B207A Big ideas in organizations

1. B207ABig ideas in organizations Shaping Business Opportunities I

2. Block 1 Session 13.1: Raising finance

3. Block 1- Reading 16 Raising finance- small and medium-sized organizations

4. Introduction • Major forms of finance are: • retained earnings: post-tax undistributed profits of a company, working capital management • Debt factoring • Bank overdrafts • Bank facilities • Leasing • Equity finance (venture capital and private equity) Reading 16: Raising finance- small and medium-sized organizations

5. Financing through retained earnings and working capital management • Working capital comprises the resources organisations have at their disposal as a result of the day-to-day running of their business. • It comprises cash held at the bank, the value of the holdings of stock (also known as ‘inventory’) plus the cash due to be received from customers (‘receivables’) less the cash due to be paid to suppliers (‘payables’). • For new organisations the early years of business may see limited or no profitability due to the burden of start-up costs. The capacity to use retained earnings as a form of finance is limited in this case. • Equally, many small businesses have limited working capital, which constrains their ability to grow the organisation. Reading 16: Raising finance- small and medium-sized organizations

6. 1- Financing through retained earnings and working capital management • Organisations may also manage their cash flows with the intention of using them to provide liquidity by operating with ‘negative working capital’. • This is where the outstanding amounts due to creditors, or trade payables, exceed those due to be received from customers, the trade receivables. In these circumstances, the organisation’s creditors are, in effect, providing finance for the business. Reading 16: Raising finance- small and medium-sized organizations

7. Exercise 1: Working capital (Part 1) • Would a water company (e.g. Anglian Water) or a car manufacturer be better placed to use working capital management to finance their business? Consider why. • Water companies receive payments from their customers at the start of every half-year or on a monthly basis. Some customers pay the full annual bill at the start of the year. Consequently water companies are well placed to have trade payables (creditors) exceeding trade receivables (debtors) in monetary value and hence operate with negative working capital. • By contrast, those buying a new car only pay the full amount on its delivery – although a deposit may have been placed earlier to secure the vehicle. As the manufacturer will have to pay its labour force and at least most of its suppliers before it receives the full payment from the customer, the likelihood is that trade receivables (debtors) will exceed trade payables (creditors) in monetary value. This excess of receivables over payables will, though, be moderated by requiring customers to pay an upfront deposit for new cars that are manufactured only after receipt of orders for them. Reading 16: Raising finance- small and medium-sized organizations

8. Exercise 1: Working capital (Part 2) • Looking at Tesco’s Balance Sheet for 2012 (Appendix 1), what is the value of its debtors (receivables) and creditors (payables) at the end of Tesco’s 2011/ 1 financial year? What does this tell us about how Tesco may be managing its working capital? • At Tesco’s 2011/12 year end, debtors (receivables) were £2,657 million whilst creditors (payables) were £11,234 million. The differential effectively provided Tesco with £8,577 million of (albeit temporary) finance. Clearly Tesco – like many large retailers – is in a position to use effective working capital management to help finance its business. Reading 16: Raising finance- small and medium-sized organizations

9. 2- Financing through debt factoring • Debt factoring or, simply, factoring, is an exercise in both credit exposure reduction and cash flow management employed by many small and mediumsizedorganisations. Factoring is where an organisation sells its accounts receivables (i.e. its invoices) to a third party (a factoring house) at a discount to the total value of the receivable amounts. • Factoring is, in effect, another way of using working capital management to finance an organisation. It involves an organisation entering into an agreement with a factoring house. The house acquires the organisation’s trade debts – at a discount – as they arise in the course of its business in return for payments to the organisation. Reading 16: Raising finance- small and medium-sized organizations

10. Exercise 2: Deciding on factoring Company ABC has average trade receivables of £200,000 and annual sales of £2.4 million. It is considering the use of factoring given that this would result in a reduction in credit control costs of £50,000 per annum. The factoring house charges a fee of 1.5% of sales. It will provide an advance to company ABC of 85% of its receivables and will charge interest on this advance of 7% per annum. Assess whether it is financially beneficial for company ABC to enter into this factoring arrangement. Reading 16: Raising finance- small and medium-sized organizations

11. Exercise 1: Working capital (Part 2) • The estimated annual costs to the company from the factoring arrangement would be: • It is therefore beneficial for company ABC to proceed with factoring Reading 16: Raising finance- small and medium-sized organizations

12. 3- Bank overdrafts and bank facility finances • Bank overdrafts are simply bank current accounts that have a negative balance. These are a type of bank loan and can be a useful way in which businesses manage their cash flow requirements. • Access to this form of finance requires negotiation with the bank provider. This will set the terms in respect of: • the maximum size of the overdraft • the interest chargeable • whether fees are charged when the overdraft is utilised • the review period – typically this is at least once a year • the covenants on financial performance (covenants are conditions • imposed by lenders on borrowers, for example in respect of the • borrower’s financial performance) • the notice periods, if any, for drawing on the overdraft • the security provided – the owners of small organisations in particular • may be required to provide security against the overdraft usually in the • form of property. Reading 16: Raising finance- small and medium-sized organizations

13. 3- Bank overdrafts and bank facility finances • Bank facility finance can be used to draw on a larger pool of funds from either one or several banks. • Bank finance is a major source of funds, particularly for organisations that have neither the critical size (to support the costs of entry) nor credit standing (including credit ratings) to borrow money from the money and capital markets. • The capital markets are the 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. Reading 16: Raising finance- small and medium-sized organizations

14. 4- Lease finance • Leasing is another widely used form of finance for organisations. • Leasing is 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. • In this arrangement the bank is the ‘lessor’ and the organisation the ‘lessee’. • During the term of the lease the organisation makes payments to the bank – in effect akin to repayments on a loan. • At the end of the term of the lease the lessee may make a final payment to secure ownership of the assets. Reading 16: Raising finance- small and medium-sized organizations

15. 4- Lease finance • Leasing is attractive to both lessors and lessees for various reasons. Given that the lessor retains ownership of the leased assets, they have security in the event of the lessee defaulting on lease payments. Leasing is therefore, in effect, a form of secured borrowing. • For the lessee there are cash flow benefits, as it does not commit large sums upfront to buy the assets. By contrast the stream of leasing payments over the life of the assets is likely to be more manageable. • Additionally small organisations may not to be able to borrow the sums required to buy the assets if they have a poor or limited credit history – so leasing provides the means to acquire the use of the assets needed to support their business activities. • Read Box 3 Reading 16: Raising finance- small and medium-sized organizations

16. 5- Equity finance • Both public and private incorporated companies can issue shares in order to finance their operations. Those who invest in shares expect a return blended from dividend yield and capital growth, which is the increase in the share price over time. • Shares may take the following forms: • Ordinary shares – These give the shareholders ownership of the company and entitlement to a share of the profits of the business only after the creditors, including bondholders and the banks, have been paid. Ordinary shareholders have voting rights but no automatic entitlement to dividend earnings. • Preference shares – Like ordinary shares, these give shareholders ownership of a company, but the rate of the dividend on preference shares is usually fixed and is payable before an ordinary share dividend can be paid. Reading 16: Raising finance- small and medium-sized organizations

17. 5- Equity finance • Shares have a nominal value (or par value) as well as a market value. • Nominal value (or par value) is the face value of a security, being the amount of principal an issuer will pay to the investor on its maturity date. It is this nominal that determines the statement of share capital in a company’s balance sheet. • The market value of shares is the price at which they may be currently bought or sold in the market. Indeed it is the trading in shares that generates movements in their market prices Reading 16: Raising finance- small and medium-sized organizations

18. 6- Venture capital and private equity • When new private companies issue shares, a major target group of investors, apart from the founders of the company and its management, are venture capital companies. Venture capital companies are suppliers of private equity finance to new or recently formed companies. • For many companies, private equity together with retained earnings have been a sufficient source of finance allowing these companies to avoid listing on a stock exchange. • Read box 4: Hedge funds Reading 16: Raising finance- small and medium-sized organizations

19. The benefit to companies that provide private equity finance is the prospect of higher returns from their investments than through conventional investments in shares listed on stock exchanges. • The spread of returns is likely to be far wider than that resulting from stock exchange investments. This is because the investments tend to be riskier than those in listed companies because the latter are more mature. Reading 16: Raising finance- small and medium-sized organizations

20. Angel investors • A subset of venture capital investors are angel investors. • ‘Angels’ typically invest in smaller companies at the very early stages of their life span. • So called angels are high-net-worth individuals who invest on their own, or as part of a syndicate with other angels in larger deals. Reading 16: Raising finance- small and medium-sized organizations

21. Exercise 4 • For what reasons do companies use private equity as opposed to using a public offering of shares to raise finance? • There are four major benefits to using private equity: • Equity finance may simply not be available through the ‘public’ route. This may be because the company is too small or because it does not have an established financial track record. • Private ownership usually means a less onerous compliance and corporate governance environment for a company and the avoidance of 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. Reading 16: Raising finance- small and medium-sized organizations

22. Initial public offering (IPO) • 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. • It is at this point that the company may go to the public equity market to raise capital. • This activity is known as an IPO ‘initial public offering’ of shares. Reading 16: Raising finance- small and medium-sized organizations