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Share and loan capital (Preference shares (Holders are members of a…
Share and loan capital
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Short term financing is usually in the form of cash in the bank and at hand, bank overdrafts, supplier credit etc
Long term financing is achieved by either issuing equity shares (to shareholders as members of the company) or issuing debt such as loan tock (to lenders as creditors of the company)
Directors of the company need to consider carefully the implications of issuing equity or debt because this can affect amongst other things, ownership and control, the level of gearing, risk and level of taxation
Share capital represents the amount of cash and non-cash considerations raised by a company in return for issuing shares
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Shareholders cannot demand their capital back from a company, it is kept to protect creditors by subordinating shareholders' rights to the assets of the business to those of creditors
Share capital can be redeemed or repaid, it can only be done so in specific circumstances where creditors are protected
Ordinary shares
Holders of ordinary shares are members of a company who receive voting rights and dividend entitlements (which are not guaranteed and depend on the company's financial performance)
Ordinary shareholders rank lat in line for dividend payments and for repayment of capital if the company goes into liquidation
Normally carry ore risk than preference shareholders and lenders so hope to benefit from dividend growth and increasing share prices
Holders have more power through their voting rights including the right to vote directors off the board and to vote on directors remuneration
Preference shares
Holders are members of a company who are entitled to dividends (if declared ahead of ordinary shareholders)
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IAS 32 requires preference shares to be repented as a liability in a company's balance sheet if it contains an obligation to pay interest or capital because its holder is not taking the residual risk in the business. This is usually the case which makes preference shares more akin to debt that equity
A company following IFRS Standards will therefore present the capital amount as a liability and dividends payable will be presented as interest in the statement of profit or loss although legally they are still dividends (EG OF SUBSTANCE OVER FORM)
Authorised share capital
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A company cannot issue more than the authorised amount of share capital which for some companies is an unlimited number of shares
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Called up share capital
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This occurs when a company does not initially require all the funds from a share issue and so only calls up a set amount to begin with
Paid up share capital
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If any Called up capital has not been paid then it is traded as a debtor on the asset side of the company's balance sheet and is termed 'Called up capital not paid'
Capital requirements
Companies are sometimes required to maintain a minimum level of share capital to safeguard against risk and ensure they are better placed to survive reduced levels of business and exposure to market risk, operational risk and credit risk
A bank must maintain the minimum level of capital stipulated by the relevant supervisory authorities and these calculations can be complicated as capital may be ranked in different tiers of safety and the calculation may relate to how risky the assets of the bank are
A well capitalised bank or financial institution is better placed to survive a market downturn or financial crisis than a bank with no safety buffer
Loan capital is a type of long term debt in the form of loan stock or debentures. A company may raise money by accepting loans from investors and issuing loan notes, bonds or debentures in return which entities the lenders to a fixed interest payment
Debentures are secured loans which rank ahead of shareholders and trade creditors in the event the company enters into liquidation. Lenders normally carry less risk than shareholders
Loan capital is often preferred to equity because issuing debt does not affect ownership and control of the company. If a c company issues mores shares to raise finance, existing shareholders may find their shareholdings are diluted if they do not take up the share offer. Raising funds by issuing debt does create gearing and tax implications which directors need to take into consideration when determining how to raise finance
A highly geared company might be considered more risky then a company without gearing because the highly geared company will have regular interest payments to service the debt and in times of increasing rates, businesses with high levels of borrowing with variable interest rate payments may find themselves with uncomfortably large monthly outgoings in order to service the debt
Lenders of finance are particularly interested in a company's gearing ratio since a high gearing ratio might indicate a company's inability to repay the debt. It is not unusual for lenders to restrict a company's level of gearing through the use of financial covenants
The interest element on debt is usually deductible for corporation tax purposes which reduces the net rate of taxation and thereby the company's cost of capital
Companies raise finance in order to generate greater returns. The choice of equity or debt can influence a number of key investor ratios, such as return on equity and EPS
If a company issues shares rather than debt, there will be more shares in issue and the EPS is likely to fall. Issuing debt can have a positive impact on the company's EPS as the additional funds can be used to generate greater profits without increasing the number of shares in issue
Equity Shares: Instruments issued by a company to give holders a residual interest in its assets and liabilities
Loan stock: shares of common or preferred stock that are used as collateral to secure a loan from another party. The loan earns a fixed interest rate, much like a standard loan ad can be secured or unsecured
Financial Covenants: Ratios that the borrower is required to stay above or below but there are usually also often absolute restrictions on debt levels and minimum working capital requirements