The self-financing capacity of a company is a key indicator for assessing its performances. Self-financing capacity means the surplus cash from a company’s business, which allows it to finance its growth. But this cash surplus can also be used for other purposes, and its calculation serves as a measurement tool in several important ways. So what is the Self-Financing Capacity of a Company? How is it calculated? And, above all, how should it be analyzed and used?
Self-Financing Capacity Defined
Self-financing capacity is an indicator relating to a company’s business: it compares the income received with the expenses generated.
It aims to determine whether the business has generated more money than it spent, and therefore shows whether its business model is profitable.
The self-financing capacity of a business therefore means all the gross resources that are available for use at the end of a year.
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What is the purpose of Self-Financing Capacity?
The self-financing capacity of a business is an indicator that compares cash income and expenditure. This indicator therefore serves several purposes:
Assess the financial health of the business based on its Self-Financing Capacity
When a business has a positive self-financing capacity, this means that it earns more money than it spends, and therefore generates a cash surplus that it will be able to reuse later. In other words, it shows whether the company’s business is making money and therefore whether its business model is sound.
The more profitable the business, the higher its self-financing capacity will be.
Finance investments
By calculating its self-financing capacity, the company can estimate its capacities to invest and its need to resort to loans. If the self-financing capacity is positive, the company will be able to invest in its growth without depending on external sources of funding.
Repay loans
If the company wishes to take out a loan, its self-financing capacity will be a key indicator. Because the self-financing capacity of a company determines its capacity for repayment. It is therefore vital for a company to assess its self-financing capacity before taking out a loan, as it may find itself unable to meet the repayments.
A distinction should be made between self-financing capacity and self-financing. Self-financing represents the remaining amount of the self-financing capacity, after payment of dividends to shareholders. Self-financing therefore represents the "actual" amounts the company can use to invest or pay off its loans.
Shareholders and investors can have a significant say in deciding on the amount of dividends distributed each year. This is why it deserves particular attention: the more dividends are paid, the lower the company’s self-financing will be.
Why Calculate Self-Financing Capacity?
The self-financing capacity of a business therefore allows it to anticipate its future needs and actions (contributions, borrowings, developments, etc.). All these decisions can have serious consequences if they are taken without knowing the company’s real self-financing capacity.
For example, a poor calculation or an incomplete view of the self-financing capacity can lead a business to:
take out a loan that it will not be able to repay if it has overestimated its self-financing capacity;
or miss an investment opportunity or an opportunity for growth if it has underestimated this capacity.
This is why calculating self-financing capacity is so important for company managers: it provides a complete picture of the amounts the company can pay to its shareholders in the form of dividends, those it can reinvest in its development, and those it can use to take out a loan.
How to Calculate Self-Financing Capacity
Basically, the formula for calculating self-financing capacity is as follows:
Self-Financing Capacity = receivable income - payable expenses
In detail, there are two main ways of calculating the self-financing capacity of a business to reach the same result.
Self-Financing Capacity calculated using net profit
Self-Financing Capacity = Net Profit - recognised income and proceeds from disposals + recognised expenses and book values of asset disposals
This method, known as additive, is the fastest and most widely used. It is based on the net book profit.
In practice:
Self-Financing Capacity = Net Profit
- other non-cashable income (operating, financial and exceptional write-backs)
- proceeds from the disposal of assets
- the share of investment grants transferred to income for the year
- other non-cashable expenses (operating, financial and exceptional allowances)
- the net book value of asset disposals
Self-Financing Capacity calculated using GOS
Self-Financing Capacity =
GOS - other expenses (corresponding to outflows with the exception of recognised expenses (allowances) and book values of fixed assets sold + other income (corresponding to inflows with the exception of recognised income and income from the disposal of fixed assets)
This formula, referred to as subtractive, is based on the GOS. The GOS (Gross Operating Surplus) shows the company's operating resources over a given period, after payment of personnel costs and before depreciation.
In practice:
Self-Financing Capacity = GOS - other operating expenses (excluding allowances) - financial expenses - non-recurring expenses (excluding allowances and costs of fixed assets disposed of) - employee profit-sharing - tax on profits + other operating income (excluding write-backs) + financial income (excluding write-backs) + non-recurring income (excluding write-backs and disposals of fixed assets) + expense transfers +/- Share of profits from joint operations
Calculating Net Self-Financing Capacity
As it stands, the self-financing capacity calculation does not include any loan capital repayment over the given period. It may be a good idea to calculate "net self-financing capacity", which corresponds to your capacity after payment of the loan capital.
Here is the net self-financing capacity formula:
Net Self-Financing Capacity = self-financing capacity - Loan capital repayment over the period concerned
Self-Financing Capacity Ratios
Self-financing capacity is an indicator often used by banks, executives and investors. For this purpose, ratios comparing the self-financing capacity with other data are regularly calculated.
Financial debt / Self-financing capacity ratio
For banks, the self-financing capacity of a business is interesting as it allows them to calculate the repayment terms of a loan taken out by the company. The financial debt / self-financing capacity ratio is used.
As an example, a company with a debt of $100,000 and a self-financing capacity of $20,000 (over a year) will have a ratio of 100,000 / 20,000 = 5. With its current self-financing capacity, this company will be able to repay its loan within a minimum of five years.
Self-financing capacity / Turnover ratio
For companies, comparing the self-financing capacity with turnover shows exactly what portion of internal resources the company uses for its financing.
If a company obtains 10% with this calculation, then for $100,000 of turnover, $10,000 (10%) of internal resources have been used to finance investments in growth.
Difference between Self-Financing Capacity and Cash Flow
Self-financing capacity differs from cash flow (or Free Cash Flow) as it does not integrate inflows and outflows over the period. So, a company may obtain completely different results depending on whether it calculates its Cash Flow or its self-financing capacity.
Let's take the example of a company with a monthly turnover of $100,000, out of which it pays $55,000 in expenses. Its turnover consists of $45,000 in trade receivables, and it has incurred $20,000 in trade payables. In this example, only the cash flow will take the trade receivables and trade payables into account. So: the company's immediate cash flow will be $0: 100,000 - 55,000 - 45,000 The company’s self-financing capacity will be $25,000: 100,000 - 55,000 - 20,000
Difference between Self-Financing Capacity and Profit/Loss
The company’s profit or loss is essentially a fiscal metric. Its calculation takes into account deductible disbursem*nts, which are not necessarily actual financial flows (e.g. depreciation). Moreover, it does not take other real financial flows into account, such as the repayment of loan capital. Conversely, the self-financing capacity shows the wealth created by the business, i.e. its real profitability.
Difference between Self-Financing Capacity and Gross Cash Flow
Gross cash flow is a very similar indicator to the self-financing capacity. The difference stems from the fact that gross cash flow includes capital gains and losses on fixed asset disposals, which are real cash flows, but remain exceptional. Depending on the required analysis, gross cash flow may be a more appropriate indicator.
Interpreting Self-Financing Capacity
Calculating the Self-Financing Capacity of a business therefore determines the potential amount of cash generated by the company. With this calculation, two situations are possible:
- either the company’s self-financing capacity is positive;
- or it is negative.
Positive Self-Financing Capacity
If a company's self-financing capacity is greater than 0, this indicates that it makes operating profits, which it can convert into cash, investments or dividends.
To sum up, having a positive self-financing capacity:
- fosters the company’s independence;
- secures its financing capacity;
- and means it makes less use of external funding.
Negative Self-Financing Capacity
If a company's self-financing capacity is below 0, this indicates that it does not generate sufficient income to cover its operating cycle. A negative self-financing capacity will often imply external funding (loans, capital contributions, etc.).
A negative self-financing capacity is not necessarily a negative indicator for the business. Start-ups for example often have a negative self-financing capacity in the early stages. However, if this situation lasts or does not change when the company has reached cruising speed, the situation will be more worrying.
What should your self-financing capacity be?
Minimum self-financing capacity from a bank’s perspective
As we have already seen: banks use a company's self-financing capacity to determine its ability to repay a loan: this is the financial debt / self-financing capacity ratio.
In general, banks would rather this ratio did not exceed 2, or 3, so as to grant shorter loans.
Minimum self-financing capacity for companies
The minimum self-financing capacity of a company varies with its structure, strategy and context (start-up phase, etc.). But generally speaking, the minimum self-financing capacity of a business should:
- represent 5% of its turnover if the company pays corporate tax;
- represent 15% of its turnover if the company pays income tax.
Improving Your Self-Financing Capacity
There are two main levers for improving your self-financing capacity:
- Increase the company’s turnover;
- Reduce the company's expenses.
Improving self-financing capacity by increasing turnover
An increase in turnover often means an increase in available resources, and therefore an increase in your self-financing capacity. There are many ways of increasing turnover:
- launching a new, more profitable product;
- increasing the volume of sales;
- increasing the average basket;
- winning over new customers;
- securing the loyalty of existing customers;
- increasing the price of the products the company sells (while being careful not to affect the sales volume), etc.
These solutions are obviously to be considered according to the context, means and strategy of each company. Launching a new product without assessing its market relevance (marketing mix) can lead to commercial failure, and this could reduce rather than increase the company's self-financing capacity.
Improving self-financing capacity by reducing fixed and variable costs
Another option: Reducing costs automatically increases your self-financing capacity. It is advisable to start by reducing fixed and variable costs, to avoid reducing the company’s operating expenses which could impact quality.
To reduce its fixed and variable costs, a business can particularly:
- buy less expensive raw materials (but still of good quality);
- reorganise its staff;
- change premises, etc.
Self-financing capacity is very useful in assessing how appropriate a company’s business model actually is. It is often used by banks and investors, and taking steps to achieve a positive self-financing capacity is often essential for businesses. However, other indicators can also be considered to analyse the sustainability of a company depending on the context, such as gross operating surplus (GOS) or gross cash flow. It is therefore essential to know what you want to analyse, and choose the right indicators to make the right decisions.
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