Fundamentals of Accounting Business Finance 14. Long-Term Finance – Sources & Features This topic will help you in achieving a basic level of understanding on the options that a Company has in obtaining finance for its various growth initiatives as well as its longer term viability.
14.0 Objectives After going through this lesson, you will be able to: • •
Understand the need for a particular type of financing that a Company may choose or has chosen Able to differentiate between the advantages and disadvantages of various options over other.
14.1 Introduction Long term financing refers to funding for periods over 1 year. Whether it is an established corporation or a new business entity, it is common for small and large companies to have some kind of debt throughout the life of their business. These businesses normally turn to lenders not only to expand their companies or to purchase equipment, but also to finance operating capital in order to even out cash flows.
14.2 Uses of Long - Term Debt Financing • • • • •
Fixed Assets Large Capital Equipment Purchases Large Scale Construction Projects Expansion and / or Upgradation of Facilities Operating capital Once the cost of the same has been estimated, the means of finance is to be finalized. This has an impact on profitability and should, therefore, be evaluated carefully.
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Self-Check Questions Answer True or False 1. Long Term Debt can be used for the purchase of new machinery. 2. Purchase of a Car by CEO for his wife can be financed through Long Term debt
14.3 Sources of Long - Term Finance 1. Share capital a. Equity Shares. b. Preference shares. 2. Retained earnings. 3. Debentures/Bonds of different types. 4. Loans from Commercial banks & Financial institutions. 5. Venture capital funding / seed capital funding 6. Deferred credit 7. Asset securitization 14.3.1 Share Capital The most important source of long-term finance for a limited company is usually Share capital which refers to capital that is raised from the owners of the business, as shareholders, as well as the public. Share Capital is raised through the sale of shares to individuals or institutions, who in return for their investment receive interest in the form of a dividend, which constitutes a share of the profits made by the business. In addition the shareholder may be able to make a Capital Gain on their investment by selling their share holding at a later date. The different types of Share Capital are: •
Equity Share Capital: the majority of Share Capital will be raised through the issue of Equity Shares. Equity Shareholders, are the legal owners of the business, and are entitled to full shareholder voting rights at meetings – the Annual General Meeting (A.G.M.), or at Extra-Ordinary General Meetings (E.G.M.s). They are entitled to receive returns out of the company’s profit, in the form of Dividends. Unfortunately, such dividends are dependent on the performance. Further there is considerable risk involved in being an Equity Shareholder, particularly if the business is declared insolvent. However in good years the dividend payout, and potential Capital Gain, may be high enough to justify this risk The advantages to the Company of Equity capital are:
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o Dividend payment is not obligatory. Thus if the business has had a particularly poor year, the Directors of the company may decide that a dividend is not paid to the equity shareholder o It is permanent capital until liquidation of the Company The disadvantages are: o Dividend payable by the Company is not a tax deductible expense o Issuance of share capital results in dilution of control Another form of raising equity share capital is through American Depository Receipts (ADRs). An ADR is a dollar-denominated negotiable certificate that represents ownership of shares in a non-U.S. company. The structure of an ADR includes a ratio, which correlates the amount of underlying shares to the receipt. An ADR can be canceled for its underlying shares at anytime. The name Global Depository Receipt (GDR) is a generic term describing structures deployed to raise capital either in dollars and/or euros. •
Preference Share Capital: Preference capital is a hybrid form of capital between equity and debt (discussed later). It is designed for investors who do not wish to take the degree of risk associated with being an equity shareholder. While the claims of the preference share holders are above those of equity shareholders, they are sub-ordinate to the claims of all other stakeholders of the company. Preference shares offer a guaranteed dividend, at a fixed percentage of the face value. However, this is not a tax deductible expense. At the same time, the Companies Act requires that preference shares be redeemed within a maximum period of 20 years, which, alongwith the fixed nature of dividend gives them characteristics of debt. The advantage of issuing such shares is that while they get included in Net Worth, the Preference shareholders are not strictly owners of the business and therefore have limited voting rights, in comparison to the Equity Shareholder.
14.3.2 Retained Profit A major source of long-term finance for a business is retained income, i.e. Profit which is not distributed to the shareholders in the form dividends at year end, but instead retained within the business. The profit retained by the business over the years can be seen in the Profit & Loss Account on the company’s Balance Sheet. One of the advantages of this form of internal finance is the savings in cost, when compared to external sources of finance. Further, the end use of such funds is not directed by any external financial institution. 14.3.3 Debentures Debt can be raised through the issue of instruments referred to as debentures. Debentures are normally associated with limited companies. The investors, called debenture holders, are deemed as creditors to the business and not owners, and will receive interest payments from the company until, at
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an agreed date, the loan is redeemed, i.e. paid back in full. This interest paid by the Company to its debenture holders is tax deductible, like any other form of debt. Most debentures are secured, in that the holder of the debenture will have claim over either specified assets of the business should the business default on interest payments, or claim over general assets of the business up to the value of the debenture loan. Further, there is no restriction to the tenor of issuance of such debentures though, typically, the tenors range from 5 years upto 10 years. Debentures may be fully convertible into equity shares at some later date (referred to as fcds), partly convertible (pcds) or Non-convertible (ncds). When such instruments are issued in Euromarkets to raise debt in foreign currency, they are called as Euro Convertible Bonds (ECBs), which carry an option to convert the bonds into equity shares at a rate specified. 14.3.4 Term Loans Loans of longer tenors, given by financial institutions or banks are referred to as term loans. These, typically, have a range of between 5 years and more. Term loans are given in order to provide an organization with working capital to acquire assets or inventory, or to set up new projects as also for upgradation / expansion or modernization of existing projects. The term loan is the most common form of intermediate-term financing arranged by commercial banks & financial institutions, and there is wide diversity in how it is structured. Foreign currency term loans are generally given for import of equipment and technology or for technical know-how. Term loans are paid back from profits of the business, according to a fixed amortization schedule. These loans are secured by way of a first charge on the underlying assets which are financed and a second charge on other assets of the company. Loan interest normally is payable monthly, quarterly, semi-annually, or annually. At the same time, most loans contain both affirmative and restrictive Covenants that impose certain conditions on the borrower that permit acceleration of the maturity if the loan conditions are violated. The lender may, for example, restrict cash dividends paid and usually will require the borrower to maintain the business in good order, keep adequate insurance, and file quarterly financial statements with the bank. Larger borrowings often are financed by several banks through a Syndication arrangement 14.3.5 Venture Capital Venture capital refers to financing, provided by investors (venture capitalists) to startup firms and small businesses with perceived, long-term growth potential. This is a very important source of funding for startups promoted by entrepreneurs that do not have access to capital markets. It typically entails high risk for the investor, but it has the potential for above-average returns. Venture capital can also include managerial and technical expertise. Most venture capital comes from a group of wealthy investors, investment banks and other financial institutions that pool such investments or partnerships. 4
This form of raising capital is popular among new companies, or ventures, with limited operating history, which cannot raise funds through a debt issue. At the same time, venture capitalists will require shares in the business and influence in the running of the company at a strategic level, to protect their investments, normally in the form of a non-executive position on the board. Their aim is to see the value of their shares in the business grow, so that at some latter date they may sell their interests in the business at a profit. Often this may involve the business being floated on the stock-exchange. Similar to this, is the seed capital assistance provided to small and medium ventures started by generally first generation entrepreneurs who are technically qualified but do not have the sufficient resources. This type of finance, mostly at low rates, is provided by government bodies. 14.3.6 Deferred Credit Suppliers of equipment often allow the buyer to pay in installments. The period of the credit, and the finance charges depend on the credit standing of the buyer & the value of equipment. Hire purchase is a common application of this concept which allows a buyer, who cannot afford to pay the asked price as a lump sum but can afford to pay a percentage as a deposit, to enter into a contract which allows the buyer to hire the goods for a monthly rent. When a sum equal to the original full price plus interest has been paid in equal installments, the buyer may then exercise an option to buy the goods at a predetermined price (usually a nominal sum) or return the goods to the owner. If the buyer defaults in paying the installments, the owner can repossess the goods. 14.3.7 Securitization This refers to the process of conversion of loans given (asset side) and other assets into marketable securities for sale to investors. Securities offered for sale can be purchased by banks, institutions or non-bank investors. By securitizing credit receivables, Companies are able to remove assets from the balance sheet if certain conditions are met, thereby boosting its capital ratios. Securitization also redefines the definition of asset quality, and loan underwriting standards, because lenders will be looking at loan quality more in terms of their marketability in the capital markets than probability of repayment by the borrowers. For regulatory reporting purposes, a loan that is converted into a security and sold as an asset-backed security qualifies as a sale of assets. The seller retains no risk of loss from the assets transferred and has no obligation to the buyer for borrower defaults or changes in market value of securities sold. Asset transfers where the buyer has Recourse against the selling institution are treated as financings or a borrowing secured by assets.
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Self-Check Questions Give Short Answers to following questions: 3. List advantages of Equity Share capital 4. List the disadvantages of Equity Share capital 5. What does Preference capital tell you about the risk level of investor holding such shares? 6. List two advantages of Retained Earnings as a source of finance 7. What are the different types of Debentures? 8. What types of businesses need venture capital? 9. Define securitization
14.4 Summing Up You have seen how a Company, looking to expand its operations or streamline its cashflows, has various options before it, in terms of deciding the most optimal solution, based on all relevant factors.
14.5 Answers to Self-Check Questions 1. True 2. False 3. Advantages of Equity Share capital are: i) Dividend payment in not obligatory. ii) It is permanent capital until liquidation of the Company. 4. Disadvantages of Equity Share capital are: i) Dividend payable by the Company is not a tax deductible expense ii) Issuance of share capital results in dilution of control 5. What does Preference capital tell you about the risk level of investor holding such shares? 6. The advantages of Retained Earnings as a source of finance are: i) Saving in cost, compared to external sources of finance. ii) The end use of such funds is not directed by any external financial institution. 7. Debentures can be fully convertible into equity shares at some later date (referred to as fcds), partly convertible (pcds) or Non-convertible (ncds). 8. Startup business promoted by entrepreneurs that do not have access to capital markets need venture capital. 9. The process of conversion of loans given (asset side) and other assets into marketable securities for sale to investors is known as Securitization
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14.6 Terminal Questions 1. Describe the various forms of equity capital that a Company may issue. Compare the characteristics of the forms of capital i.e. on the basis of return, voting rights, claims etc. 2. Enumerate the characteristics of debentures and term loans as sources of long term finance. What are the key differences between the two? What could be the possible advantages of one over the other? 3. What does securitization refer to and what are the distinct advantages in this form of financing, from both the borrower and the lender’s perspective? 4. Describe the key aspects of debt in understanding a Company’s health
14.7 Glossary • • • • •
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Share Capital: This refers to capital that is raised from the owners of the business, as shareholders, as well as the public Retained Profit: This is Profit which is not distributed to the shareholders in the form dividends at year end, but instead retained within the business Debentures: An instrument used to raise debt Term Loans: Loans of longer tenors, given by financial institutions or banks Venture Capital: This refers to financing, provided by investors (venture capitalists) to startup firms and small businesses with perceived, long-term growth potential Securitization: This refers to the process of conversion of loans given and other assets into marketable securities for sale to investors
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