Equity is capital made available to the company by its owners. As a result, owners are entitled to the right to inspect the firm.
Equity includes the resources that the founder or a third party (for example friends, acquaintances or other investors) make available to the company in the form of shares or an interest in the share capital. They also include accumulated earnings.
The term ‘foreign fund’ is generally used to refer to capital made available to the company by creditors in the form of a bank loan for instance. Such lenders impose preconditions to the granting of credit and demand interest proportional to the risk.
Golden rules of financing
Equity should cover the risk of bankruptcy. But what is the balanced proportion between equity and foreign funds? There is no general formula for this. However, it is often estimated that at least 50% equity is necessary for industrial companies and at least 40% for commercial companies.
… and the golden rules for banks
Another classic rule of financing (golden rule for banks) relates to the matching of maturity of fund assets (capital element) and liabilities (foreign funds and equity). This refers to maturity matching.
Long-term assets must therefore be financed by funds (equity and debts) due in the long term. This will ensure that long-term funds (whose maturity is often estimated to take over a year) are greater than long-term assets. As a result, short-term assets (with a maturity of less than a year) should be greater than foreign funds maturing in the short-term.
In practice, the financing structure must also take the specificities of the sector and those of the company into account. The structure must be considered from a liquidity, security and profitability point of view. It must enable the company to weather a crisis and exist sustainably.
Source: Page revised on 9 July 2020 by Vincent Dousse, HEIG-VD, Yverdon.
