Corporations and their trading activities provide the life-blood of the economy; they power the trading cycle and bring substantial investment into the UK from foreign countries. Without these corporations the economy would surely die, however this creates an unbalance in power – an issue which I have addressed in my post ‘The UK economy is currently ‘drowning’ in debt – is there a realistic solution?’
There are a number of different sources of finance available to corporations depending on a variety of different factors including;
- Duration – short, medium or long-term (depends what the money is needed for)
- Gearing – debt or equity (their relationship and the company’s capital structure)
- Cost – associated costs to acquire or finance e.g. interest, administrative costs
- Accessibility – availability, ease and speed of acquisition etc.
Short-term sources of finance often last anywhere from a few months up to a period of two years. This type of finance is most commonly used for working capital requirements and generally has higher borrowing costs associated with it e.g. high interest rates on overdrafts.
Medium-term sources are often used to finance periods between 2 to 10 years and may be used for purchasing fixed assets such as vehicles and machinery or equipment.
Long-term finance such as debentures (which covers mortgages, fixed and floating charges, and unsecured loans), long-term bank loans, share issues etc. are aimed to finance longer-term fixed assets such as land, buildings and other companies, which the company is expected to possess for periods over 10 years.
Ideally, a company should fund its assets following the diagram below.
However, this is an ideal, and therefore it is common that many companies in fact have poor capital management e.g. non-current assets are financed using short-term sources of finance.
Sources of Corporate Finance
There are two main methods for generating capital finance; internally generated or externally acquired sources of finance.
Internal sources of finance are often preferable, as they tend to be cheaper to the company and much easier to arrange at a much shorter notice. One would assume that profit would be a good source of internal finance, however profit does NOT equal cash! A company can be extremely profitable but have little cash, and may even fall insolvent if it does not have enough money to pay off its debts as they fall due.
One way liquidity issues can largely be improved is simply through good working capital management; cash management, credit control, stock management etc., and the way in which the company’s assets are funded (as mentioned above). Simple cash management means planning what levels of cash will be needed by the company, and when – this can be achieved through a simple budget/cash flow forecast. Credit control is reliant on the credit control department and their efficiency in following up debtors on payments, however if it is inefficient or if the company experiences rapid growth they may consider using other options such as factoring companies. Management of stock by using efficient methods such as EOQ, just-in-time (JIT) and others, not only reduces the costs associated with stock, but also the amount of working capital tied up in stock, increasing the liquidity position of the company i.e. the amount of additional money available to the company.
Any generated profits that are not paid out as dividends are put into the company’s retained earnings account. Retained earnings is an important source of funds, however it is not free – if earnings are not paid out as dividends, shareholders expect to receive a greater return on them. Therefore, there are costs associated with using retained earnings as an internal source of finance, but they are generally still cheaper than share issuing, as there are no issue costs.
Finally, a company may decide to raise cash by selling off some assets such as equipment, vehicles etc. This can be either a slow of fairly quick source of finance, but it depends largely on the demand for the asset being sold. However, a company seen to be selling its assets sends out a bad signal (the ‘signalling effect’) to the market, suggesting the company may be in trouble.
External sources of finance can be arranged to cover any timescale, but each method will need to be considered from many aspects – normally the terms and conditions that accompany the borrowed finance.
One method of generating finance externally is the use of shares. Corporations (only Plc.’s and some Ltd.’s) can issue more shares (these can vary in attached rights) to raise capital. This is a much longer-term source of finance as these shares are often unable to be bought back, however, this form of finance allows companies to raise extremely large amounts of capital in a short space of time.
If business capital is limited a company may choose to lease or hire purchase certain assets. With both leasing and hire purchase, the company will pay an agreed monthly fee and have use of the asset. However, unlike hire purchase, if a company leases an asset then it will never own that asset. By accessing particular assets this way, it allows the company to spend and use money for its trading, financing or investing activities that would otherwise be tied up in those assets.
The Funding Gap for Small/Medium-sized Businesses
Small, unquoted companies can often find it harder to raise capital funds for a number of reasons. Smaller firms are often considered to carry a greater risk due to a lack of expertise, financial control systems, good quality assets etc. The initial capital injected into the company may be owner’s savings and money from family members. A funding gap exists where a company is not big enough to be listed on the Alternative Investment Market (AIM) and is unable to raise finance elsewhere. They may be able to get small loans from banks, but due to the financial banking crisis in 2008/09, banks are increasingly risk averse.
Venture Capitalists ad Business Angels
A venture capitalist is a wealthy individual investing in a start-up business and often requires a place on the board. They tend to be more involved in the management and running of the company, offering their expertise and advice to the company.
Business angels on the other hand are wealthy individuals investing in a business in return for equity (just think of Dragon’s Den!). They often don’t require a place on the board as their time is more valuable – it is the financial investment and occasional expert advice that are the most valuable assets. However, they often want an exit strategy i.e. how soon will they get a return on their investment?
The government provides regional assistance to businesses that set up in areas that have traditionally higher levels of unemployment. This assistance can be in the form of grants, cheaper rent, free or subsided advice and tax incentives. They can also provide information or advice to companies, giving them potentially useful business links, which may help with any problems the business may be facing. There may also be EU funding available to those companies promoting regeneration (sustainable development).
Financial markets are markets that facilitate the buying and selling of assets such as equity, debt, currencies and derivatives. Financial markets often have strict regulations and criteria that must be met to allow a company to trade on it e.g. London Stock Exchange listing rules.
There are two main financial markets in the UK; money and capital markets.
A money market is where assets with high liquidity and/or very short maturities are traded, and short-term funds are raised. These funds are raised to support a company from anywhere between several days to just under a year.
A capital market is a financial intermediary on which equity and debt instruments e.g. shares and loans, can be traded to generate long-term sources of finance. It is essentially where those with surplus funds (wealthy individuals, companies or government) can invest money to be put to better use, on which they will earn a return. The two main capital markets in the UK are the Alternative Investment Market (AIM) for small to medium-sized companies, and the London Stock Exchange (LSE) for extremely large companies. The main purpose of capital markets is that they allow companies to raise finance, and offer investors liquidity if they wish to sell their shares.
Featured image courtesy of http://www.vinge.com/Global/Bilder/Verksamhetsområden/Corp%20Finance%20and%20Capital%20Markets%20webb.jpg