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Raising finance to support business operations (Forms of finance employed…
Raising finance to support business operations
Key points
SMEs
Employ a large percentage of the workforce
Account for the majority of output in the private sector.
Are major employers and drivers of economic growth.
Main source of innovation for an economy
Entrepreneurs struggle to make funds and will typically turn to friends and family
External funding from financial institutions
Banks
Venture capital funds
Investment funds that manage the money of investors who seek private equity stakes in start-up and small- to medium-sized enterprises with strong growth potential.
Investments are generally characterised as high-risk/high-return opportunities.
Forms of finance employed by small and medium-sized organisations
Retained earnings
Monies not paid out in dividends and not yet capitalised as
additional shares
Working capital management
Debt factoring
Bank overdrafts
Bank facilities
Leasing
Equity finance
Bear in mind
Organisation size and finance employed
There is no strict relationship between an organisations size and the forms of finance it utilises
Large organisations make extensive use of lease finance – a form of finance commonly used by small entities
Large organisations may remain in private ownership and
not raise share capital in the public equity markets
Small organisations may raise equity finance through the London Stock Exchange (LSE)’s Alternative Investment Market.
Finance: liquidity and capital
Raising finance performs two roles for organisations
Provides cash to help enable organisations to meet
their obligations in respect of payments to creditors and employees - finance provides liquidity for an organisation enabling payments to be made in a timely way.
Equity and debt finance provide organisations with ‘capital’.
This provides the financial resoruces to establish buisness operations and support their development and expansion
Capital can also provide finance for long term investments, eg in infrastructure.
Retained earnings and working capital management
Finance to support small operations by providing effective working capital management and the use of retained
earnings from earlier business activities.
Working capital
The resources organisations have at their disposal
as a result of the day-to-day running of their business
Cash held at the bank
Inventory
The value of the holdings of stock
Trade receivables less trade payables
The cash due to be received from customers less the cash due to be paid to suppliers
The capacity to use retained earnings or working captial as a form of finance is limited to new businesses
In the early years of business may see limited or no
profitability due to the burden of start-up costs
Many small businesses have limited working capital, which
constrains their ability to grow the organisation.
Operating with negative working capital
Organisations may manage their cash flows with the intention of using them to provide liquidity
Where trade payables exceed trade receivables
Where the outstanding amounts due to creditors exceed those due to be received from customers
The organisations creditors are providing finance for the business
The ability to do this depends on
The size of the organisation relative to its customers and creditors
Smaller organisations are likely to have less bargaining power when it comes to getting customers to pay early and make creditors tolerate late receipt of monies due
The nature of the business undertaken
Retail businesses like supermarkets where customers pay immediately are well placed to have the monies due to their creditors (suppliers) exceeding that due from their customers
Building companies that normally only receive the full amount of the cost of properties on their construction are, by contrast, poorly positioned to have their creditors finance their business
Disadvantages
Delayed payments to creditors may result in price discounts on supplies being forfeited
This may undermine the rationale for operating with negative working capital.
Legal constraints of late payments
Small companies are vulnerable to late payments by customers as they are less likely to have deep sources of liquidity and many will have only limited borrowing facilities from their bankers
There is legalisation that supplier have the right to claim an interest penalty from purchasers if payments for goods and service occur beyond the agreed credit period (30 days)
Late Payment of Commercial Debts (Interest) Act of 1998
Initially only gave small companies (<50 employees) the right to claim from larger companies (>50 employees)
2000, the act was extended to enable small businesses to claim from other small businesses
2002 the power under the Act were extended to all organisations (including the public sector) enabling any organisation to claim interest for late payments from any organisation
Debt factoring
aka Factoring
An exercise in both credit exposure reduction and cash flow management employed by many small and medium sized organisations
Def - where an organisations sells its accounts receivables (its invoices) to a third party (a factoring house) at a discount to the total value of the receivable amounts
Another way of using working capital management to finance an organisation
Involves an organisations entering into an agreement with a factoring house
The house aquires the organisations trade debts - at a discount
The factoring house has the right to these trad debts whilst the organisation has reduced its credit exposure to its business customers and improved its cashflow
The factoring house may initially pay up to 90% of the trade debt after deducting charges
The remaining balance is only paid if and when the organisations debtor pays the factoring house
By holding back part of the payment to the organisation, the factoring house gives itself some protection in the event of a default by the debtor
The organisation will therefore receives less than if they had chased the debtor itself for the full amount
Advantages
The organisation gets cash promptly allowing it to pay its suppliers and providing working capital to continue its business activities
Doesn't waste time on the analysis of the creditworthiness of its customers nor engage in the time consuming task of chasing payments (factoring houses are good at this and gain a fee for it)
Two types of factoring
Resource factoring
The factoring house will come back to the organisation in the event of non-payment by the debtor
Non-resource factoring
The risk of non-payment by the debtor is completely
transferred to the factoring house - the fees are much higher here
Overdrafts and bank facility
Overdrafts
The only finance that may be available
Other than that generate by retained earning or effective working capital management (debt factoring)
Well suited to the financing of seasonal or other temporary cash flow shortages
Represent a further form of working capital management as they directly impact on the cash immediately available to an organisation (short term)
Requires negotiation with the bank provider and will set the terms of
The max size of the overdraft
The interest chargeable
Whether fees are charged when the overdraft is utilised
The review period (1 yr)
The covenants on financial performance - conditions imposed by lenders on borrowers - the borrowers financial performance
The notice period for drawing on the overdraft
The security provided - the owners of small organisations may be required to provide security against the overdraft usually in the
form of property
Organisations need to take account of the relative cost of this form of short-term finance to alternatives like factoring
Bank facility finance
Major source of funds, particularly for organisations that
have neither the critical size (to support costs of entry) nor credit standing (including credit ratings) to borrow money from the money and capital markets
Capital markets - financial markets for the raising of long-term finance through the issuance of bonds and other securities
They are the long-term partner of the money markets
Credit ratings - the measures of an organisation’s creditworthiness and determined by credit rating agencies
Form of 'bilateral facility'
The borrower raises funds or establishes the right to draw on a banking facility from one bank
'Syndicated'
Where a number of banks have a share in the facility, with the borrower drawing funds from each
Credit risks to the lending banks is shared
One bank is the arranger of the syndicate inviting other banks into the deal and often initially bearing a large proportion of the facility until portions of it are ‘sold down’ to partner banks
Interest rate charged is linked to the 3 month money market rate - LIBOR with the bank(s) adding a margin
Drawn fee
The overall rate charged to the borrower is known as the drawn fee
The fee paid by a borrower to the lender(s) when borrowing (‘drawing down’) funds under a bank facility
A commitment fee usually added
The commitment fee is paid by the borrowing organisation when the facility is in place but where no actual funds are being drawn down from it
The fee is paid to the (potential) lender(s) for provision of a bank facility when no borrowing is taking place under the facility
The borrower is paying for the right to borrow under the facility when funds are required.
To be of practical benefit they must take a ‘committed’
rather than an ‘uncommitted’ form
Committed form
Provided the organisation is complying with the terms of the facility agreement, funds may be drawn down when required.
Uncommitted form
The bank has no obligation to provide funds when required and would choose to avoid doing so if economic conditions and/or the organisation’s circumstances at the time of the request made lending unattractive to them
Benefits
May form a relationship with a bank
‘Partner’ banks tend to have a good understanding of the organisations they are lending to – including the business risks and the quality of the management
With a relationship it is possible for quick and flexible solutions to be found for financing needs
Useful if the bank is employed at a later date if the organisation wants to undertake an issuance of shares
Lease finance
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Where an organisation arranges for a bank to acquire an asset that it needs (e.g. IT equipment) and then leases it from the bank for a defined term
The bank is the 'lessor' and the organisation is the 'lesee'
Similar to repayments on a loan, during the term of the lease the organsation makes payments to the bank
At the end of the term the lessee may make a final payment to secure ownership of the assets
In reality, many leased items often have an operational life of just a few years due to technological developments
Two types of lease finance
Finance leases
Legal ownership of the assets remains with the bank, with all the benefits and risk assosited with the leased assets being transferred to the lessee
Operating leases
Typically short term agreements
The lessorr retains the risk and benefits of the leased assets
Benefits to the lessor
The lessor retains ownership of the leased asset which mean they have security in the event of the lessee defaulting on lease payments
Leasing is a form of secured borrowing
Benefits for the lessee
Cashflow benefits
It does not commit large sums upfront to buy the assets - the stream of smaller payments is likely to be more manageable
Small organisations who may not to be able to borrow the sums required to buy the assets if they have a poor or limited credit hisorty can allow them to utilise the assets needed to support their business activities
Equity finance
Public and private incorporated companies can issues shares in order to finance their operations
Shareholders expect a return of
dividend yield
and
capital growth
Dividend yield = dividend paid divided by the prevailing share price
Capital growth = the increase in share price over time
Dividends
Payments - typically annual or half yearly - to investors in shares
The size of the dividend payments is usually linked to the financial performance of the company that has issued the shares
It is at the discretion of the company, subject to approval by its shareholders, whether dividends should be paid
Forms of shares
Ordinary shares
Give shareholders ownership of the company and entitlements to a share of the profits of the buisness only after creditors have been paid
They have voting rights
The have no
automatic
entitlements to dividend earnings
Ordinary shareholders stand behind preference shareholders when it comes to the payment of dividends
Preference shares
Shareholders are given ownership of the company
Shares are usually fixed and is payable before ordinary share dividend can be paid
Most shares are cumulative - all back payments of dividends on preference shares (if overdue) have to be paid before an ordinary share dividend can be paid
Usually only have voting rights in the event of a major issue affecting the company (eg an alteration of its capital structure)
Share warrants
Options that give the holder the right, but not the obligation, of exercise to obtain shares at a defined price (strike price)
Share values
Nominal (par) value
The face value of a security
The amount of principal an issuer will pay to the investor on its maturity date
Typically expressed as £100 or £1000
Determines the statement of share capital in a companies balance sheet
If shares are issues above the par value the difference is termed the 'share premium' and this is placed in the share premium account on the organisations balance sheet
In the USA nominal value is higher than the UK
In the USA there are shares of 'no par value'
Allows shares to be issues at any price, with no minimum price being prescribed
Market value
The minimum price at which it may be issued
The price at which they may be currently bought or sold in the market
It is the trading in shares that generates movements in their market prices
Shares should be valued at the ‘bid’ price on the exchange
The price at which a financial asset can be sold
The 'offer' price
The price at which shares can be bought and is slightly higher
Bid to offer spread
The difference between bid price and offer price
Typically small for shres in major companies in which there are high trading volumes
There is not need for the market value of a share to be close to its nominal or par value
EG - a 25p par value share can trade at a market value a of £10. If the share is trading below 25p, however, new shares cannot be issued below the par value
Venture capital and private equity
Venture capital companies
When a new private company issues shares, a major target group of investors, apart from the founders of the company and its management, are venture capital companies
THey are suppliers of
private equity
finance to new or recently founded companies
In recent years they have targeted more mature companies
Private equity related to non-public issuance of shares
For many companies private equity and retained earnings have been a sufficient source of finance
Allows companies to avoid listing on a stock exchange
Larger companies have recently been providing private equity have begun to dominate the mergers and acquisitions business and have become active in buying existing public companies and returning them to private ownership
Venture capital investors are called 'angel investors'
Invest in smaller companies at the very early stages of their life span
Are high-net-worth individuals who invest on their own, or as
part of a syndicate with other angels in larger deals
Typically experienced entrepreneurs who often make their own skills, experience and contacts available to the company in which they invest, along with their capital
Hedge funds
Fund management companies that adopt a range of investment and trading strategies
Media have painted them as adopting an aggressive and high risk investment activites
Many hedge funds have conservative investment strategies
The term relates to an array of funds with a variety of structures and investment strategies
Common features
Some are targeted at wealthy individuals (with high net worth) who may be prepared to take greater risks with their investors than ordinary investors
The managers of hedge funds charge high fees for their services,
often linked to the performance of their funds
The funds tend to adopt riskier investment strategies, often building up their positions by borrowing money from the wholesale of markets to finance their investments
They have tended to be lightly regulated by comparison with
conventional investment funds
Criticisms
There is evidene that they target organisations they percieve to be in difficuties and engage in startegies to profit from a fall in their share prices
Short selling
Entering into agreements to sell shares they do
not possess for settlement at a future date
Intention is that between the transaction date and the settlement date, the market price of the shares will fall, enabling the hedge fund to buy them at a lower market price to deliver them as required under the terms of the original transaction
Profits arise from having originally sold the shares at a higher price than the one at which they were ultimately acquired for delivery to the customer
Often a disadvanateg to the affected organisation where share prices have dropped or there was panic selling
The term ‘hedge’ is widely used in the financial markets to
describe a method for reducing risk
FOHF
In recent years have seen the rise of the ‘fund of hedge funds’
Investors buy into a FOHF and leave the manager of the FOHF to use their skill and judgement to decide which hedge funds to buy into
Can provide greater investment diversification and thus help to reduce the overall risk to the investor
Companies that provide private equity benefit from the prospect of higher returns from their investments than through conventional investments in shares listed on the stock exchange
Investments tend to be riskier than those in listed companies because the latter are more mature and have lower ‘gearing’ than the companies financed by private equity
Gearing
The measure of the amount of debt an organisation has in its capital structure.
Debt/(debt + equity) ratio – the market value of debt as
a percentage of the total market value of debt and equity combined
Equivalent of leverage in the US
The greater risks potentially result in a higher volatility of returns to the investor
Benefits to using private equity
Equity finance may simply not be available through the ‘public’ route
May be because the company is too small
May be because it does not have an established financial track record
May have too high a business risk profile to be attractive to a wide investor base through a public share offering
Private ownership usually means a less onerous compliance and
corporate governance environment for a company
Avoids the costs and management time involved in maintaining a public listing
Raising private capital is usually faster than accessing
public capital markets.
By remaining private, the company is less exposed to predatory attacks by those wishing to take it over
‘Initial public offering’ of shares.
It is at this point that the company may go to the public equity market to raise capital
As a company grows and establishes a track record of performance, a point may be reached where it needs more finance to support the development of the business
The founders of the company and those other investors who have provided the initial private equity may want to realise (i.e. sell) at least part of their investment