Managing Finance and Budgets

1
Managing Finance and Budgets

• Lecture 8
• Sources of Finance

2
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.

3
Key Concepts

• Characteristics of Finance
• Share Capital
• Loans, Bank Finance
• Leasing

4
Structure of the Lecture

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

5
Section A

• The Nature of Limited Companies

6
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)

7
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 shareholders investment (shares) in the
  company is called the share capital
• The shares may be sold or given to another person.

8
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

9
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

10
Section B

• Financing a Limited Company

11
Where does the money come from to finance a a
limited company?

• Looking at a companys Balance Sheet, we can
  detect how a companys 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

12
Balance Sheet Sheer Fiction PLC

• Fixed Assets 800,000
• Current Assets
• Stock 500,000
• Debtors 50,000
• Creditors Amounts falling due within 1 yr.
• Trade Creditors -100,000
• Tax -50,000
• Creditors Amounts falling due after 1 yr.
• Long Term Loan -200,000
• 1,000,000
• Capital Reserves
• Share Capital 500,000
• Capital Reserves 250,000
• Retained Profits 200,000
• Profit for the Year 50,000
• 1,000,000

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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.

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Financing a Limited Company 2

• In the middle section of the balance sheet we
  have
• Creditors Amounts falling due within 1 yr.
• Trade Creditors -100,000
• Tax -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.

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Financing a Limited Company 3

• On the final section of the Balance Sheet is
• Capital Reserves
• Share Capital 500,000
• Capital Reserves 250,000
• Retained Profits 200,000
• Profit 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.

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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.

17
Section B

• Sources of Finance

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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)

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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)

20
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

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Capital Structure Long Term Elements

• Shares
• Ordinary
• Preference
• Reserves
• Long Term Loans
• Fixed Term Loans
• Debentures

22
Shares and Shareholdings

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

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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

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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.

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Dividends

• A Dividend is the amount earned by the
  shareholders 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.

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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.

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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

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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

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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

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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.

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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.

32
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 companys 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.

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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

34
New Share Issues - Example

• Balance Sheet
• Share Capital 100,000 shares _at_ 50p
  each 50,000
• Capital 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 Sheet
• Share Capital 120,000 shares _at_ 50p
  each 60,000
• Capital Reserves 45,000

35
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

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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 Sheet
• Share Capital 50,000 x 1 share 50,000
• Capital Reserves 78,000
• ---Additional 50,000 shares issued---
• New Balance Sheet
• Share Capital 100,000 x 1 share 100,000
• Capital Reserves
  28,000

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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.

38
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.

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Revaluation of Shares - Example

• Share Splitting
• Balance Sheet
• Share Capital 100,000 shares _at_ 20p
  each 20,000
• Capital Reserves 10,000
• The company decrees that each 20p share becomes
  2 shares each worth 10p
• New Balance Sheet
• Share Capital 200,000 shares _at_ 10p
  each 20,000
• Capital Reserves 10,000

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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

41
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
  companys assets, with conversion to shares when
  the business is successful

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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)

43
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)

44
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?

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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.

46
Activity One Solution (2)

• What price should the new shares be issued at?
• The shares should be issued at 3.00 each
• The 25,000 shares carry a a nominal face value
  of 1.00
• Each 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

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Other Long Term Financing

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

48
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

49
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
  organisations 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
  shareholders option) into shares after specific
  period
• May be transferred at different value to nominal
  value, and may be sold on the stock market.

50
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.

51
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

52
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

53
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

54
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

55
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

56
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

57
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

58
Credit Control

• If a high proportion of a companys 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.

59
Stock Control

• If a high proportion of a companys 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.

60
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.

61
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

62
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?

63
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.

64
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?

65
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

66
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.
• Summarise the Balance Sheet with headings,
  subheadings totals and subtotals.
• Discuss the companys capital structure, using
  ratios where appropriate and evaluate alternative
  sources of finance open to the company.

67
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