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Financing a business: internal and external financing options

In Accounting, Finance on April 29, 2013 at 1:32 pm

Public domain image, royalty free stock photo from www.public-domain-image.com

Capital is the lifeblood of any business. As well as supporting long term investment, working capital is used to invest in the current assets used in a company’s day-to-day operations.

Businesses have multiple ways of raising finance which may be suitable depending on the characteristics of the firm, the nature of the intended investment and the economic environment. To simply the advantages and disadvantages of these options, HBR has compiled the following table (click to enlarge).

Financing options table

Note: This table shows the general characteristics of financing options. However, most change according to factors such as business reputation, credit ratings, market conditions and service used.

DEFINITIONS

Internal sources of finance

Retained profits:
Companies can increase funds by retaining profits and not distributing them as dividends. The shareholders deprived of capital will expect retained profits to be invested to achieve a competitive rate of return. Most big businesses retain 50% of profits to fund expansion.

Tighter credit control:
The remaining internal financing options increase businesses’ cash assets by decreasing working capital items. For example, chasing trade receivables owed by credit customers releases funds which can be re-invested in the business.

Reduce inventories:
Purchase and storage costs use revenue that could otherwise be used to expand the business. However, when reducing inventories enterprises should be careful to retain the capacity to meet future demand.

Delay paying trade payables:
This cheap form of finance extends the period before a business has to make good on their credit payments, releasing the funds in the interim. This can come at a reputational cost, which damages the possibility of buying on credit in the future.

External sources of finance

Ordinary shares:
Under this arrangement, companies raise capital by selling stock in their business. This entitles the purchaser to a voice in the decisions made by the firm. While ordinary shares do not have a fixed rate of dividend (a share of company profits) from profits after current liabilities and other investors are services, not paying them can diminish share value. A business will avoid this if they hope to issue shares in the future.

Preference shares:
Preferential shareholders receive dividends before individuals with ordinary shares. Their lower risk and lower levels of return mean that preference shares have a less volatile market price. These have lost popularity since, while they are alike borrowings in many other aspects, dividend payments are not tax deductible.

Rights issue:
In order to raise finance without diluting control of the business, a rights issue offers new shares to existing shareholders. Shares issued this way generate goodwill and maintain the predictability of shareholder governance, but must also be discounted (sold at an average of 31% under market price).

Bank overdraft:
Businesses can access funds by maintaining a negative balance on its bank account. The advantages of using an overdraft include flexibility, competitive interest rates and can become a long term source of finance (dependent on the confidence inspired by the borrower). But, reliance on an overdraft can have devastating consequences, since it is repayable on demand.

Term loan:
Financial institutions provide negotiable loans in which the rate of interest, repayment dates and security for the capital offered must be agreed. Because they are commonplace, this option is easy to set up and has a degree of flexibility. At the same time, borrowed capital often comes with obligations and restrictions known as ‘loan covenants’.

Loan notes/stock:
This form of borrowing, exchanges capital from investors for a note representing the loan which can then be traded on the Stock Market. The value of a loan note fluctuates with the business’s performance.

Finance lease:
Under this arrangement, a business will select an asset which is then purchased by a finance company. The lease will then be paid in a series of rentals or instalments. This avoids the large cash outflows of an outright purchase. The risks and rewards associated with the purchased item are transferred to the lessee.

Operating lease:
This is similar to the finance lease, except the rewards and risks of the item stay with the owner. The asset becomes security, meaning that operating leases are usually given without detailed credit checks. The term of an operating lease is short compared to the useful life of the asset, and so the asset might be used by multiple lessees in its lifetime. Businesses can, therefore, avoid obsolesce risks by this means.

Sale and lease back:
Businesses can raise funds by leasing their unused assets to a financial institution.

Debt factoring:
Debt collection can be outsourced to specialist subcontractors. This can increase cash assets by providing savings in credit management and certainty in cash flows. Stakeholder opinion should be considered before opting for this financing option, as the use of outside agents could be viewed as an indication of financial difficulties.

Invoice discounting:
This is a loan based on the value of a business’s outstanding credit sales. This is used as a short term alternative to debt factoring. It is more widely used based on its low service charges and the autonomy it gives to the business to collect payment for its own credit sales. However, repayment of the advance not dependent on trade receivables being collected, so a business must have confidence they can raise finance within the term of the loan.

 

Financial management cheat sheet

In Accounting, Finance on April 25, 2013 at 5:49 pm

accounting_for_non_accountants

Profitability

Return on capital employed
= (operating profit / share capital + reserves + non-current liabilities) x 100

Operating profit margin
= (operating profit / sales revenue) x 100

           Operating profit
= sales revenue – operational costs

Gross profit margin
= (gross profit / sales revenue) x 100

           Gross profit
= sales revenue – cost of sales

Return on ordinary shareholders’ funds
= (net profit after tax and preferential dividend / ordinary share capital and reserves) x 100

Efficiency

Average inventory turnover period*
= (average inventories held / cost of sales) x 365

Average settlement period for trade receivables*
= (average trade receivables / credit sales revenue) x 365

Average settlement period for trade payables*
= (average trade payables / credit purchases) x 365

Sales revenue to capital employed
= sales revenue / (share capital + reserves + non-current liabilities)

Sales revenue per employee
= sales revenue / number of employees

Liquidity

Current ratio
= current assets / current liabilities

Acid test
= current assets (excluding inventories) / current liabilities

Gearing ratio
= (long term liabilities / (share capital + reserves + long term liabilities)) x 100

Interest cover ratio
= operating profit / interest payable

.Investment

Dividend pay-out ratio
= (dividends announced for year / earnings per year available for dividends) x 100

Dividend cover ratio
= (earnings per year available for dividends / dividends announced for year) x 100

Dividend yield
= ((dividend per year / (1 + ‘dividend tax credit’ rate of income tax) / market value per share) x 100

Earnings per year
= earnings available to ordinary shareholders / number of ordinary shares issued

Price/earnings ratio
= market value for share / earnings for share

Cost-volume-profit analysis

Break-even point
Total sales = total costs

Number of units sold at break-end point
= fixed cost / contribution per unit

Number of units sold to achieve target profit
= (fixed cost + target profit) / contribution per unit

Contribution margin ratio
= (contribution/sales revenue) x 100

                Contribution
                = sales revenue per unit – variable cost per unit

Margin of safety
= actual sakes – break-even sales

Investment decisions

Payback period
= length of time it takes for the initial investment to be repaid from resulting cash inflows

Accounting rate of return
= (average annual profit / average investment) x 100

Average annual profit
= (total project revenue – depreciation) / lifetime of project in years

Depreciation
= initial cost – disposal value

Average investment
= (initial investment + disposal value) / 2

Present value
= future cash flow x (1 / discount factor)

Internal rate of return
= the discount rate at which future cash flows have a net present value of zero

Managing working capital

Working capital
= current assets – current liabilities

                Current assets
                = inventories + trade receivables + cash

                Current liabilities
                = trade payables + bank overdrafts

Operating cash cycle
= average inventories turnover period* + average settlement period for trade receivables* – average settlement period for trade payables*

Average inventory turnover period*
= (average inventories held / cost of sales) x 365

Average settlement period for trade receivables*
= (average trade receivables / credit sales revenue) x 365

Average settlement period for trade payables*
= (average trade payables / credit purchases) x 365

Lead time for orders (in weeks)
= annual demand for component / number of weeks in a year

* To nearest day

Global pricing: standardisation v. adaptation

In Management on April 18, 2013 at 4:38 pm

currencies

HBR has previously explored the impact of competition, product and demand on the pricing strategies of businesses. In this article, we build on this by looking at the pricing in the global context. Largely, MNEs have to adapt prices to account for local conditions. This includes factors relating to the customers, product and market.

Customer

The golden rule of standardisation extends to pricing. If prices can be extended across regional markets, multinationals reduce the complexity of marketing and their organisational structure.

In the pursuit of standardised prices, psychologists have worked with marketers to establish pricing techniques which are effective in raising sales across cultures. Bundled prices, along with ‘99p’ selling, subscription and discounting models, can make a market offering appear more attractive to buyers. However, pricing is always designed to befit the business – by encouraging rapid or widespread adoption, securing a return on capital expenditure or by positioning the organisation in the market.

Bundling is most often used to justify a higher profit margin while lowering buyers’ willingness to negotiate. For these reasons, EasyJet has become adept at building relationships with local hotels and car hire companies – using holiday packages to maintain competitive flight prices.

The elasticity of demand restricts the price range of a good and can lead businesses to interesting strategies. As the recession set in during the first decade of the 21st century, Starbucks was losing customers. Against conventional advice, the coffee chain benefitted from an 8% price rise. This is because, with the departure of price sensitive customers, Starbucks was left with inelastic demand. Instead of regaining customers, Starbucks extracted more value from their surviving base.

Product

The exclusivity and representational value of a product both impacts and is impacted by its attached price tag. Firms in luxury product segments, from LVMH’s bags to Cartier watches, use fixed prices to added representational value to products which stand for membership of a global elite. On the other side of the spectrum, Ironman marathon runners protested expensive membership schemes as antithetical to the ethos of the sport.

Covering costs is a central objective of pricing strategies, and is established by product specifications. Cost pricing provides the benefits of achieving return on investment, but needs to be set with a determined recovery period. For instance, GlaxoSmithKline’s pharmaceuticals command high premiums so that they might recoup development costs before the drugs become commoditised.

Market

Geocentric strategies have been developed to balance local conditions with the risk of pricing arbitrage. They consider the different levels of wealth and development across global markets. Correspondingly, prices vary even within clustered economies. In terms of consumer prices, Demark is 42% higher than the average EU state, whereas Bulgaria is 49% below the average.

Market pricing relies on market forces to set price levels. This enables companies to maintain their positions through fluctuations in demand, but can result in a lack of differentiation between market offers. Due to this pricing method, the competition between Swedish food retailers was unresolved through the 2000s.

Companies might otherwise be obliged to adapt price because of legal requirements, exchange rate fluctuations or opportunities for counter-trade as in BAE Systems’ arrangement with Saudi Arabia.

Conclusion

International pricing strategies can successfully have standardised features, such as promotional reductions, and be rooted in the same orientation – cost, market or value. However, the level of maturity and currency used in a national market will determine the relative prices at which a product can be expected to be embraced by a local customer base.

Pricing strategy in B2B markets: Demand (1/3)

In Informatics, Management on April 16, 2013 at 3:50 pm

1956_The Price is Right

The price is right

Price is an essential component of marketing and revenue generation which cuts to the heart of the purpose of modern enterprise. Businesses address customer needs through the provision of goods and services. However, this is not an end to itself. Primarily, firms exist to increase the wealth of their owners. To do this they engage in revenue and profit generating activities.

Revenue = price of good x quantity of good sold

Profit = total revenue – total costs

The profitability of a business can be increased by selling more, decreasing costs or raising prices. Although most obviously involved in the latter option, price strategy is an element of all of these methods. Enterprises can alter price to maximise profits, penetrate or skim markets, reduce inventories or encourage up- or cross-selling. Typical objectives include getting a return on investment and increase market share.

Businesses do not operate in a vacuum, however. Only certain pricing decisions will be viable for any one market situation. This article separates the relevant factors into demand, product and competitive conditions.

Demand

In neoclassical economics, lowering prices increases demand and adding to buyer costs reduce the number of potential customers willing to buy. However, more sophisticated models differentiate between inelastic and elastic demand.

Price elasticity refers to the percentage change in the quantity of a good demanded resulting from a 1% price change. If demand is inelastic, price alterations have a rapid effect. On the other hand, customers who are slow to be discouraged from buying as prices increase demonstrate elastic demand. The second scenario occurs when a product cannot be easily substituted or provides value through high quality. Similarly, buyers who are not attentive spenders or find searching for lower prices challenging are flexible in the prices they will pay.

CONTINUED IN PART 2.

Pricing strategy in B2B markets: Product factors (2/3)

In Management on April 16, 2013 at 3:47 pm

Price target

Product

Analysing demand elasticity soon reveals that product and market factors enable or constrict businesses in setting prices. At the most basic level, the cost of producing a market offering usually needs to be covered by its selling price. Businesses aiming to achieve a certain rate of return will price to gain a percentage of profit in addition to covering costs of production.

Cost based prices are easy to administer and use in forecasts, but come with several drawbacks. Firstly, the rationale of this pricing system (price = costs + profit %) means that cost reductions do not increase the profitability of the sale of individual units. Further, companies risk missing opportunities to profit by selling products and services at a level below the maximum customers would be willing to pay.

Evidently, a more satisfying pricing structure would consider both product and demand conditions. Value pricing addresses this desire by considering the buyer side of the buyer-seller relationship. Buyer value (the worth of an object or condition, relative to competing offerings) is measured by weighing the costs incurred and benefits gained through the purchase of a good or service.

Customer perceived value = perceived benefits / perceived costs

According to theory of wealth maximisation, a consumer will choose the good or service which they believe provides the most favourable benefit to costs ratio. Perceived benefits include physical attributes, service attributes, associated prestige and technical support. Costs consist of purchase price, opportunity costs, risk of failure and other sacrifices made in the exchange. Companies create differential advantage based on superior benefits and/or costs.

A value pricing strategy charges in line with customers’ assessments of the benefits and costs promised by a purchase. This has the benefit of balancing considerations of customer goodwill with supplier profitability, and highlighting product lines which do not adequately meet the needs of a market.

Value pricing also considers external changes, such as the product lifecycle. A business producing a new product to address nascent consumer demand might opt for high initial prices to engage in ‘time segmentation’. ‘Time segmentation’ involves tailoring product offers to extract value from each stage of the product life cycle. In pricing this typically means using high initial prices to maximise profits from the inelastic demand in early adopter segments before reducing buyer costs for a more mainstream appeal and finally inventory reduction as the product becomes obsolete.

CONTINUED IN PART 3.

Pricing strategy in B2B markets: competition (3/3)

In Management on April 16, 2013 at 3:43 pm

17rhod600.1

Competition

Exclusivity is an element of value. Businesses without competition enjoy markets with inelastic demand conditions and can price accordingly.

Industrial component manufacturer, Parker Hannifin was able to transform its fortunes by establishing five categories of products, priced according to value. These included A items which were bought at high quantities in competitive markets and B items which were differentiated to add value. At the other end of the scale, items which were exclusively sold by Parker in the E category commanded high prices.

One of the most extreme effects of competition on price can be in price wars where firms repeatedly cut their prices in an attempt to win market share. Oftentimes, this is unsustainable and is only advisable if your business is starting from a position with a substantial cost advantage or if market share growth is clearly prioritised regardless of profitability concerns.

Conclusion

Price strategies offer tempting routes to competitive advantage. Not only does pricing clearly affect the profitability of sales, but it its easier and quicker to change than other areas of the marketing mix. However, pricing alterations should be adopted to achieve long term growth, not as a short term fix. This involves considering market conditions, including demand, product and competitive factors. Just as the customer considers the value of their purchase, so should business leaders evaluate pricing options. Costs must be justified by the benefits received in return.

Always Be Closing: the dirty business of direct selling

In Coaching, Management on April 13, 2013 at 9:01 pm

alec-baldwin-glengarry-glen-ross-always-be-closing (1)

It is indicative of the strains of direct sales, that the biggest issues facing customer-facing departments are the recruitment and retention of salespeople.

The sales function has an average labour turnover of 100% per annum. Small wonder! Salespeople can expect brusque rejection, high pressure targets, pick up deflected business risk and see skill go unrewarded, while ineffectual effort is recognised.

It’s a difficult job, but somebody needs to do it.

The six million involved in all variations of direct sales in the US are employed with a purpose. Teams of experts in face-to-face selling was conceptualised as a response to the burst of innovation and mass-production in the late 19th century. Firms suddenly had great need for a form of selling which consistently created need for products which the public did not understand, let alone want. The travelling salesman would pound pavements and knock doors, demonstrating why the latest output of Fordist manufacturing was an essential addition to their home.

By the 1920s, the essential characteristics of the profession had been etched. Attracting Attention, fostering Interest, forcing Decisions and driving Action continues to be the preserve of salesmen and saleswomen. Likewise, businesses knew which products benefitted from direct sales channels, namely experience goods which a demonstrable function in markets characterised by strong customer inertia and limited price transparency.

Direct selling was designed to meet the business needs of an era of transformation in manufactured goods. By going to possible customers and engaging them in a face-to-face meeting during which a sales representative hoped to create a urgency to purchase, direct sales pioneers found a way to quickly distribute products in advance of demand, at low costs (saving on promotions) and even passing the risk of failure onto the sales force.

This last point is particularly true of multi-level distribution systems which use independent contractors as salesmen. In this model, the sales force buy stock and the rights to sell in return for commission. The business is relieved of employment costs, but loses control over its sales force, the behaviour of which can establish or destroy a brand.

Recommended practice in direct sales mercilessly pushes for improved results. Managers encourage a vigorous culture of success, built on providing good careers for top salesmen and weeding out those who fail to meet the required number of conversions. Status is based on financial success, enshrined in tiered sellers clubs. Further, ostentatious consumption is institutionalised in schemes such as Eureka Forbes’ ‘Buy Your Own Bike’ incentive.

So, direct sales serve a unique and results-driven role in business. But brutalised and independently-minded salesmen are liable to strive to improve their lot by acting opportunistically. This includes jumping ship for a more attractive role in another business. Salesmen are a necessary part of business, but salesmen may not be tied to their firms until they are seen as a long term investment.

Why we buy (2/2): social spending

In Management, Marketing on April 10, 2013 at 3:40 pm

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Psychological models provided much-needed insight into non-rational motivations. Sociologists became active in this field, recognising the social nature of purchase decisions. When we buy shoes, we may consciously emulate our peers, weigh their symbolic value and their suitability against the ‘habitus’ of the social ‘world’ we occupy, even before questioning their durability and comfort. Snowden (2009) found, for instance, that SUV drivers strongly identified with their ownership in-group.

The contribution of sociologists

Maslow established a hierarchy of rational and non-rational needs in 1945, unwittingly setting the model for marketer’s understanding of consumer needs, wants and desires. A need complies with the bottom of Maslow’s hierarchy, something required for physiological comfort, health or survival.  The higher levels needs of a sense of belonging, esteem and self-actualising activity represent a spectrum of intangible desires which goods can fulfil.

A woman might need to carry her diary, purse and spectacles, but she wants a Gucci handbag because of the status gained from owning it. Hirsch (1979) would describe the Gucci bag as a ‘positional good’, because it places its owner in a particular social role by association.

The importance of being ‘seen’ as owning representational goods is at the heart of conspicuous consumption, a theory established by Veblen in 1899. Veblen and Hirsch have been criticised for assuming that every consumer purchase in emulation of higher social groups. In doing so, they do not account for peer pressure to reject the behaviours of other groups. The bitterness towards middle class grocers Waitrose was publically revealed when its ‘#WaitroseReasons’ Twitter promotion was hijacked by tweets such as ‘I shop at Waitrose because … I don’t like being surrounded by poor people.’

Human capital

Bourdieu (1979) helped to set purchase decisions into their social context in his writing on human capital. In his theory, consumers can be grouped by their economic capital (material/financial wealth), cultural capital (education/aesthetic tastes) and social capital (network of friends/influencers/family). An individual’s human capital, therefore, places them in a distinct social ‘world’.

These worlds come with their own fashions, ‘habitus’ (social norms and habits) and sanctions. For example, members inclined to the mod subculture by economic, cultural and social conditions are more likely to buy into a nexus of goods, including the iconic motor-scooter, suit and shades.

Bourdieu’s understanding is flawed, more representative of the separate class cultures of France, than the Western world as a whole. Moreover, he neglects Galbraith’s (1950) ideas of external factors, such as marketing, imposing wants on social groups.

Conclusion

So, are we left with merely a handful of imperfect theories? Yes, but theories which can build upon each other to bring us nearer to the truth. Reflect on our economic, psychological and behavioural explanations next time you are scanning the shelves.

Why we buy (1/2): understanding consumer purchase decisions

In Management, Marketing on April 10, 2013 at 3:36 pm

ishop

We live in a mass consumption society. The majority of citizens have access to a range of standardised and mass-produced goods. We can all relate to models describing the stages of consumer decision-making: need recognition, information search, evaluation of alternatives, purchase and post-purchase behaviour.

When a large proportion of our daily purchase decisions are routine and almost reflexive, it is easy to forget the complexity of the transactions occurring over tills and online shopping baskets. In fact, experts remain divided between 3 ways of thinking about consumer purchase decisions.

Model Economic Psychological Consumer behaviour
Basis Rationality Cognitive processes Mixed economic and psychological
Evidence Quantitative Qualitative Mixed
Used by Economists Sociologists Marketers

(To view click article heading for full display)

Neoclassical economics

Over time, business has taken to each type of model and is currently enamoured by hybrid explanations of consumer behaviour drawing on economic and psychological models. The most famous of these describes demand as being based on price. This idea stems from neoclassical economics which regard the consumer as a rational actor who should demonstrate consistent preferences between goods based on value. Logically, therefore, consumer demand will increase as price decreases, with products being substituted because of a change in income or the relative price of goods.

s and d

Neoclassical Supply and Demand Curve

This curve persists as the foundation of many business decisions. For example, the prices at which Nestlé can procure coffee are determined by supply and demand calculations in world commodity markets. Setting prices according to demand affects Nestlé’s fair trading commitments. The multinational protects against this by advising producers in how to increase payment (take on processing stages, sell directly) and reduce costs (share processing/transport facilities).

However, neoclassical economics have become part of a wider picture as experts have realised that few markets exist with the perfect information required for consumers to be so logical. A more complicated picture of consumer motivations has emerged.

Consumer information-gathering process

One criticism of neoclassical readings of purchase decisions is that they assign a minimal role to marketing. Our current understanding is based on a more contextual view. Namely, the influence of marketing on a purchase decision is determined by the nature of the good in question. Phillip Nelson distinguished 3 types of consumer good.

Type Search goods Experience goods Credence goods
Definition Characteristics identifiable through inspection Features revealed by consumption Value hard to measure even after consumption
Examples Glassware, camera Wine, cosmetics Vitamins, maintenance
Impact of marketing Positive relationship between advertising and product quality Advertising plays an important signalling role Advertising plays an important signalling role

Technology can turn experience goods into search goods. Klein (1998) argues that the internet has had this effect by lowering the search costs of certain product attributes (for example, accessing a rotational view of a car without being at a showroom) and providing ways of experiencing products virtually without direct inspection (e.g. software).

CONTINUED IN PART 2 …

The value of marketing

In Marketing on April 9, 2013 at 2:45 pm

marketing

Marketing is the activity of creating, communicating, delivering or exchanging offerings with customers.  As one of the functional areas of business, the end-goal of marketing must be aligned with the purpose of companies more generally.

Profit (buying low and selling high) is often cited as the purpose of business. While profit is a necessity, profit maximisation is damaging to businesses’ long-term prospects. Iceland posting record results in June by not chasing short-term profit targets (Retail Week, 2012).

Drucker (1986) proposes different priorities: “Businesses exist to supply goods and services to customers, rather than to supply goods to workers and managers, or even dividends to the business enterprise.”

Exxon connects its responsibilities: “Our mission is to provide quality petrochemical products and services in the most efficient and responsible manner to generate outstanding shareholder and customer value.” (Exxon, 2012)

Economic profit validates actions which create customers. Only by meeting customer needs and building customer relationships can an organisation achieve profitable growth (Doyle, 2000). By these means, marketing creates value for customers in order to capture value for the business and its shareholders.

Consequently, the value created by marketing can be considered from the buyer perspective (competitive offer), the seller perspective (customer equity) and the buyer-seller perspective (relationships, partnerships and alliances).

Buyer value (the worth of an object or condition, relative to competing offerings) has been measured in various ways.[1] Today, relativism dominates the discourse on customer value. Marketing’s definition of customer value accounts for this:

Customer perceived value = perceived benefits / perceived costs

According to theory of wealth maximisation, a consumer will choose the good or service which they believe provides the most favourable benefit to costs ratio (Kronman, 1980). Perceived benefits include physical attributes, service attributes, associated prestige and technical support. Costs consist of purchase price, opportunity costs, risk of failure and other sacrifices made in the exchange. Companies create differential advantage based on superior benefits and/or costs.

Conclusion

Marketing has great potential to create value for firms and customers. In contrast to previous business philosophies, the marketing concept focusses on building profitable buyer-seller relationships based on competitively satisfying customer needs. Marketing’s assured philosophical foundations are attractive in the uncertain context of the global integration of markets, rising consumer expectations and transformative technologies.

By managing long-term relationships and responding to customers’ needs, rather than encouraging short-term profit, marketing has become a driver of competitive growth with benefits to all business stakeholders reflected in increases in share value.


[1] Neoclassical economics posits value is determined by the market. In classical economics, value describes the amount of labour saved through the consumption of an object or service. ‘Real value’ measures the utility of market offerings (Peter and Olson, 1993).