11/13/2020 10:40 AM

Where Do Businesses Get Money?

During turbulent and uncertain times, it’s extremely important for businesses to ensure an adequate level of liquidity. Sufficient cash reserves make it easier for companies to meet their liabilities and survive unexpected circumstances.

However, reliable and sustainable sources of funding are required to achieve this goal. It’s interesting to examine the types of financing instruments and other sources of funding used by Lithuanian companies and the recent trends associated with this.

Equity: The Main Financing Instrument

According to Eurostat, the external debt of Lithuanian businesses accounts for 35% of the country's GDP, which is the lowest level in the EU. This means that most purchases are financed using internal resources. According to financial accounts published by the Bank of Lithuania for Q2 2020, equity represented more that half of corporate liabilities (55.3%).

This financing structure appears to have been chosen for a number of reasons. First, it is associated with having sufficient equity. According to the Bank of Lithuania’s survey about 60% of the respondents indicated that they have sufficient own funds to carry out their activities and therefore borrowing is not necessary.

It’s also important take into account the high level of conservatism of Lithuanian business owners and managers. Two-thirds of them said they avoid borrowing because they simply do not want to take on liabilities, and associate indebtedness with the risk of losing control of the company.

The supply factor is also crucial. A significant number of companies operating in Lithuania are SMEs. SMEs generally have higher credit risk and therefore it is difficult for many of these companies to secure external financing. This is confirmed by the fact that loans represent just 19% of total corporate liabilities.

Importance of equity is increasing further, while loans are shrinking

According to current trends, the importance of equity for companies is likely to continue to rise, while that of traditional loans is set to decrease. For example, during Q2 2019 – Q2 2020, the proportion of equity on the balance sheets of non-financial corporations increased by 3.4 per cent, while it increased by almost 6 per cent over the past decade.

While equity is gaining importance, loans are becoming less so. Over the last ten years, the proportion of loans on corporate balance sheets has decreased significantly from 27.8% to 18.9%. Long-term loans have seen a particular decline.

The decrease in corporate reliance on loans as a source of financing is caused by the relative rise in popularity of other financing instruments. In recent years, for example, businesses have started to issue more bonds. During Q2 2019 - Q2 2020, the total value of bonds issued increased by EUR 421 million.

Although the percentage of finance through the issuing of bonds is relatively small (1.7%), it is growing steadily. One of the factors for this small percentage is that currently it’s primarily only large and listed companies using this instrument. However, legislative changes are being made, which will present better opportunities for SMEs in this area.

Non-financial corporations, individuals and foreign business entities are the main sources of financing

In addition to the aforementioned instruments, other sources of funding are also important. Financial accounts data show that Lithuanian non-financial corporations are most likely to borrow from three sources, i.e. other non-financial corporations, individuals, and foreign business entities. Corporate liabilities to these sources respectively account for 26.2%, 26.7% and 23.7% of total liabilities.

Private individuals and foreign businesses usually provide financing through equity, while local non-financial corporations provide funding through trade credits or loans (e.g. borrowing from affiliated companies is very popular). Although liabilities to other non-financial corporations and foreign entities are increasing, their share in the overall liability structure has not changed significantly over the last decade. This is a strong indication that shareholders are becoming an increasingly important source of corporate finance.

The importance of banks as a source of funding is rapidly decreasing while the popularity of alternative sources is growing

In the past, traditional commercial banks have also been one of the most important sources of corporate funding. However, the percentage of corporate liability to commercial banks has dropped from 17.9% to 9.1% over the last decade. A particularly pronounced contraction has been observed over the last few years, for which there are three main reasons:

First, due to the higher credit risk associated with SMEs, banks are less willing to lend.

Secondly, companies now tend to borrow less from banks.

In addition, there has also been a significant increase in the number of alternative financing companies, which has without a doubt had an impact on the space.

For example, there has been an increase in the use of investment and pension funds. Although their role in corporate financing is still relatively small (0.7%), it continues to get bigger. Funding from other non-bank financial institutions has also seen substantial growth. Over the last ten years, corporate liabilities to these institutions increased by EUR 3.2 billion, and their proportion of the total liability structure increased from 4.4% to 6.1%.

From the available evidence, it's clear that the funding structure of Lithuanian companies compared to other EU countries is relatively different. Equity represents a popular method of corporate funding and this is unlikely to change, at least in the near future. On the whole, these are trends that should be welcomed. Low financial leverage makes it easier for companies to survive challenges, while presenting wider business opportunities for financial institutions.