self-financing can be seen as a fund or stock, or as a current or flow. The calculation of

self-financing as a fund refers to the total of self-financing accumulated from the
creation of the company to the present time. In this sense, and in view of a balance
sheet, the amount of the self-financing can be calculated by adding balances of the
reserve funds and provisions and accumulated depreciation allowances. On the other
hand, self-financing as a flow will be measured as a variation in a given period with
respect to a previous one. This occurs when we compare two balance sheets, each one
completed at different moments of time.

8.2. SELF-FINANCING IN THE COMPANY

Self-financing is reflected in the balance in the reserve fund account: legal reserve,
statutory reserve, voluntary reserve, remnant and special reserves.

Looking at the following balance structure in two consecutive periods of time:

Page 152

 FINANCIAL MANAGEMENT

Year n Year n+1

Non-current 10 Owner’s Equity 11 Non-current 11 T. Equity 135

Assets 0 0 Assets 5

Current assets 50 Liabilities 40 Current Assets 60 Liabilities 40

Total Assets 15 Total 15 Total Assets 17 Total 175

0 0 5

If we consider that the increase in equity was due to an increase in reserve funds of 25,
this means that the company obtained additional financing that allowed it to finance the
increase in its non-current assets by 15, and its current assets by 10.

Additionally, this increase in self-financing via reserve funds can have a multiplier effect.
In year one we obtain the debt ratio:

!"#$%&'($)* ,-.%/
Indebtedness =
01-#)*

Value obtained 0.36.

In year n + 1 debt ratio would amount to 0.30.

§ Debt ratios are used to identify the quantity and quality of the debt of the
company, as well as to verify to what extent the sufficient benefit to support the
corresponding financial burden is obtained.

- Total debt ratio results from the quotient between total debts (current and non-
current liabilities) and the sum of liability and owner’s equity.

Page 153

 FINANCIAL MANAGEMENT

Liability (debts)

-------------------------------------------

Owner’s Equity + Liability (debts)

The optimal value of this ratio lies between 0.4 and 0.6. If it exceeds 0.6, it indicates that
the volume of debts is excessive and the company is losing financial autonomy through
third parties. If it is lower than 0.4, it may occur that the company has an excess of
equity.

Sometimes, the following quotient is also called debt ratio:

Liability (debts)

---------------------------

Owner’s Equity

This ratio is intended to measure the intensity of the debt compared with the company's
own financing funds, and based on this, to identify the degree of influence of the third
parties on the operation and permanent financial balance of the company.

The lower the ratio, the more autonomous the company is. Its optimum value ranges
between 0.7 and 1.5. * (Source: http://davidespinosa.es/)

Therefore, the debt ratio improved from one year to the next, from 0.36 to 0.30. In this
sense we can talk about the multiplier effect of self-financing. An improvement in the
debt ratio may imply that the company will be able to access higher external resources
until it reaches a level of indebtedness that provides a debt ratio similar to that of year
n.

Page 154

 FINANCIAL MANAGEMENT

Year n+1 Extended

Non-current assets 118.5 Owner’s Equity 135

Current assets 65 Liabilities 48.6

Total assets 183.5 Total 183.6

If we calculate the debt ratio from this new balance structure, we will obtain 0.36.
Therefore, self-financing through fund reserves led to a multiplier effect, allowing
increasing the indebtedness of the company while maintaining the proportion between
the external and internal funds of the company.

Maintenance self-financing is reflected (in the balance sheet) in the accounts related to
the accumulated depreciation and in the accounts of reserve funds and general
provisions. These items are devised to maintain "intact" the capital or Shareholder’s
Equity of the company, and not to increase it.

Broadly speaking, depreciation is an accounting method of allocating the cost of

a tangible asset over its useful life. Businesses depreciate long-term assets for both tax
and accounting purposes. Depreciation is often a difficult concept for accounting
students as it does not represent real cash flow; but rather it is an accounting convention
that allows a company to write-off the value of an asset over time, but it is considered
a non-cash transaction.

In forecasts, it is not certain whether the estimated risks will take place; although within
provisions it is known that losses or expenses will occur, but the amount is unknown.

Page 155

 FINANCIAL MANAGEMENT

Let us imagine that in the event of a dispute that may lead to a financial loss to the
organisation, it is decided, following a criterion of prudence, to devise a provision.

Actually, as long as the loss does not really take place, the company may use these
resources for the financing of its current or fixed assets. Likewise, the provision for
depreciation is a self-financing that is available to the organisation until the asset is
replaced.

§ Advantages of self-financing:

- It provides greater financial autonomy and implies greater independence in

business management.

- Benefits retained under fund reserves entail financing for the company that
does not necessarily have to be remunerated.

- For some companies, generally SMEs, self-financing is practically the only way
to obtain long-term financial resources.

- It improves the debt ratio of the company by increasing shareholder’s equity

with respect to third-party funds.

§ Disadvantages of self-financing:

- For shareholders: if funds are earmarked for self-financing, the shareholder is

not remunerated.

- It reduces the return on shares and, consequently, the possible market

valuation of the company, decreasing the chances to attract new investors.

- Unprofitable investments. The fact of having free resources may lead to a

relaxation in the investment policy and undertaking projects with a low rate of
return.

Page 156

 FINANCIAL MANAGEMENT

8.3. COST OF SELF-FINANCING & SELF-FINANCING RATIOS

In every company a large part of investment projects is financed through self-financing.

It might seem that this financing is free as it does not have an explicit cost, but the truth
is that it entails an opportunity cost.

§ Opportunity cost:

It is the alternative benefit that the company could have obtained if the best possible
alternative had been selected at the given time.

Considering this, a return from self-financing that should at least equal the average gain
that shareholders would have obtained if such benefits had been distributed in the form
of dividends. On the other hand, regarding the maintenance self-financing, the company
must obtain a return from financial investments that, at least, equals what would have
been obtained by investing in a financial product.

As an illustration, imagine that the company obtained a result of €1,000, and €400 from
this amount become dividends, whereas €600 become fund reserves. The company
should "demand" from assets (self-) financed with these €600, a minimum return equal
to the profitability of the best financial product in the market at this time.

In relation to the policy of the company, when applying the result either to fund reserves
or to dividends, we can analyse the percentage thereof in relation to the result after
taxes, through an indicator that shows the relationship between both factors:

23/3$43 5-.%/ (6678()3% )7 7'3$()#7./

Self-financing Ratio =
23/-6)/ (,)3$ )(93/

This indicator shows the percentage of the result after taxes intended for fund reserves.

As a complement to this indicator, we have one known as Payout:

Page 157

 FINANCIAL MANAGEMENT

:#4#%3.%/ )7 ;3 %#/)$#;-)3%
Pay-Out =
23/-6)/ (,)3$ )(93/

In our example, the Self-Financing Ratio has a value of 60% and the Payout has a value
of 40%.

In relation to maintenance self-financing, we can obtain the following indicator:

<..-(6 %3'$38#()#7. (667=(.83

Maintenance self-financing =
:3'$38#(;63 ,#93% (//3)/

This indicator shows the allowance percentage of the annual depreciation in relation to
the total depreciable fixed assets.

An analysis of the self-financing policy needs to complete the evolution of the self-
financing variables by means of a temporary analysis and an in-depth analysis from a
specific year.

8.4. DIVIDEND POLICY

As indicated above, the after-tax benefit may be paid out totally or partially in the form
of dividends, or may remain totally or partially within the company for reinvestment. A
dividend policy is the policy a company uses to decide how much it will pay out to
shareholders in the form of dividends, and many investors rely on dividends as a vital
source of income. Normally members/shareholders of the company are remunerated in
cash and some benefits are retained in the form of reserve funds. Both decisions are
interdependent and complementary.

A greater distribution of dividends may lead to a lower retention of profits, which may
imply a lower growth and a lower market value of the shares. Consequently, the
dividend policy is very important because it can have a considerable effect on the value
of the company.

Page 158

 FINANCIAL MANAGEMENT

We can distinguish between four possible dividend policies that a company may
adopt:

a) Fixed percentage on annual profits. This option makes the dividend of the
company depend on the bottom line of the company. In case of losses, the
company will not distribute any dividends.

b) Constant annual dividend, regardless of the results. In the event that the
annual result is insufficient for the dividend payment, it should be financed
through unrestricted fund reserves, in order to follow the established dividend
policy. For example, establishing a criterion based on the nominal value of the
share (an annual dividend of 5% of the nominal value of the share, or a constant
amount every year, etc.)

c) Constant annual dividend depending on the situation and convenience of its

distribution. This policy provides some stability to the company, but it can carry
some uncertainty for the shareholder about the amount of the dividend to be
received. It is about setting a minimum dividend payment that may be
supplemented by another dividend payment, according to the circumstances
considered by the company, for instance, an annual dividend of 5% of the
nominal value of the share plus 20% of the result after taxes.

d) Arbitrary dividend. The company does not follow a specific dividend policy
and the establishment of a dividend is totally arbitrary.

On the other hand, it is necessary to point out that in any case, the distribution of
dividends will generally affect the liquidity of the company, which will have to be taken
into account when making the necessary fund forecast. Sometimes the payment of
dividends is made through the delivery of shares released from the company itself (self-
portfolio), or from some other company partially owned by the organisation in the form
of shares.

Page 159

 FINANCIAL MANAGEMENT

Additionally, dividends spread information in the market: if they remain stable and
present a certain annual growth rate, there may be positive effects on the company's
valuation. The distribution of dividends affects the valuation of the company’s shares
(theoretical value of the shares). However, it is important to consider the valuation of
the stock market (stock market quote). Although theoretical value and market value
tend to come closer, sometimes there may be significant differences between them.

A stable distribution of dividends may contribute to a company’s economical and

financial growth. In the medium term, it can facilitate an adequate remuneration for the
shareholder and encourage a revaluation of the company in the market. Imagine that a
company decides to distribute dividends; this will imply a decrease in the theoretical
value of the share at the time of distribution, although the market valuation of the
company may not be affected. This is possible because the market valuation may also
be subject to other constraints, such as the future prospects of the company or the
prospects of some purchase or sale operation that affect the valuation of the market.

Page 160