Managing Finance and Budgets

Lecture 8

Sources of Finance

Session 8 -Sources of Finance

LEARNING OUTCOMES Understand and choose relevant investment decision

techniques to critically analyse situations typically found in SMEs and VCOs and to inform decision making.

Key Concepts

Characteristics of Finance Share Capital Loans, Bank Finance Leasing

Structure of the Lecture

A : Limited Companies B : Financing a Limited Company C: Sources of Finance

Section A:

The Nature of Limited Companies

The Different Types of Organisation

In lecture 1, we discussed: Sole Trader Partnership Limited Company (Ltd) Public Limited Company (PLC) Voluntary organisations Central and local government Quasi-governmental bodies

(See M & A Chapter 1)

Limited Companies

In this lecture, we will concentrate on two of these: Limited Company (Ltd) Public Limited Company (PLC)

These organisations are similar, in that A limited company is an artificial legal person They are normally owned by at least two people

called shareholders A shareholder’s investment (shares) in the company

is called the share capital The shares may be sold or given to another person.

Limited Company (Ltd)

Subject to strict regulatory framework Owned by shareholders, run by Directors Separate legal entity to those who own it or run it Limited liability (may be limited by guarantee) Pays Corporation Tax on profits Profits distributed to shareholders through dividends Registers with Companies House Governed by Articles/Memorandum of Association

Public Limited Company (PLC)

Similar to Limited Company but shares traded publicly through Stock Exchange

This provides a method of raising finance (e.g. through sale of ‘new’ shares)

Must adhere to specific legislation (e.g. 6 monthly accounts, qualified accountant as Company Secretary)

Original owners can realise some of the value of their shares

Section B:

Financing a Limited Company

Where does the money come from to finance a a limited company?

Looking at a company’s Balance Sheet, we can detect how a company’s finances are deployed, and what is the source of their financing. The headings for a limited company are:

Fixed Assets Current Assets Creditors: amounts falling due within 1 yr

(i.e. current liabilities) Creditors: amounts falling due after more than 1 yr

(i.e. long-term liabilities)

Capital & Reserves

Balance Sheet: Sheer Fiction PLC

Fixed Assets £800,000Current Assets

Stock £500,000Debtors £50,000

Creditors: Amounts falling due within 1 yr.Trade Creditors -£100,000Tax -£50,000

Creditors: Amounts falling due after 1 yr.Long Term Loan -£200,000

£1,000,000

Capital & ReservesShare Capital £500,000Capital Reserves £250,000Retained Profits £200,000Profit for the Year £50,000

£1,000,000

Financing for a Limited Company 1

If we take these in turn,

Fixed Assets £800,000

Current Assets

Stock £500,000

Debtors £50,000

This section shows what the company owns. There are several important ways a company can use

to raise finance through its assets, which we will see towards the end of this lecture.

Financing a Limited Company 2

In the middle section of the balance sheet we have:

Creditors: Amounts falling due within 1 yr.Trade Creditors -£100,000Tax -£50,000

Creditors: Amounts falling due after 1 yr.Long Term Loan -£200,000

£1,000,000

This is what the company owes, and each item can be viewed directly as a source of finance.

They are items that we have either borrowed, or not yet paid. Therefore in some sense they represent money which is not ours, but we currently have in our possession and can deploy to our benefit.

Financing a Limited Company 3

On the final section of the Balance Sheet is:

Capital & ReservesShare Capital £500,000Capital Reserves £250,000Retained Profits £200,000Profit for the Year £50,000

£1,000,000

This section again can be viewed as what the company owes, and so it is a source of finance.

In this case, the money is owed to its shareholders, the investors who have chosen to lend money to the company in return for a ‘share’ in the profits.

Financing a Limited Company

Share Capital

The amount of money invested in the company represented by the ‘face value’ of the shares.

Capital Reserves

The additional amount of money generated by the share capital from special transactions: e.g. upwards valuation of fixed assets, selling new shares for a price above their face value.

Retained Profits

The total amount of profit made prior to this year, but which has not been distributed to shareholders.

Profit for the Year

The amount of profit generated this year.

Section B:

Sources of Finance

Sources of finance - characteristics

Important issues we need to consider are:

Degree of permanence of the finance Whether it is redeemable Type of return required - e.g. fixed, variable,

guaranteed, discretionary or none! Rates of return anticipated Security - specific charge or floating charge (a charge

levied out of particular assets if the company defaults)

Sources of finance - characteristics

In addition we need to consider:

The length of financing period – short-term (1 year), medium-term (2 to 5 years), long-term (over 5 years)

The different types of Risk – investment risk (short or long-term, secured or not), finance risk (mix of finance), business risk - higher risk should bring higher returns

(probably longer term)

Capital Structure

Capital Structure is a term used to describe the mix of share capital, reserves and long-term loans etc. used to finance the company

The long term elements of Capital Structure are invested in Fixed Assets, with some left over for working capital

The short term elements come from items such as trade creditors and bank overdraft. They are normally used to cover seasonal or cyclical fluctuations

Long term finance incurs costs even when not needed Short term finance is flexible but may be more

expensive

Capital Structure – Long Term Elements

Shares Ordinary Preference Reserves

Long Term Loans Fixed Term Loans Debentures

Shares and Shareholdings

We will examine the following issues: Types of Share Dividends Bonus Shares & Rights Issues

Shares

Shares are the basic units of ownership of a business. The number of shares that are issued and their nominal

(or ‘face’) value are at the discretion of the people who start up the company.

For example, a company may have an initial capital requirement of £10,000. This could be obtained by issuing: 10 shares at £1,000 each, 10,000 shares at £1 each 1 million shares at 1p each.

All shares must have the same value

Shares and the Stock Exchange

Shares in a PLC may be traded at the Stock Exchange. This is simply a marketplace for the buying and selling of

shares. Prices on the stock exchange are subject to the law of

supply and demand. The Market Price of a share is simply what another

investor is prepared to pay for it. This may be well above (or below) the face value of the share.

No money from this buying or selling of shares goes to the company.

Dividends

A Dividend is the amount earned by the shareholder’s investment over a period of time.

The term comes form the ‘dividing up’ of the profits so that each person get their ‘share’.

Companies will declare ‘dividends’ on each share. For example a dividend of 6.8% on a share with face value of 50p means that each share will earn 3.4p.

Types of Shares

There are two different types of share that we need to consider:

Ordinary Shares All companies issue these type of shares. The total of the amount invested in these is normally

referred to as the equity of the company.

Preference Shares These shares guarantee that if a dividend is paid,

preference shareholders get the first part of it.

Rights of Shareholders

A shareholder in a company has the right to: Share in any profits Share in any funds remaining if business is wound up

(after all other liabilities paid off) (Usually) Vote at shareholders’ meetings over electing

directors & auditors, and accepting corporate report Vote to accept or reject takeover bids

Ordinary Shares: Technical Details

The money invested is not refundable (normally) unless organisation wound up. There is no security.

Issued Share Capital = amount actually issued Authorised Share Capital = Amount which can be issued Shares may be sold to another party but are not

redeemable (cannot be sold back to the company) Shareholders are rewarded by dividends and the increasing

value of their shares Normally each ordinary share carries one vote Shareholder rights are explained within the Memorandum &

Articles of Association

Preference Shares: Technical Details

Preference shareholders are entitled to the first part of dividend payments (up to a maximum value)

e.g. 10,000 preference shares, value £1 at rate of 6% - first £600 of dividends goes to preference shareholders

Forms include: cumulative preference shares (which accumulate if a dividend is missed one year); convertible preference shares and redeemable preference shares

These shares do not normally carry voting rights

Changing the number and value of shares

Companies may Issue new shares Offer ‘rights issues’ Issue bonus shares Revalue shares

Each of these may have implications for current shareholders and may require changes to be made to the ‘Capital & Reserves’ section of the Balance Sheet.

New Share Issues

A company may offer new shares for sale on the market, in order provide additional finances.

These shares must have a nominal value equal to the shares currently available.

The price for the shares must reflect the current value of the company.

New Share Issues – example

A company started up with 1 million shares each with nominal value £1

Currently the company has net assets of £2 million. Each share now has an actual value of £2.00

If the company issues another million shares at £1 each, the company’s wealth will be:

£2m + £1m = £3 million There will now be 2 million shares.

This means that each share is now actually worth £3million 2 million = £1.50

The original shareholders have lost 50p per share, the new shareholders have gained 50p per share.

New Share Issues

The sale price for new shares must therefore be calculated to safeguard the original shareholders’ investment.

The sale price will therefore be higher than the nominal value: for example a share with a nominal value of 10p may be sold for as much as £6.50

The capital generated from the sale will be entered into the balance sheet under Capital & Reserves The income from the nominal value is entered as Share

Capital The income from the “excess” or premium is entered as

Capital Reserves

New Share Issues - Example

Balance SheetShare Capital 100,000 shares @ 50p each £50,000Capital Reserves £25,000

The company issues 20,000 new shares at the market value of £1.50 per share.

This gives 20,000 x 50p = £10,000 new Share Capital In addition we have and additional premium of £1 This gives 20,000 x £1 = £20,000 Capital Reserves. New Balance SheetShare Capital 120,000 shares @ 50p each £60,000Capital Reserves £45,000

Rights Issues

Used by established companies to raise additional share capital for expansion, or to solve liquidity problem

Existing shareholders have “right” of first refusal on new shares (in proportion to existing holding)

Ideally, existing shareholders purchase all new shares, so that control remains with same people, and costs are kept to a minimum

Selling price tends to be below current share market price to encourage take up

Bonus Shares (1)

A company may take their Reserves and turn them into Share Capital New shares are known as Bonus Shares (“freebies”)

Example Balance SheetShare Capital 50,000 x £1 share £50,000Capital Reserves £78,000

---Additional 50,000 shares issued--- New Balance Sheet:Share Capital 100,000 x £1 share £100,000Capital Reserves £ 28,000

Bonus Shares (2)

Net Effects of issuing bonus shares: Locks up reserves in share capital Lowers ‘actual’ worth of each share, although the nominal

value of each share is the same, and the market price may not reflect this.

Provides a “feel-good” factor - shareholders may now “sell-on” their part of the reserves.

Revaluation of Shares

Companies are free to alter the nominal value of their shares in two ways:

Share Splitting – for example a company with 1 million shares each having nominal (face) value 10p, could split each old share into two new shares, each worth 5p.

Consolidation – the company could choose to reduce the number of shares to 500,000 million by increasing their nominal value to £1 each.

Neither of these methods alters the actual amount of capital invested.

Revaluation of Shares - Example

Share Splitting

Balance SheetShare Capital 100,000 shares @ 20p each £20,000Capital Reserves £10,000

The company decrees that each 20p share becomes 2 shares each worth 10p

New Balance SheetShare Capital 200,000 shares @ 10p each £20,000Capital Reserves £10,000

Venture Capitalists

Individuals or Institutions looking to help business exploit a profitable opportunity, e.g. start-ups, buy-outs, new product lines.

Source of long-term finance through equity purchase, normally in the form of ordinary shares

They will be looking for an exit route and a return commensurate with risk

They may require a management input through non-executive director

Management Buy-out

This occurs when: Managers of a division or subsidiary purchase it from the

parent company Managers take large risk by inputting their own funds Financial institutions or Venture Capital companies

provide additional funds secured on company’s assets, with conversion to shares when the business is successful

Implications for the Balance Sheet

On the balance sheet, we find these items related to shares: Share Capital - The total amount of money invested in the

company represented by the nominal value of the shares. This includes both the original and new shares issued.

Retained Profits – these are the cumulative undistributed profits - owned by shareholders but retained by company

N.B. Retained Profits do not equate to cash - cash may already have been used to fund the business (as working capital or to obtain assets)

Reducing dividend payments will increase Retained Profits and avoid need to seek additional outside finance (from share issues, loans, banks etc)

Implications for the Balance Sheet

Revenue Reserves. Retained Profits are sometimes shown under the heading of

Revenue Reserves. These are simply the funds which arise from trading profits or from the disposal of fixed assets.

Capital Reserves arise from two sources: Issuing shares at a value above their nominal price. In this case

the total nominal value of the shares would be allocated to Share Capital, and the excess to Capital Reserves (sometimes under a heading called the Share Premium Account)

Revaluation of assets (This is sometimes entered under the heading of Revaluation Reserves)

Activity One

On commencement of trading a company issues 50,000 ordinary shares at a nominal value of £1 each. 2 years later, the Company wishes to raise additional funds for expansion. The net assets of the Company are now worth £150,000. An additional 25,000 shares are to be issued.

What are the implications of issuing them at £1 per share?

What price should the shares be issued at to ensure that the current shareholders do not see the value of their investment diluted?

How is the premium received on the share price shown on the Balance Sheet?

Activity One – Solution (1)

A company issues 50,000 ordinary shares, nominal value £1 each.

Net assets of the Company two years later are worth £150,000.

An additional 25,000 shares are to be issued.

What are the implications of issuing them at £1 per share?

£1 is the minimum stake in the company.

If it grows to 100 times its current size, the minimum stake would then be worth £100. This might cause problems in finding small investors.

Activity One – Solution (2)

What price should the new shares be issued at?

The shares should be issued at £3.00 eachThe 25,000 shares carry a a nominal face value of £1.00Each share carries a premium of £2.00 above this value.

The additional funds generated (total premium) will be: 25000* £2 = £50,000

How is the premium received shown on the Balance Sheet?

This will be shown under Capital Reserves

i.e. 25,000 x £1 … is recorded as … Share Capital 25,000 x £2 … is recorded as … Capital Reserves

Other Long Term Financing

We will look briefly at Long Term Loans Debentures Leasing Sale & Lease Back Government Grants

Term Loans

There are equivalent to the Hire Purchase or Bank Loans agreements used by individuals to finance a new car, or a holiday etc.

They are arranged with an individual institution such as pension fund, insurance company, bank or finance house

Low set up costs compared to issues of equity Tend to be secured (e.g. a mortgage) Terms usually incorporate repayment of capital and interest The timescale is usually fixed (e.g. 5 or 10 year loan) May incorporate restrictive terms and will be subject to financial

status

Loan Shares or Debentures

Composite Loans - a loan denominated in blocks (usually with a nominal value of £100)

Common forms include “bonds” or “debentures” Debentures tend to be secured against organisation’s

assets (in UK) - sometimes called mortgage Investors hold loan certificates and receive interest at a

stated rate (fixed or variable) Interest is paid before tax is calculated on profit Convertible loan shares may convert (at shareholder’s

option) into shares after specific period May be transferred at different value to nominal value,

and may be sold on the stock market.

Leasing

Method of acquiring finance to purchase assets Cost of assets fully deductible (immediately) from profits for

tax purposes Operating Lease - manufacturer or stockist of equipment

provides a short-term contract to use the equipment subject to payment of lease charges (or subject to ongoing purchase of “consumables”)

Finance Lease - finance house provides cash to purchase capital item, but remains the owner

Off balance sheet borrowing - lease previously did not have to appear as Long Term Liability so Balance Sheet appeared to be stronger. Now changed.

Sales and Lease Back

Existing (owned) assets sold to finance house or Pension Fund and leased back over number of years

Organisation benefits from cash injection whilst Finance House has secured loan plus interest payments

Government Grants

Funds provided by government grant initiatives in return for relevant outputs (jobs created, people trained, buildings renovated etc)

Organisation likely to be asked to provide “matching funding” (which may be “in kind”)

Initiatives run by variety of agencies (Government Offices, Euro-funding, SRB, Lottery)

Funds repayable if organisation fails to supply outputs (or changes its activities, closes down etc

Short Term Financing

The following represent six ways in which a company can increase their level of finance in the short term:

Sales of Assets Revaluations of Assets Bank Overdraft Debt Factoring/Credit Control Stock Control Delaying Payment

Sales of Assets

Selling Current Assets (stock) is simply part of the day-to-day business, and may yield cash immediately or in the near future.

Selling Long-Term Fixed Assets can also provide financing in the short term. This is normally done where assets have reached the end of their useful life, or where they are no longer required.

Some Assets may have a market value which is above their ‘book’ value. The profit from such sales is entered on the balance sheet under “Revenue Reserves”

Revaluation of Assets

Where an asset is worth more than its historic cost, assets may be re-valued to reflect their current market value.

For example land purchased for £100,000 five years ago, in the current market may well be worth an additional £50,000.

Revaluing an asset does not provide additional ‘cash’, but does increase the funds available to the company. Such amounts are entered in the Balance Sheet under “Revaluation Reserves”

Bank overdraft

Overdraft - repayable on demand Suitable for working capital, but not all funding requirements Likely to require security Almost certainly will involve a variable higher interest rate. Sometimes will require personal guarantees of Directors

Debt Factoring

Balances owed by customers may be “sold” to a factor who collects money directly from debtor when due

Factors will tend to purchase low-risk debts only Sometimes factors bear the cost of “bad debts”, otherwise

the money is reclaimed from the company The company receives a proportion of the value of the

invoice (dependent on the arrangement) Also known as invoice-discounting An arrangement can be difficult to exit from as company

becomes dependent on cash from factor

Credit Control

If a high proportion of a company’s assets are in the form of debtors, there is an opportunity cost, since the funds cannot be used for more profitable activities.

Tighter credit control: e.g. discounts for early payment, (i.e. penalties for late payment!), cash-sales, credit references etc. may release some of these funds.

Stock Control

If a high proportion of a company’s assets are in the form of stock, here too there is an opportunity cost, since the funds cannot be used for more profitable activities.

Stock control methods such as ABC or just-in-time techniques can lead to lower stock levels. This releases more funds to the company in the form of working capital.

Delaying Payment to Creditors

Items bought on credit effectively represent a ‘free’ source of finance. The amount owed is money currently being utilised by the company to generate profit.

Increasing the amount owed, or extending the payback period effectively generates more of this free finance’.

However, there may be other penalties: penalties for late payment, refusal to supply etc.

Principles of finding finance

Match funding to need Balance shareholders funds against long-term liabilities. Be aware of effect on capital structure Be aware of tax implications

Activity Two

A Company is looking to raise additional funds to finance expansion into a new market. It believes it will need an additional £50,000 to use as working capital, £250,000 for purchase of equipment, and £75,000 to spend on marketing activities.

Which possible sources of finance should the Company investigate to finance each area of the project and what are the various issues it needs to consider before deciding on the way forward?

Activity Two -Solution

An additional £50,000 to use as working capital: This might possibly be achieved through efficiency gains (lowering current stock

levels, tighter debt control, extension of credit – or possibly debt factoring). If not, this would need to be included in the equipment purchase.

£250,000 for purchase of equipment. This will need to be funded either through additional share capital (New share issue -

look for Venture Capital), or if this is not possible, other long-term financing, such as a long-term loan, or debentures. Explore whether a Government grant is available.

£75,000 to spend on marketing activities. This is revenue expenditure, and will therefore be accounted against profits in the

year in which it occurs. If retained profit levels are high, the company could consider taking reduced profits or even a loss in the next financial year, although this would not go down well with the new shareholders! Alternatively, the company could consider an overdraft.

Activity Two - Issues

The main factors to be taken into account are:Risk:• If the company borrows, there is a risk that there may not be sufficient funds at the

maturity date to cover the repayment, and will not be able to find a replacement loan.

Matching:• The company may wish to match the life of the long-term asset with the maturity

date of the loan. Cost:• Interest rates for long-term loans are generally higher than those for short-term

loans.Flexibility:• Short term loans may be more flexible and responsive.Financial Gearing:• What is the current gearing ratio and how will the proposed funding alter this? What

would the effects be if the sales were less than expected?

Follow-up Activities

Preparation: read Chapters 4 & 15 (Both editions), Describe key concepts:

Characteristics of Finance

Share Capital

Loans, Bank Finance

Leasing

Other sources of finance Exercise 15.7 – page 508-9

Revision Seminar (Week 10) - Case Study A

John Richards and Sons Ltd is a well-established family business. The managers are considering expansion of their operations but they estimate that £2 million of additional capital will be needed to finance their plans. The latest balance sheet for the business is shown on the following page.

1. Summarise the Balance Sheet with headings,

subheadings totals and subtotals. 2. Discuss the company’s capital structure, using ratios

where appropriate and evaluate alternative sources of finance open to the company.

Case Study - Balance Sheet Entries

£ 000

Land & Buildings 1600

Plant & Equipment 3600

Stock 2000

Debtors 1600

Cash 200

Trade creditors (1000)

Long Term Loans - 12% repayable in 10 years time (2600)

Ordinary Shares of £1 each 2000

Retained profits 1200

8% Preference Shares 1200