Chapter 7 - Business Finance Flashcards
What are the two main ways a business is financed?
By equity (from its owners in return for dividends) and/or by debt (from lenders in return for interest). e.g. bank loans, higher purchase for assets), loan stocks, debentures
What distinguishes the different forms of equity and debt financing?
Their different levels of risk.
What are the characteristics of debt holders? 4
Debt holders face lower risk but lower returns.
They receive interest before equity holders receive dividends, debt is often secured by fixed or floating charges, and in the event of company failure,
debt holders rank higher than equity holders to receive their capital back.
However, they receive a lower rate of return on their capital.
What are the characteristics of equity holders?
Equity holders face higher risk but can enjoy higher returns.
They suffer the downside of any loss but any profits after (interest and tax) go to the equity holders, not the debt holders.
Define risk-return trade-off
The risk/return trade-off is the relationship between the amount of risk taken and the potential return on an investment. In simple terms, it implies that investors expect higher returns for taking on more risk. If an investment is riskier, investors would expect a higher return as compensation. Therefore, in structuring its finances, a company must have regard to the risk-return trade-off desired by potential investors.
What must a company consider when structuring its finances?
A company must have regard to the risk-return trade-off desired by potential investors.
What are examples of immediate financial needs for a business?
Immediate financial needs include paying wages and payables.
What are the long-term financial needs of a business?
Long-term (defensive) financial needs include funding increases in inventory and receivables as the business grows, as well as funding non-current assets.
How is financing current assets typically structured?
Businesses commonly use long-term (defensive) finance for non-current assets and permanent current assets, and short-term (aggressive) finance for fluctuating current assets.
What options do firms have when structuring their finances for current assets?
Firms can choose more long-term (defensive) or short-term (aggressive) finance structures.
Why is short-term finance usually cheaper than long-term finance?
Short-term finance is cheaper because lenders take on lower risks over the short-term.
When can short-term interest rates be higher than long-term rates?
Short-term interest rates can be higher if rates are expected to fall over the period. This is occassionally not the standard
What is an advantage of the flexibility of short-term finance?
The flexibility of short-term finance may reduce overall costs, as long-term finance is less easy to repay early.
What is a risk associated with short-term finance such as payables?
Making payments late to suppliers can cause potential damage despite the low cost of short-term finance.
What risks are associated with borrowing short-term finance? 2
The risks include renewal risk and interest rate risk.
Renewal risk
The risk that the loan is recalled in at the end of the term and is not refinanced. Renewal risk is the probability that a customer will not renew their contract or subscription with your business. It can have a significant impact on your revenue, retention, and growth. Therefore, it is essential to identify and mitigate renewal risk as early and effectively as possible.
Interest rate risk
The risk that between borrowing terms that interest rate changes.
What factors influence the decision between short-term and long-term finance?
The decision depends on the risk appetite and the perceived risk/return trade-off of the business.
What is the financial position of aggressive companies?
Aggressive companies have more short-term credit than equity, offering higher profits but at greater risk.
What is the financial position of average companies?
Average companies match maturities to have less risk than aggressive companies but also lower returns.
What is the financial position of defensive companies?
Defensive companies prioritize liquidity over profitability, using little short-term credit to finance fluctuating current assets, resulting in low risk and low returns.
Saying Revenue is ….. Profit is …….. Cash is ……..
Revenue is vanity, Profit is sanity and Cash is reality
What is the cost of holding cash for a business?
The cost of holding cash is the opportunity cost of what else could be done with the money.
What are the costs of running out of cash for a business?
Costs include loss of settlement discounts, loss of supplier goodwill, delayed wage payments leading to poor industrial relations, and payables petitioning to wind up the business.
What are the motives that influence the level of cash balances in a business? 4
The motives include
transactions motive - meet day to day obligations
finance motive - pay big bills e.g. tax
precautionary motive - e.g. rainy day
investment motive/speculative motive - make cash work in the business
If we have surplus cash what can we do? 5
Offer customer discounts
Start a price war
Payment to shareholders (dividends)
Settle debts
Make acquisitions
What should a business do if it identifies a short-term surplus of cash?
It should aim to invest the surplus cash to earn a return.
How should a business handle surplus funds in the longer term?
The use of funds will differ significantly in the long term compared to the short term, often involving more strategic investments.
What is financial intermediation?
Financial intermediation is the process where banks take deposits from customers and use that money to lend to other customers.
What are the benefits of financial intermediation? 4
Benefits include:
combining small amounts to provide larger loan packages,
transferring short-term savings into long-term loans,
allowing companies to approach banks directly for loans,
and reducing risk by not tying up an individual’s savings with one borrower.
How does financial intermediation reduce risk?
Risk is reduced as an individual’s savings are not tied up with one individual borrower directly.
Why is financial intermediation useful for companies seeking loans?
Companies can approach banks directly rather than finding individuals to lend to them.
What are primary banks and what services do they provide?
Primary banks operate cheque accounts, deal with cheque clearing, and provide internet banking services. They are also known as commercial, retail, or clearing banks.
What are secondary banks and how do they differ from primary banks?
Secondary banks are a wide range of merchant banks that do not take part in the clearing system. Range large corporate finance.
What are the two main roles of the Bank of England in the UK?
The Bank of England carries out monetary policy and ensures financial stability.
What is the role of the Monetary Policy Committee (MPC) of the Bank of England?
The MPC sets the base rate to meet the inflation target set by the Chancellor of the Exchequer and serves as a banker to other banks.
What is the role of the Financial Policy Committee (FPC) of the Bank of England?
The FPC ensures financial stability by removing systemic risks in the UK financial system, such as reducing banks’ reliance on wholesale money markets.
Financial Services Authority
They 1. Regulates banks themselves and 2. financial conduct authority which looks at financial markets
What determines the interval between when amounts are paid into a bank and when they can be drawn upon?
The interval depends on the clearing mechanism used.
What are some examples of clearing mechanisms?
Examples include general clearing, Electronic Funds Transfer (EFT) using EFTPOS, Banks Automated Clearing System (BACS), Clearing House Automated Payment System (CHAPS), Society for Worldwide Interbank Financial Telecommunication (SWIFT), payment gateways, and digital commerce platforms.
What is general clearing?
Mainly checks - clears within 3 days
Electronic Funds Transfer (EFT) using EFTPOS
Electronic Funds Transfer (EFT) using EFTPOS (POS = Point of sale) VISA Mastercard, Amex
Banks Automated Clearing System (BACS)
3 day turnaround. 1968, Pay people in bulk e.g. salaries, batch payments, drect debits
Clearing House Automated Payment System (CHAPS)
Same day system. 1984
Society for Worldwide Interbank Financial Telecommunication (SWIFT)
International same day system
Payment gateways, and digital commerce platforms.
Internet trade e.g. world pay. To take payment via their websites
What are the four types of bank/customer contractual relationships?
The four types are
Debtor/creditor e.g. saver is the CR of the bank
Bailor/bailee - bank must take reasonable care of your deposits
Principal/agent - issue instructions to bank to do things
Mortgagor/mortgagee relationship - security on assets
What is the fiduciary relationship between a bank and a customer?
A fiduciary relationship means the bank, as the party with more relative power, is expected to act in good faith in its relationship with the customer.
What are the duties of a bank as part of its fiduciary relationship with a customer? 5
The duties include:
- Honouring a customer’s cheques if correctly made out and sufficient funds are available.
- Crediting cash/cheques paid into the customer’s account.
- Complying with customer instructions given by direct debit or standing order.
- Respecting the confidentiality of the customer’s affairs.
- Providing reasonable notice before closing a customer’s account.
Types of money markets for national stock exchange 2
The money markets are a vast array of markets that buy and sell different forms of money or marketable securities. They allow financial institutions to manage short-term fluctuations in their assets and liabilities.
What are marketable securities?
Marketable securities are short-term, highly liquid investments that are readily convertible into cash.
What are the main types of financial instruments traded in the money markets? 6
The main types are:
- Treasury bills - worth 500k in UK. Issued by treasury. Deemed to be the most secure form of investment
- Deposits - fixed term investments ffered by banks
- Certificates of deposit (CDs)
- Gilts (longer-term government debt) - long term gov debts last between 5 to 50 years bearing amount of interest
- Bonds - Loans of quoted companies, tradeable, rates at issue can fluctuate as interest rate changes
- Commercial paper - IOUs for companies, they are tradeable
What is the capital market?
The capital market is the national and international market where a business can obtain finance for its short-term and long-term plans.
What are the different ways businesses can access finance in the capital market? 6
- National stock exchange (Primary markets for new finance and Secondary markets for securities already issued).
- The banking system (retail and wholesale markets).
- Bond markets (for large organizations to raise substantial amounts). - form of debt finance
- Leasing (important for various entities).
- Debt factoring (used by smaller businesses for working capital). Through the sale of their recievables ledger.
- International markets (larger companies finance in different currencies).
Types of money markets for national stock exchange 2
For companies in the UK this includes the Main Market and the AIM (alternative investment market) of the London Stock Exchange.
Primary markets – source of new finance e.g. new share issue
Secondary markets – for securities that are already in issue
What is the difference between primary and secondary markets in the national stock exchange?
Primary markets are the source of new finance (e.g., new share issues), while secondary markets deal with securities that are already in issue.
What is equity in the context of business finance?
Equity represents ordinary shares in the business, making shareholders the owners who exercise ultimate control through voting rights. Right to dividends and right to share of assest on winding up (if anything is left)
What are preference shares and how do they differ from ordinary shares?
Preference shares are part of the risk-bearing ownership but carry less risk than ordinary shares. They entitle holders to dividends before ordinary shareholders, typically at a fixed maximum rate, making them similar to debt.
What are loan stocks and debentures?
Loan stocks and debentures are fixed interest rate borrowings with a set repayment date. They are often secured on specific or general assets, providing lenders protection above unsecured creditors in liquidation.
What are retained earnings in the context of equity finance? 2
Retained earnings are the profits earned by a business that can either be 1. paid out to owners as dividends or 2. reinvested in the business. They are the most important source of equity in the real world.
What is a rights issue of shares?
A rights issue is an issue of new shares for cash to existing shareholders in proportion to their existing holdings. Shareholders in private and public companies have pre-emption rights to maintain their percentage holdings, but they can waive these rights by selling them to others.
What factors should be considered when making a rights issue? 4
Factors include
issue costs - administration % per £Million
shareholder reactions - dilution
control
and whether the company is unlisted.
What are the two main avenues for issuing new equity?
- Placings: Fresh shares are offered to institutional investors (e.g. pension and insurance companies) first, then sold to the public on the secondary market.
- Public offers: Shares are sold directly to the public through either offers for sale (via an issuing house e.g. investment bank which then sells shares to the public) or direct offers (no intermediary) sold direct to public.
Define what offers for sales mean in public offers
- Placings: Fresh shares are offered to institutional investors (e.g. pension and insurance companies) first, then sold to the public on the secondary market.
Define what offers for sales mean in direct offers
- Public offers: Shares are sold directly to the public through either offers for sale (via an issuing house e.g. investment bank which then sells shares to the public) or direct offers (no intermediary) sold direct to public.
What are preference shares 1 and their benefits 2 and drawbacks 1?
Preference shares usually carry no voting rights and no right to share in excess profits. Fixed rate dividend.
Benefits: Avoid creating extra debt, don’t dilute current shareholders’ holdings.
Drawbacks: Fixed-rate dividends must be paid and are not optional. Can be cummulative prefercne shares where they can be paid year after, for two years worth of dividends
What advantages and drawbacks to a company with regards to gaining a full listing?
Listing is the process of a private company making its shares available for trading to the public on a recognised stock exchange. Public to private company. Shareholders sell their shares at market rate (pay day). Company may raise finance in the process through the issue of new shares.
Advantages
Gives access to a large source of finance
Improves the marketability of shares, which should increase the value of the company
Improves the standing of the company, as it will be under more scrutiny once listed, so raising more finance may then be easier
Disadvantages/problems
Cost: costs run into hundreds of thousands of pounds even for modest issues
Dilution of control (at least 25% of the company has to be in public hands)
Need to have traded for three years
Having to answer to other investors – often professional institutional investors
Greater scrutiny of the affairs of the company and the actions of the directors
Listing might not be successful unless the business is worth at least £50m (often referred to as market sentiment)
Possibility of being taken over
Extra costs of control and reporting systems to meet the increased demands on the company. A listing agreement commits directors to certain levels of compliance, of reporting to shareholders and of corporate governance
What is an overdraft?
An overdraft is a short-term loan of variable amount up to a limit from a bank, typically repayable on demand. Interest is charged on a day-to-day basis at a variable rate.
Can you think of advantages 2 and drawbacks 3 of using an overdraft as a longer-term funding solution?
Advantages of an overdraft
* Flexibility: an overdraft can be used and repaid as desired, giving the borrower
* Cost: overall interest cost can be lower than a term loan, as interest is only paid when overdrawn
Disadvantages of an overdraft
* Risk: as it is repayable on demand it is not strictly suitable as a long-term source of capital, since banks can – and do – demand immediate repayment
* Cost: if the account is permanently in overdraft, the overall interest cost is higher than with a term loan as the interest rate is generally higher
* Control: the bank may require security on assets of the business
What is debt factoring?
Debt factoring is when a business receives loan finance and insurance (non-recourse factoring) such that, if a customer does not pay, the business does not have to repay the loan. Loan made against recievables ledger. Good as instant cash. Bad as can be aggressive in credit collection which can upset customer
What is a term loan?
A term loan is a loan with a repayment date set at the time of borrowing, typically from a bank. It is not repayable on demand unless the borrower defaults on repayment.
What is loan stock?
Loan stock refers to debt capital in the form of securities issued by companies, governments, or local authorities. They are also known as bonds or debentures.
What is leasing, and what are its types? 2
Leasing is a source of finance commonly used for vehicles, office, and production equipment. Types include:
- Finance lease: Transfers risks and rewards of ownership from lessor to lessee.
- Operating lease: Any lease other than a finance lease.
What are other forms of debt finance? 3
Other forms include
1. money market borrowing - can borrow money from the market
2. securitisation (asset-backed borrowing) - long term secure loan set against a particular asset
3. public sector grants and loans - usually cash for gov usually have strings attached e.g. making sure a certain no of people are employed as a result of taking the grant
What are the likely characteristics of small but growing businesses that create financing problems? 3
Management
A lack of knowledge about the possible sources of finance available, and a potential lack of financial acumen, may compound the inherent problems facing a small business. Inability to present a financial argument.
History
Businesses in their early stages of development are small. Such businesses lack any convincing trading history upon which potential investors can rely, making them unattractive investments. Credit score
Size
A small business will lack assets to offer as security. It will also have less diversity of products and markets to spread risk, and the small scale of business will not generate reliable cash flows, all of which preclude investment finance
What are the sources of finance mentioned? 4
The sources of finance include
1. Business Angels - experienced people with money seeking an investment
2. Venture Capitalists - high risk, high return investors. Often provide a lot of capital
3. Alternative Investment Market (AIM) - floatation of a private business into a plc. Can issue primary market and issue new share capital and raise finance that way
4. Crowdfunding - raise finance from the public, uses an intermediary (e.g. crowd funding website), can take form of loans, donations, pre-purchase. May be incentives for people to take this up.
What are the types of trading risks in exporting? 4
Types of trading risks include:
- Physical risk: Loss or theft of goods in transit, or loss of accompanying documents.
- Credit risk: Possibility of customer payment default.
- Trade risk: Customer refusal to accept goods or order cancellation in transit.
- Liquidity risk: Inability to finance the credit given to customers.
Define trade risk in relation to exporting
Trade risk: Customer refusal to accept goods or order cancellation in transit.
Define liquidity risk in relation to exporting
liquidity risk: Inability to finance the credit given to customers.
How can trading risks in exporting be reduced? 4
Trading risks can be reduced using banks, insurance companies, credit reference agencies, and government agencies such as the UK’s Export Credits Guarantee Department (ECGD).
What are methods to reduce credit risk in foreign trade? 3
Methods include:
- Bills of exchange - promise to pay, its contractualised. Can be sold at a discount to recieve funds and security is given by buyers bank. 3 partes involved: buyer, seller, buyers bank
- Letters of credit - supplier deals with customers bank not customer themselves
- Export credit insurance
What is green finance?
Green finance comprises sources of finance used to fund projects that benefit the environment, such as specialised green bonds, green loans, grants, and venture capital funds.
What are green bonds?
Green bonds are bond instruments where proceeds are exclusively applied to finance or re-finance, in part or in full, new and/or existing eligible green projects. They align with the Green Bond Principles set by ICMA.
What are the Green Bond Principles? 4
The Green Bond Principles are voluntary guidelines by ICMA, including:
- Use of proceeds: For projects with clear environmental benefits.
- Process for project evaluation and selection: Defined process to determine project eligibility.
- Management of proceeds: Proceeds tracked or kept in separate accounts.
- Reporting: Information on the use of proceeds must be made available.
