Financing Entity: Meaning, Regulation, Pros and Cons

What Is a Financing Entity?

A financing entity is the party in a financing arrangement that provides money, property, or another asset to an intermediary or financed entity. A financing entity receives a fee for its services and is linked to the financed entity through a chain of financing transactions across all intermediaries.

How a Financing Entity Works

Financing entities and financed entities represent the two major parties in a financing arrangement. A financing entity provides money that is used by the financed entity. Other entities may serve as middlemen or intermediaries.

The most common financing entities are financial institutions (FIs) such as central, retail, commercial, Internet, and investment banks (IBs). Credit unions, savings and loan associations, mortgage companies, brokerages, and insurers can also act as financing entities.

In insurance, financing entities include underwriters, lenders, and purchasers that have direct ownership in a life insurance contract. A financing entity's primary role in a life insurance transaction is to provide funds. They are involved in the business of viatical settlement, which includes activities related to the offering, purchasing, investing, financing, selling, and underwriting of life insurance policies.

Financing entities aren't the only providers of loans. Private individuals can also be financing entities. For instance, individual investors become a financing entity when they purchase stock from public companies because they are providing funds to the company.

How a Financing Entity Makes a Profit

One of the main concerns for financing entities is generating a profit. Financing entities don't provide any loans of capital without charging a fee. This ensures they make money from each of their transactions. The interest and the fees that financing entities charge for lending capital are one of their primary sources of revenue.

Among their many tasks, financing entities must do their best to ensure that they are only providing capital to those capable of paying it back. When a business or an individual cannot pay back a loan, they have defaulted on the loan. To reduce the risk of default, the financing entity will usually compare the income of the prospective financed entity to its other debts and expenses. A financing entity will also often look at the applicant's credit score to confirm a good record of paying back financial obligations.

If all the right boxes are ticked and an application is given the green light, the financing entity will then need to secure the necessary funding. One option is to borrow the money from a bank or another financial institution using assets as collateral. For example, a business may sell its inventory to a financing entity, which uses this new collateral to secure a loan from a bank.

The financing entity then remits the bank funds to the business, and the business repurchases the inventory and provides the financing entity with a fee. While the legal title of the business’ inventory was transferred to the financing entity, the inventory is still essentially owned by the business.

Regulation of Financing Entities

Regulators seek to ensure that financing entities are in good financial condition, and consider any actions that misrepresent or conceal their actual financial health as fraudulent. 

The Internal Revenue Service (IRS) reviews such arrangements in order to determine if the purpose of the intermediaries was to disguise the transactions as being a financing arrangement. If the IRS determines that the purpose of the financing arrangement is to lower withholding tax, it may decide that the intermediate entities are acting as conduits.

Advantages and Disadvantages of Financing Entities

Financing entities make the economy tick. Loans boost the money supply, help companies to expand their operations, and promote competition in the marketplace.

Businesses and individuals depend on financing to achieve their goals and improve their circumstances. Financing entities are largely responsible for meeting those needs.

However, there are caveats to this system. Taking money under the wrong circumstances or on unfavorable terms can have big implications. Companies and individuals who enter into transactions with financing entities might find themselves locked into repayment terms that significantly impair their financial health for years to come. A company might be tempted to enter into the relationship and use the fund to invest in securities through an entity trading account. If the investment they made from the financing doesn't work out or their financial status changes considerably, they may even be forced into bankruptcy.