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teaching that you need to understand and sufficient to move on to more
esoteric aspects of finance should the need ever arise。
2
Finance 53
SOURCES OF FUNDS
There are many sources of funds available to businesses； however； not
all of them are equally appropriate to all businesses at all times。 These
different sources of finance carry very different obligations； responsibilities
and opportunities for profitable business。 Having some appreciation of
these differences will enable managers and directors to make an informed
choice。
Most businesses initially； and o。。en until they go public； floating their
shares on a stock market； confine their financial strategy to bank loans；
either long term or short term； viewing the other financing methods as
either too plex or too risky。 In many respects the reverse is true。 Almost
every finance source other than banks will to a greater or lesser extent share
some of the risks of doing business with the recipient of the funds。
Debt vs equity
Despite the esoteric names – debentures； convertible loan stock； preference
shares – businesses have access to only two fundamentally different sorts
of money。 Equity； or owner’s capital； including retained earnings； is money
that is not a risk to the business。 If no profits are made； then the owner and
other shareholders simply do not get dividends。 They may not be pleased；
but they cannot usually sue； and even where they can sue； the advisers
who remended the share purchase will be first in line。
Debt capital is money borrowed by the business from outside sources； it
puts the business at financial risk and is also risky for the lenders。 In return
for taking that risk they expect an interest payment every year； irrespective
of the performance of the business。 High gearing is the name given when
a business has a high proportion of outside money to inside money。 High
gearing has considerable a。。ractions to a business that wants to make high
returns on shareholders’ capital。
HOW GEARING WORKS
Table 2。1 shows an example of a business that is assumed to need ￡60；000
capital to generate ￡10；000 operating profits。 Four different capital structures
are considered。 They range from all share capital （no gearing） at one end
to nearly all loan capital at the other。 The loan capital has to be ‘serviced’；
that is； interest of 12 per cent has to be paid。 The loan itself can be relatively
indefinite； simply being replaced by another one at market interest rates
when the first loan expires。
Following the tables through； you can see that return on the shareholders’
money （arrived at by dividing the profit by the shareholders’ investment
54 The Thirty…Day MBA
and multiplying by 100 to get a percentage） grows from 16。6 to 30。7 per cent
by virtue of the changed gearing。 If the interest on the loan were lower； the
ROSC； the term used to describe return on shareholders’ capital； would be
even more improved by high gearing； and the higher the interest； the lower
the relative improvement in ROSC。 So in times of low interest； businesses
tend to go for increased borrowings rather than raising more equity； that is；
money from shareholders。
At first sight this looks like a perpetual profit…growth machine。 Naturally；
shareholders and those managing a business whose bonus depends on
shareholders’ returns would rather have someone else ‘lend’ them the
money for the business than ask shareholders for more money； especially if
by doing so they increase the return on investment。 The problem es if
the business does not produce ￡10；000 operating profits。 Very o。。en a drop
in sales of 20 per cent means profits are halved。 If profits were halved in
this example； the business could not meet the interest payments on its loan。
That would make the business insolvent； and so not in a ‘sound financial
position’； in other words； failing to meet one of the two primary business
objectives。
Table 2。1 The effect of gearing on shareholders’ returns
No gearing Average
gearing
High
gearing
Very high
gearing
N/A 1：1 2：1 3：1
Capital structure ￡ ￡ ￡ ￡
Share capital 60；000 30；000 20；000 15；000
Loan capital （at 12％） – 30；000 40；000 45；000
Total capital 60；000 60；000 60；000 60；000
Profits
Operating profit 10；000 10；000 10；000 10；000
Less interest on loan None 3；600 4；800 5；400
Net profit 10；000 6；400 5；200 4；600
Return on share capital = 10；000 6；400 5；200 4；400
60；000 30；000 20；000 15；000
= 16。6％ 21。3％ 26％ 30。7％
Times interest earned = N/A 10；000 10；000 10；000
3；600 4；800 5；400
= N/A 2。8 times 2。1 times 1。8 times
Finance 55
Bankers tend to favour 1 ： 1 gearing as the maximum for a business； although
they have been known to go much higher。 As well as looking at
the gearing； lenders will study the business’s capacity to pay interest。
They do this by using another ratio called ‘times interest earned’。 This is
calculated by dividing the operating profit by the loan interest。 It shows
how many times the loan interest is covered； and gives the lender some
idea of the safety margin。 The ratio for this example is given at the end of
Table 2。1。 Once again rules are hard to make； but much less than 3× interest
earned is unlikely to give lenders confidence。 （See later in this chapter for a
prehensive explanation of the use of ratios。）
BORROWED MONEY
Towards the lower…risk end of the financing spectrum are the various
organizations that lend money to businesses。 They all try hard to take li。。le
or no risk； but expect some reward irrespective of performance。 They want
interest payments on money lent； usually from day one； though sometimes
they are content to roll interest payments up until some future date。 While
they hope the management is petent； they are more interested in
securing a charge against any assets the business or its managers may own。
At the end of the day they want all their money back。 It would be more
prudent to think of these organizations as people who will help you turn a
proportion of an illiquid asset； such as property； stock in trade or customers
who have not yet paid up； into a more liquid asset such as cash； but of
course at some discount。
BANKS
Banks are the principal； and frequently the only； source of finance for 9 out
of every 10 unquoted businesses。 Firms around the world rely on banks
for their funding。 In the UK； for example； they have borrowed nearly ￡55
billion from the banks； a substantial rise over the past few years。 When this
figure is pared with the ￡48 billion that firms have on deposit at any
one time； the net amount borrowed is around ￡7 billion。
Bankers； and indeed any other sources of debt capital； are looking for
asset security to back their loan and provide a near…certainty of ge。。ing
their money back。 They will also charge an interest rate that reflects current
market conditions and their view of the risk level of the proposal； usually
anything from 0。25 per cent to upwards of 3 or 4 per cent for more risky or
smaller firms。
Bankers like to speak of the ‘five Cs’ of credit analysis； factors they look
at when they evaluate a loan request。 When applying to a bank for a loan；
be prepared to address the following points：
56 The Thirty…Day MBA
。 Character： Bankers lend money to borrowers who appear honest
and who have a good credit history。 Before you apply for a loan； it
makes sense to obtain a copy of your credit report and clean up any
problems。
。 Capacity： This is a prediction of the borrower’s ability to repay the loan。
For a new business； bankers look at the business plan。 For an existing
business； bankers consider financial statements and industry trends。
。 Collateral： Bankers generally want a borrower to pledge an asset that
can be sold to pay off the loan if the borrower lacks funds。
。 Capital： Bankers scrutinize a borrower’s net worth； the amount by
which assets exceed debts。
。 Conditions： Whether bankers give a loan can be influenced by the current
economic climate as well as by the amount。
Types of bank funding
Banks usually offer three types of loan：
。 Overdra。。s： Though technically short…term money as they can be called
in at a moment’s notice； these tend to form a part of the permanent
capital of a business； albeit a fluctuating one。
。 Term loans： Offered for set periods。
。 Government…backed loans： These are available to some types of business；
usually small or new ventures； where the banker’s normal criteria
might not be met； but the government would like to encourage the
sector。
Overdrafts
The principal form of short…term bank funding is an overdra。。； secured by
a charge over the assets of the business。 A li。。le over a quarter of all bank
finance for small firms is in the form of an overdra。。。 If you are starting
out in a contract cleaning business； say； with a major contract； you need
sufficient funds initially to buy the mop and bucket。 Three months into the
contract they will have been paid for； and so there is no point in ge。。ing a
five…year bank loan to cover this； as within a year you will have cash in the
bank and a loan with an early redemption penalty！
However； if your bank account does not get out of the red at any stage
during the year； you will need to re…examine your financing。 All too o。。en
panies utilize an overdra。。 to acquire long…term assets； and that overdra
。。 never seems to disappear； eventually constraining the business。
The a。。raction of overdra。。s is that they are very easy to arrange and take
li。。le time to set up。 That is also their inherent weakness。 The key words in
the arrangement document are ‘repayable on demand’； which leaves the
bank free to make and change the rules as it sees fit。 （This term is under
Finance 57
constant review； and some banks may remove it from the arrangement。）
With other forms of borrowing； as long as you stick to the terms and conditions；
the loan is yours for the duration。 It is not so with overdra。。s。
Term loans
Term loans； as long…term bank borrowings are generally known； are funds
provided by a bank for a number of years。
The interest can either be variable； changing with general interest rates；
or fixed for a number of years ahead。 The proportion of fixed…rate loans
has increased from a third of all term loans to around one in two。 In some
cases it may be possible to move between having a fixed interest rate
and a variable one at certain intervals。 It may even be possible to have a
moratorium on interest payments for a short period； to give the business
some breathing space。 Provided the conditions of the loan are met in such
ma。。ers as repayment； interest and security cover； the money is available
for the period of the loan。 Unlike in the case of an overdra。。； the bank
cannot pull the rug from under you if circumstances （or the local manager）
change。
Just over a third of all term loans are for periods greater than 10 years；
and a quarter are for 3 years or less。
Government Small Firm Loan Guarantee Schemes
These are operated by banks at the instigation of governments in the UK；
and in Australia； the United States and elsew
