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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.

 

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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

Imperilled Business Machines: the rise and fall and rise of IBM

In Finance, Management on January 21, 2013 at 11:14 am

IBM_PC_5150

IBM’s history reads like a thriller.

From its 1911 foundation, its character quickly emerges: professional, innovative and enigmatic – operating under the motto: ‘THINK’. From the 1950s to the 1980s IBM’s heroic rise was marked by large and farsighted investments. Under Thomas J Watson Jr. IBM produced the System/360 computer, computer languages, the hard and floppy disks, the supermarket checkout, an early ATM. The IBM PC stands out even among these impressive contributions. The computer was the most successful technology introduction of its time. Within a single month, unit sales had exceeded 5 year forecasts. In 1990, the company was the 2nd most profitable enterprise in the world and was believed to be set to benefit from the continued growth of the IT industry.

However, just as IBM was being lauded by many commentators as the ‘greatest company in the world’, the company succumbed to deep-seated structural problems and started bleeding profit at a startling rate. In 1991, the company’s earnings dropped to -$2.8bn, and would drop by 60% during each of the next 2 years.

IBM problems

(Click to enlarge) 

Beginning from basics

After initial attempts of cost cutting, which saw 40,000 leave the company, Loius Gerstner was appointed as the first outsider CEO in IBM’s history. While business analysts questioned whether Gerstner could save the technology multinational without an industry background, insiders knew that the real purpose of the appointment was to break the group up for sale.

Gerstner took control in April 1993 and began a revaluation of IBM’s competitive advantages from the perspective of their clients. In the first 2 months, Gerstner travelled thousands of miles visiting customers and analysts to one conclusion:

“They said repeatedly, ‘We don’t need one more disk drive company, we don’t need one more database company or one more PC company. The one thing you guys do that no one else can do is help us integrate and create solutions.’”

At the end of 1993, the CEO understood that selling of IBM’s businesses would be the worst possible course of action. Customers valued the scope of IBM’s products and expertise. He would respond by pushing for ‘One IBM’:

“[We had to change] the view that IBM was a group of fiefdoms. We needed to have a sense that we were going to operate as a team, as a global entity ….”

IBM solutions 1

IBM solutions 2

(Click to enlarge)

One IBM

Gerstner led IBM to transform its organisation, processes, culture and strategy to better serve customers. His and York’s cost control and efficiency drive made the group profitable: posting a profit of $382m in 1993, rising to $5bn by the end of 1994. IBM’s shift also complemented that of the global economy as a whole, as services became increasingly important in the 1990s. By 2000, IBM Global Services had grown into the world’s largest IT consulting and web services organisation, contributing 38% of IBM’s $88.4bn revenue.

Running the world: The surprising reality behind global oil

In Finance on November 13, 2012 at 10:48 pm

Black gold runs through the veins of industrial civilisation. A US Energy Information Administration estimate for 2011 placed world consumption at 87.42 million barrels of oil each day. As such, oil accounts for 32% of Europe and Asia’s energy consumption, 53% of the Middle East’s needs and is used to meet around 40% of Africa and North and South America’s energy requirements.

Majid Jafar, CEO of Crescent Petroleum predicts that gas and oil will play a dominance role in energy for at least the next half century. The importance of oil is unquestionable, so why is it so hard to determine who is in control?

Changes in the industry have reverberations which touch almost every level of our lives. To take an obvious example, when the world crude-oil market tightens and lowers inventories, petrol prices increase. When their behaviour has such a direct bearing on our everyday concerns, it is unsurprising that the titans within the field are well-known, if not well-loved. BP, Shell, Exxon Mobil are household names.

Yet, the reality is more complicated than the Fortune 500 would suggest. The multinational enterprises we view as being “Big Oil” are downright diminutive when compared with state owned firms.  National oil companies hold 70% of world oil reserves and an even greater proportion of remaining reserves of “easy oil”.

Oil companies controlled by kings, presidents and democratic governments enjoy privileged access to the natural resources of their countries. This provides an essential competitive advantage for companies like the Chinese Sinopec and China National Petroleum, the 4th and 5th largest oil and gas MNEs. Protectionism has made it difficult for privatised MNEs to gain a foothold in the Middle East, South America and Africa.

One of the largest producers of oil is Rosneft, Russia’s state-controlled oil company which is in a “strategic global alliance” with BP. Rosneft’s relationship with BP is set to be consummated with the Russian titan’s purchase of TKN-BP, placing Roseft in charge of more than 4 million barrels of oil production a day. The interaction between BP and government-controlled business under President Putin is indicative of the future, which might see MNEs entering previously forbidden territories as partners of the national government.

The protection afforded to nationalised businesses makes them uncompetitive internationally. When Saudi Arabia nationalized its oil industry in 1980, the country was producing more than 10 million barrels of oil per day. Within five years, production had fallen by more than 60%. Putin hopes to avoid strategic laziness, by using the expertise and experience of BP to tap Russia’s massive reserves.

In addition to political leaders who could strangle oil supply and raise prices, the market is hostage to fortune in a myriad other ways. For the past decade, world politics has had a cumulatively negative impact on the oil industry. The US military (the largest consumer of oil which isn’t a country) has been at war in Iraq and Afghanistan. Iraq’s production has been disrupted and the countries of the Arab uprisings face an uncertain future. Venezuela and Nigeria have suffered because of production problems. NATO has intervened in Syria and Libya and Israel threatens Iran.

The commodity markets gamble on the price of crude oil. With the household names of MNEs presenting a comforting illusion, the true numbers of variables should be recognised. The oil industry is affected by innovation, mergers, wars and state leaders. It is time we understood who controls the capacity to keep the world running.

Star in Stripes: The US may lead, but not dictate

In Finance, Management, Marketing on October 14, 2012 at 11:42 am

America might lead the Fortune 500, but there is a lot more to its dominance than cultural imperialism.

Today, individuals, corporations and nation-states are able to reach around the world farther, faster, deeper and cheaper than ever before.

Traditional globalisation theory argues that those companies capable of doing the same business or selling the same product worldwide will be rewarded by economies of scale. The logical end of this process would be homogenised global consumption. Market connections and advanced communication technologies are creating a single marketplace, but, in 2012, we are finding that the most successful multinationals are adapting their offer to local tastes.

The modern advance of globalisation occurred after WWII. American policymakers – Stimson, Patterson, McCloy and Howard C. Peterson – agreed with Forrestal that the long-term prosperity of the United States required open markets, unhindered access to raw materials and the rehabilitation of much – if not all – of Eurasia along liberal capitalist lines.

By guaranteeing a minimum standard of living through the Marshall Plan and European Payment Union, policy-makers created an environment characterised by stability in domestic prices and exchange rates, increasing trade and confidence in the future both sides of the Atlantic. Washington’s reaction to the divisions of the Cold War foreshadowed the integration of the late twentieth century.

America’s leadership in the integrated world market can be explained, in part, by understanding the American origin of many of the key institutions controlling the global economy today. For instance, the capital markets and multinational corporations which make up Friedman’s ‘Golden Straitjacket’ were forged in American and the United Kingdom. The world’s financial centres are led by Wall Street.

Moreover, the information revolution, also of American invention, has provided the tools of cultural transmission – satellite television and the internet – which can easily surpass national boundaries and form an arena in which cultures vie for attention.

Through its economic reach, the USA has come to exert a powerful cultural pull. Here, America held two major advantages. Firstly, the prevalence of English as the principle language for science, business and diplomacy and mass culture gave America a distinct advantage over Germany, France, Russia and Japan. Secondly, America has mastered modern media technology before other countries.

From the 1920s, American culture was disseminated through movies, modern music such as jazz and rock, publications such as newspapers, mass-circulation magazines and comic strips. The diverse domestic market serviced by Hollywood created a movie industry well-practised in producing films with messages, images, and story lines that had broad multicultural appeal. Americans’ huge appetite for the movies provided Hollywood with financial resources and production facilities unmatched the world over. Consequently, by 1951, 61% of the movies playing on any given day in Western Europe were American.

Coca Cola’s uptake the world over is an example of the enviable ability of American companies to excel in the globalised economy. By the mid-1990s, only 21 per cent of Coca Cola’s sales were made in the United States. The product, inseparable from its American origin, was overwhelmingly glugged overseas.

The impressive international sales since the late twentieth century drive fears of Americanisation today.  Ishal Ismail, owner of all Malaysian KFC outlets understands the appeal of American products:

Anything Western, especially American, people here love. They want to eat it and be it. I’ve got people in small [rural] towns around Malaysia queuing up for Kentucky Fried Chicken – they come from all over to get it. They want it to be associated with America. People here like anything that is modern. It makes them feel modern when they eat it. 

However, the success of global franchises is as much about new foodstuff, international sanitation standards, quality controls and affordable prices as cultural statements.

America is a powerful exporter of culture, but these fears tend to be exaggerated in two ways. Firstly, critics take American culture to be the antithesis to Europeanism and the enemy of the continent’s common cultural heritage. Secondly, theories of Americanisation oversimplify the process of cultural influence.

James Cantalupo, President of MacDonald’s International undermines the concept of Americanisation as a zero-sum game:

You don’t have two thousand stores in Japan by being seen as an American company. Look, McDonald’s serves meat, bread and potatoes. They eat meat, bread and potatoes in most areas of the world. It’s how you package it and the experience you offer that counts.

James Cantalupo’s appreciation of the give and take necessary to make an American product successful abroad makes a strong argument for viewing globalisation as consisting of the interaction of cultures over Americanisation. MTV is one of the definitive exports of American popular culture of the late twentieth century. Yet, press reports in early 1996 suggested that, in a number of diverse television markets around the world, MTV was losing ground to local imitators who adapt its formulas but use local language and locally popular performers.

Though the aspirations of poorer countries to emulate America’s modern standards stokes fears of cultural imperialism, for the most part American businesses thrive today because they offer products and experiences palatable the world over and carefully moderated to appeal to local markets. We are caught in an international interchange of cultures, creating hybrid forms, trends and a new idea of what it means to live beyond borders.