Module2 L1 Financing companies

Financing Limited Companies

Internal Sources of Finance

• Long-term Finance: Funds sourced internally typically last longer.

• Retained Profits: Profits that are not distributed as dividends; reinvested in the company.

• Short-term Finance: Funds required for immediate expenses.

  • Tight credit control of receivables.

  • Reducing inventories to free up cash.

  • Delaying payments to suppliers to manage cash flow.

Capital

• Definition: The long-term financing of a company.

  • Share Capital: Funds raised by selling shares. Shareholders are owners.

  • Loan Capital: Funds raised through loans. Lenders are creditors, not owners.

Risk/Return Characteristics of Long-term Capital

• Return/Risk Spectrum:

  • Loan Capital: Typically lower risk, lower return.

  • Preference Shares: Moderate risk, moderate return.

  • Ordinary Shares: Higher risk, potential for high return.

Share Capital Types

• Ordinary Shares:

  • Returns from dividends and increased value.

  • Voting rights at meetings.

  • Irredeemable, discretion for dividends, ranks after creditors during liquidation.

  • Variations include redeemable and non-voting shares.

  • Considered high risk/high reward investment.

• Preference Shares:

  • Provides fixed dividends and usually no voting rights.

  • Cumulative and irredeemable in nature, rank above ordinary shares in liquidation.

  • Variations:

    • Participating: Right to share profits over a threshold.

    • Convertible: Convert to ordinary shares later.

Loan Capital

• Loans: Debt obligation with interest returns including capital repayment.

• Interest payment patterns established at the beginning; typically no voting rights for lenders.

Loan Covenants

• May include conditions such as:

  • Access to financial statements.

  • Restrictions on other loans.

  • Dividend payments stipulations.

  • Liquidity requirements.

Debentures

• Secured loans against company assets.

  • Mortgage Debenture: Secured by specific assets.

  • Floating Charge: Allows use of certain assets for trading.

• Risks: Non-payment, inflation, marketability issues.

Unsecured Loan Stocks

• No specific collateral; seen as higher risk reflected in market value.

• May have conversion features into ordinary shares.

Eurobond Loan Capital

• Issued in a different currency than where issued; not subject to local tax.

• Typically involves fixed interest payments; unsecured.

• Used for large foreign currency raises (e.g., $75m+).

• Risks include currency exchange fluctuations.

Medium-term Financing

• Hire Purchase:

  • Asset rented for a period before ownership transfers upon final payment.

  • Involves three parties: supplier, customer, and financial institution.

Leasing

• Renting assets; ownership remains with the lessor.

  • Finance Leases: Lessee assumes ownership risks.

  • Operating Leases: Owner retains risks (e.g., repair).

Credit Purchase

• Company purchases an item, assuming immediate ownership with installment payments.

Bank Loans

• Secured loans with interest obligations; repayable at loan maturity.

Short-term Company Finance

• Bank Overdrafts: Immediate payment demand; interest paid only on the overdrawn amount.

• Trade Credit: Agreement allowing delayed payment to suppliers; typically interest-free.

Factoring

• Non-recourse Factoring: Company sells accounts receivable; factor takes collection responsibility.

• Recourse Factoring: Loan secured against invoices; credit risk remains with seller.

The Factoring Process

1. Credit goods supplied.

2. Customer pays the factor.

3. Factor pays a percentage to the client immediately.

4. Balance paid after customer’s payment, less fees.

Commercial Paper

• Bearer documents for high denominations; issued at discounts, redeemed at face value.

• Short-term debt securities with a maturity of 1-270 days; requires excellent credit rating.

Bills of Exchange

• Agreement for payment of goods sold; can be sold to other parties for immediate cash.

Payment Ranking Upon Company Winding Up

1. Fixed Charge Creditors.

2. Floating Charge Creditors.

3. Preferential Creditors (incl. employee claims, unpaid taxes).

4. Unsecured Creditors (e.g. trade payables).

5. Connected Creditors (loans to directors and close family).

6. Preference Shareholders.

7. Ordinary Shareholders.

Ownership of UK Listed Shares (End of 2022)

• Total market value: £2417.8 billion.

• Ownership sectors include:

  • Insurance Companies: £41.6 billion (1.7%).

  • Pension Funds: £15.8 billion (0.7%).

  • Rest of the World: £413.7 billion (17.1%).

  • Banks: £81.8 billion (3.4%).

  • Other Financial Institutions: £295.8 billion (12.2%).

  • Public Sector: £13.2 billion (0.5%).

  • Charities: £5.5 billion (0.2%).

  • Individuals: £95.3 billion (3.9%).

  • Excluded: £168.5 billion (7%).

Financing Limited Companies

Internal Sources of Finance and fun ways to memorize:

• Long-term Finance: Think of it as the marathon runner of finance; they’re here for the long haul!

• Retained Profits: Profits that are not just lounging around but are reinvested back into the company!

• Short-term Finance: Like a quick snack before a big meal, it’s for immediate expenses!

• To keep cash flowing, do credit control dances, reduce inventory clutter, and delay those supplier payments!

Capital

• Definition: Capital is like a company’s treasure chest!

• Share Capital: When shares are sold, shareholders become the proud owners of the treasure!

• Loan Capital: Borrowing pearls from creditors who will want their treasure back with interest!

Risk/Return Characteristics of Long-term Capital

• Return/Risk Spectrum:

  • Loan Capital: The dependable tortoise of finance—slow and steady!

  • Preference Shares: The cool cat, balancing moderate risk and return!

  • Ordinary Shares: The adventurous climber looking for high returns!

Share Capital Types

• Ordinary Shares: The VIP club with dividends and voting rights. But remember, they’re last in line during liquidation!

  • Variations like redeemable shares are like bouncers, controlling who gets in and out!

• Preference Shares: They’re on a fixed dividend diet, usually no voting rights but rank higher in liquidation!

  • Variations like convertible shares can SHAPESHIFT into ordinary shares!

Loan Capital

• Loans: The friendly neighborhood debt that likes to remind you of interest returns!

• Loan Covenants: Think of them as the rules for playing on a financial playground, ensuring everyone shares safely!

• Debentures: These are the secured loans, like getting a lock on your treasure chest!

  • Mortgage Debenture: Secured by specific assets, like a security blanket!

  • Floating Charge: Lets the company keep trading its assets like a crafty merchant!

Unsecured Loan Stocks: These loans are like adventurous friends—higher risk with the thrill of possible conversion into shares!

Eurobond Loan Capital: It’s about playing the currency game without local tax worries but beware of currency exchange dragons!

Medium-term Financing

• Hire Purchase: Imagine renting a magical asset that can be yours after the final payment!

  • Involves a trio: the supplier, the customer, and the financer—an ultimate team-up!

• Leasing: It’s like borrowing your friend’s cool bike while they hold onto ownership!

  • Finance leases make you feel like the bike’s owner, while operating leases are when your friend’s still the boss!

• Credit Purchase: You buy something shiny upfront but chip away at it month by month!

• Bank Loans: The classic route with secure loans that you diligently pay back come maturity!

Short-term Company Finance

• Bank Overdrafts: It’s like sneaking a treat from the cookie jar—interested only while you overindulge!

• Trade Credit: Think of it as a friendly agreement to hold off on paying your pals, often interest-free!

Factoring

• Non-recourse Factoring: You hand off your accounts receivable to a factor, who then assumes the responsibility!

• Recourse Factoring: It’s like a loan secured against invoices, where you still keep some credit risk!

The Factoring Process

1. Credit goods supplied.

2. Customer pays the factor.

3. Factor pays you a percentage immediately – it’s like a payday in advance!

4. Balance paid after customer’s payment minus fees - a win-win!

Commercial Paper: These are fancy bearer documents, like golden tickets for short-term cash!

• Bills of Exchange: The handshake agreements of trading, allowing you to sell them for immediate cash!

Payment Ranking Upon Company Winding Up:

1. Fixed Charge Creditors.

2. Floating Charge Creditors.

3. Preferential Creditors (includes employee claims, unpaid taxes).

4. Unsecured Creditors (like trade payables).

5. Connected Creditors (loans to directors and close family).

6. Preference Shareholders.

7. Ordinary Shareholders.

Ownership of UK Listed Shares (End of 2022)

• Total market value: £2417.8 billion—wow!

• Ownership sectors:

  • Insurance Companies: £41.6 billion (1.7%).

  • Pension Funds: £15.8 billion (0.7%).

  • Rest of the World: £413.7 billion (17.1%).

  • Banks: £81.8 billion (3.4%).

  • Other Financial Institutions: £295.8 billion (12.2%).

  • Public Sector: £13.2 billion (0.5%).

  • Charities: £5.5 billion (0.2%).

  • Individuals: £95.3 billion (3.9%).

  • Excluded: £168.5 billion (7%).