MA2402, MA7402 – Business Finance (CB1)
Actuarial Science Wiki
Describe the different types of loan and share capital.
Distinguish between authorised and issued share capital.
Outline the different types of medium term company finance: hire purchase, credit
sale, leasing and bank loans.
Describe the following different types of short term company finance: bank
overdrafts, trade credit, factoring, bills of exchange and commercial paper.
The financial markets are made up of short-term money markets and long-term capital
markets. The money markets enable companies to obtain working capital, which will be
discussed here later.
Capital markets (Figure 1) are used by companies to secure long-term funding, mostly in
the form of ordinary shares, preference shares, unsecured loans, bonds, debentures and
convertibles. In this sense capital markets act as a primary market, where new shares
(equity) are issued or new loans (debt) are created; the secondary market is where
existing shares and loans are traded between investors.
Figure 1 - Capital markets
Authorised and issued share capital
How does a company go about securing initial share capital through equity markets, such as
the International Stock Exchange in London or the Alternative Investment Market (AIM),
created in 1995 for smaller companies.
In the UK, limited companies must have a Memorandum of Association and Articles of
Association.
A company’s Memorandum of Association is a short document recording the intention of the
people concerned to form a company. The Articles of Association set out in detail the internal
rules for running the company. It is no longer necessary for either document to set out the
purpose of the company, so (unless it chooses otherwise) there are no restrictions on the
company’s activities.
All companies above a certain size (in terms of turnover, assets or number of employees)
must produce audited accounts each year.
The directors issue shares to sell to the new shareholders. The number and value of new
shares actually issued is known as the issued share capital. The directors may call upon the
new shareholders to pay the full amount of the purchase price but it is possible for the
purchaser to pay part now and part later. This is why the company records its called-up
share capital, i.e. the number and value of the authorised and issued shares, for which cash
has been paid
Loan capital
Apart from shares the initial capital of a company can also include loans.
Loan capital is for long-term investment rather than short-term needs. However, while
equity (shares) does not have to be repaid and the payment of dividends is arbitrary, loan
capital must be repaid and the interest paid as agreed between lender and borrower.
Nonetheless, companies benefit from securing part of their capital in the form of loans as
rates for such long-term borrowing are usually lower than their short-term equivalents.
The balance between equity and loan capital will affect a company’s capital structure and is
constantly under review, as an over-reliance on borrowed funds can jeopardise a company’s
long-term profitability.
There are three basic types of loan capital (figure 1): traded loans, non-traded loans
and others.
Traded loans include bonds and debentures , which can be bought and sold in the
secondary capital markets. Non-traded loans are those which cannot be bought and sold,
such as ordinary bank loans. The arrangement stays with the borrower and the lender until
the debt is repaid. Like traded loans, however, the debt may be secured against assets of
the company.
So bonds and loans may be secured or unsecured, traded or non-traded. However, the word
"debenture" normally refers to a secured bond. These forms of debt may attract either fixed
or variable interest charges. Unsecured debt is more expensive than secured.
Other types of loan capital include convertibles. Convertibles are bonds, which carry
interest payments but give the bond owner the right to convert the bonds into ordinary
shares at some stage in the future based on agreed terms. Convertibles may be traded or
non-traded.
In corporate finance, medium-term is generally understood to mean a period from two to five
years. Medium-term company finance, therefore, sits between capital or longterm needs of over five years and short-term needs, usually of less than two years, and
includes bank loans, hire purchase, leasing and credit sales.
Bank loans are the major source of medium-term funds with characteristics similar to those
of their long-term equivalents. Interest rates are usually tied to the bank rate and the loans
are often secured against assets, such as trading stock, property and debtors.
A hire purchase agreement is a way of obtaining and using assets. In this case a deposit of
money secures use of the asset and repayments of capital and interest are made over an
agreed period of time. Only when the final payment is made does the ownership of the asset
pass to the purchaser.
A credit sale is a normal sale of a good together with an agreement that payment will be
made by a series of regular instalments over a set period of time. Legal ownership passes to
the buyer at outset being the key difference from a hire purchase agreement.
Assets can also be obtained and used by leasing. One type of lease is the operating lease.
Under this arrangement, a company takes possession of an asset for a payment, not strictly
interest or repayment of capital, simply a payment for its use. At the end of the leasing
agreement, the asset is returned to the lessor.
A finance lease differs from an operating lease in that the lease structure (payment of
interest and capital) is so similar to a bank loan that it may be considered a loan "in
disguise". The only difference with a loan is that if the asset is financed with a loan, the user
owns the asset. With a lease, the lease company own the asset. Otherwise, for account
purposes, loans and finance leases are treated the same. Taxation varies for each type of
lease but directors will choose the most efficient type for their purpose.
Finally, a development of the leasing principle is the contract hire agreement. As the term
implies, an asset can be obtained and used without the ownership and, in some cases, the
encumbrances of ownership. The owner continues to maintain the asset and, in some
arrangements, such as vehicle fleet management, will provide extras, such as replacement
vehicles and even drivers within the hiring charge.
For finance of a short-term nature, usually less than two years, there are a number of
opportunities open to companies, including bank overdrafts, trade credit, factoring, bills of
exchange and commercial paper.
The most frequently used opportunity is the bank overdraft because of its inherent
flexibility. Bank overdrafts arise when a current bank account goes into the ‘red’, that is,
when the account ceases to be an asset and becomes a liability. Put another way, the
company owes the bank, not the other way around.
Overdrafts can be obtained relatively quickly and managed relatively easily. For these
reasons, limits are usually placed on the amount by which a bank account can be overdrawn
and the overdraft can be called in by the bank at short notice.
One of the challenges of managing the working capital of a business is the need to fund the
fiscal drag that exists between a sale on credit and collecting the payment for the debt. For
example, a customer buys a new bed from a furniture store and is given 30 days to pay for
it. The furniture store has to wait for up to 30 days to convert the sale of the bed into cash.
To overcome this drain on cash resources, financial institutions have developed factoring. A
company may choose to ‘sell’ part of its portfolio for cash, thus securing the use of the funds
before they are normally paid. The Debt Factor institution, which could be a bank or a
financial institution specialising in factoring of debts, will provide the funds at a discount.
Factoring, therefore, is a source of funding that is specific to and appropriate for those with
large outstanding sales on credit.
Similar to factoring, but not involving payment, is the use of credit agreements when making
significant purchases. A company may secure terms of payment with suppliers of up to, say,
90 days, particularly if the supplier wishes to keep the company’s business. For the company,
this represents an easy short-term loan and, if managed carefully, can be very effective.
Nonetheless, the company has to ensure that it does not take liberties with their suppliers’
credit by paying late - suppliers can withdraw supplies, putting pressure on production and
sales.
A bill of exchange is a written agreement to pay a particular sum of money on a specified
date through an intermediary, usually a bank. The simplest example of a bill of exchange is
the cheque. However, bills of exchange are used extensively in the short-term financing of
international trade.
Imagine a manufacturer of toys in the United Kingdom agrees to a sale of 1,000 games to a
customer in Australia. Most probably, the two will agree to create a bill of exchange drawn on
a UK bank in £ sterling, which will be payable when the customer takes delivery in Australia.
Simply, the manufacturer presents the bill to their bank in the UK and the funds are
transferred from Australia – the risk and wait for payment are eliminated.
Finally, commercial paper is a form of short-term borrowing available to businesses with a
high credit rating. This means businesses with satisfactory payment records. In the UK, credit
ratings of companies are provided by Moody’s (www.moodys.com) and Standard and Poor’s
(www.standardandpoors.com). Banks, which lend on commercial paper, consider it to be a
low risk investment as the borrowers usually have high credit ratings and the duration of the
loan is, typically, less than one year.
The most common forms of commercial paper are promissory notes, bank
drafts and certificates of deposit (CDs). Some of these may be traded in the money
markets.