3 Reduction of External Funding Needs
3.1 Introduction
The firm can influence its external funding needs in many ways. The firm can re-
tain earnings. The firm can manage its investment in tangible and intangible assets
as well as the amount of its working capital. The firm can use its existing liquidity
better (cash management). In addition, financial institutions which are subject to
minimum capital requirements based on their risk exposure (under a legal frame-
work implementing the Basel II framework or otherwise) can influence their capi-
tal needs by managing their risk exposure.
The less external funding the firm needs, the less the firm will have to pay for
its funding (for the “external finance premium”, see section 2.3). In addition, re-
ducing the firm’s external funding needs can: lead to a reduction of the firm’s in-
debtedness; reduce the risk of the firm defaulting on its credit terms; improve the
firm’s credit rating; and reduce the cost of debt. The Basel II framework which
applies to banks and financial institutions in the EU creates a further mechanism
that makes the reduction of capital needs influence the cost of borrowing.
If the reduction of external funding needs both saves money and is good for the
firm, why do firms not do more of it? There can be many reasons for this. First,
the firm may already be lean. Second, the firm may lack information and financial
know-how. Third, even if the firm were informed of the theoretical savings, the
transaction costs might be high. Some of the transactions that help to release capi-
tal are very complicated and expensive. Fourth, capital may be too cheap to be
worth saving: interest rates may be low; the company may have a controlling
shareholder who requires a very low level of profit distributions; the equity capital
of a state-owned company may be subsidised; and so forth.
The management of capital invested in tangible and intangible assets may typi-
cally have the largest impact on the firm’s funding needs and will therefore be dis-
cussed first. Such questions will be followed by the management of working capi-
tal, cash management, and the special case of financial institutions.
P. Mäntysaari, The Law of Corporate Finance: General Principles and EU Law,
DOI 10.1007/ 978-3-642-03058-1_3, © Springer-Verlag Berlin Heidelberg 2010