Business Finance

The fundamental choice in financing is between equity (ownership stakes) and debt (borrowing). Each has distinct characteristics:

Gearing (leverage) effect: Adding debt increases RETURNS to equity when things go well (the "benefit of leverage") but AMPLIFIES losses in bad times. High gearing = high financial risk. The optimal gearing is a balance between the tax benefits of debt and the increased bankruptcy and agency costs.

Pecking order theory (Myers, 1984): In practice, firms seem to prefer financing sources in this order:

1. Internal finance (retained earnings) — no issue costs, no information asymmetry problems
2. Debt — when internal funds insufficient. Cheaper than equity; less signal to market
3. Equity — as a last resort. Issuing equity signals to the market that managers think the shares are overvalued (information asymmetry), so the share price often falls on announcement

Ordinary shares (common stock):

• Basic ownership units — residual claim on profits and assets
• Voting rights (typically one vote per share)
• Dividends are variable and at the directors' discretion (subject to Companies Act and distributable reserves)
• Holders benefit most in success (no cap on upside) but bear first losses

Preference shares:

• Preferential right to dividends (paid before ordinary dividends) — typically at a fixed rate (e.g., "5% preference shares")
• Priority over ordinary shareholders in liquidation
• Usually no voting rights (unless in arrears of dividends)
• Varieties: cumulative (arrears accumulate and must be paid before ordinary dividends) vs non-cumulative; participating (entitled to extra dividend if company profits are high) vs non-participating; redeemable vs irredeemable; convertible vs non-convertible
• Hybrid character — sit between equity and debt
• Classification under IAS 32: Mandatorily redeemable preference shares are LIABILITIES (not equity) because the entity has a contractual obligation to deliver cash. Irredeemable preference shares with discretionary dividends = equity.

Rights issue:

• New shares issued to existing shareholders at a discount to market price
• Protects existing shareholders from dilution if they take up rights
• "Rights" are tradable — a shareholder who doesn't want to subscribe can sell them to someone who does
• Lower costs than a public offering (no underwriting, listed-company fees, marketing)
• TERP (theoretical ex-rights price) — see EPS topic for TERP calculation in relation to earnings per share
• Popular for established listed companies needing extra equity

Initial Public Offering (IPO):

• First issuance of shares to the public — "floating" the company
• Generates cash AND provides a secondary market for existing shareholders to sell
• Advantages: access to larger pool of capital, liquidity for existing holders, public profile and credibility, currency for acquisitions (can use shares)
• Disadvantages: significant costs (underwriting typically 5-7% of proceeds, legal, advisory, accounting fees; ongoing listing fees), public disclosure obligations, regulatory burden, pressure for short-term performance, risk of being taken over
• Methods: offer for sale (at fixed price or by tender), placing (shares placed with institutional investors), introduction (existing shares listed with no new issue), stock exchange listing (main market, AIM for smaller companies)

Private placements and institutional investment: Issuing shares to a small number of institutional investors (pension funds, insurance companies, asset managers). Lower costs than IPO; faster; but narrower investor base and potentially less liquidity.

Bank loans:

• Term loans: fixed amount borrowed, repaid over a fixed term (typically 1-10 years), regular interest payments. Can be secured or unsecured.
• Revolving credit facility (RCF): a pre-arranged limit the company can draw and repay flexibly (like a large business overdraft). Used for working capital fluctuations. Often committed (bank must lend up to limit) with commitment fees.
• Syndicated loans: large loans (often £50m+) shared between multiple banks (the syndicate). Spreads risk. Lead bank (agent) coordinates.
• Covenants: lenders often impose restrictions — maximum gearing, minimum interest cover, limits on disposals or acquisitions, dividend restrictions. Breach triggers default.

Bonds and debentures:

• Bonds: tradable debt securities, typically with maturity 5-30 years. Sold to institutional and retail investors. Interest paid as coupons (typically semi-annually).
• Debentures: in UK usage, a bond secured by a charge (fixed or floating) over assets. Sometimes used more broadly for any corporate bond.
• Secured bonds: specific assets pledged as security. Lower interest rates due to reduced risk.
• Unsecured bonds: general claim on company assets. Higher interest rates.
• Subordinated bonds: rank below other debt in liquidation. Higher returns to compensate.
• Issue process: similar to equity — prospectus, regulatory approval, underwriting by investment banks. More expensive for small issues; efficient for large ones.
• Credit rating: agencies (Moody's, S&P, Fitch) rate bonds — investment grade (BBB-/Baa3 or above) vs speculative/high-yield/junk (below investment grade). Rating affects interest rate.

Hybrid instruments:

• Convertible bonds: bonds that can be converted into shares at a set conversion ratio. Bondholder gets upside if share price rises AND protection if it doesn't (still receives interest and principal). Issuer typically pays a lower interest rate than on straight debt. Split into liability and equity components under IAS 32 (see Financial Instruments topic).
• Warrants: rights to buy shares at a fixed price for a certain period. Often issued alongside bonds to "sweeten" the offer. Unlike convertibles, warrants require additional cash to exercise.
• Mezzanine finance: subordinated debt with equity features (often warrants attached). Used in LBOs and growth financing. Higher interest rates than senior debt; below equity in cost.
• Hybrid capital securities: perpetual or long-dated bonds with deeply subordinated status — may have features closer to equity (e.g., coupons can be deferred). Popular for bank capital under Basel rules.

Other debt forms: commercial paper (short-term unsecured corporate debt, maturity typically <270 days — used for short-term funding by large creditworthy companies); Eurobonds (bonds issued outside the currency's home country); Islamic bonds (Sukuk — see Islamic finance section); green bonds (see financial innovation section).

Leasing: Obtaining the use of an asset without buying it. The lessee pays the lessor over time.

Finance lease vs operating lease (lessor perspective under IFRS 16):

• Finance lease: transfers substantially all risks and rewards of ownership. Economic substance: the lessee is effectively buying the asset with financing. Lessor accounts for it as a finance receivable; recognises interest income.
• Operating lease: does not transfer substantially all risks and rewards. Lessor retains asset on balance sheet; recognises straight-line rental income.
• From lessee perspective (IFRS 16): SINGLE on-balance-sheet model — ROU asset + lease liability for virtually all leases (except short-term and low-value — elections). See the Leases topic in FAR.

Advantages of leasing:

• Access to assets without large upfront cash outlay — useful for growing businesses
• Typically 100% financing (vs bank loans often requiring deposit or equity contribution)
• Lessor retains ownership — may be more willing to lend (less credit risk) than a bank making an unsecured loan
• Can include maintenance and service (particularly for operating leases)
• Asset can be upgraded/replaced at lease end (operating leases — transfers obsolescence risk to lessor)
• Tax treatment: lease payments generally deductible for tax; lessor may claim capital allowances

Disadvantages:

• Total cost over life often higher than purchasing (lessor's profit margin)
• Lessee does not own the asset at the end (unless purchase option exercised)
• Contractual commitments to make lease payments can constrain financial flexibility
• Under IFRS 16, on-balance-sheet treatment no longer provides "off-balance-sheet" benefit

Sale and leaseback: Entity sells an asset (usually property) and immediately leases it back. Generates cash (release equity tied up in property) while retaining use of the asset. See Leases topic in FAR for accounting treatment.

Venture capital (VC):

• Equity investment in high-growth companies, typically early-stage or scale-up
• VC firms raise funds from institutional and wealthy investors; invest in portfolios
• Target high returns (e.g., 3-10x investment) to compensate for high failure rate
• Expect exit via IPO or trade sale within 5-10 years
• Usually take significant ownership stake (20-50%), board seat, influence on strategy
• Stages: Seed, Series A, Series B, Series C and later
• Adds value beyond capital — experience, networks, mentoring

Private equity (PE):

• Larger, more mature businesses than VC typically targets
• Typically acquires controlling stakes in established companies, often via leveraged buyouts (LBOs) with substantial debt
• Transforms operations, grows revenue/profits, exits in 3-7 years (IPO, trade sale, secondary buyout)
• Target returns 20%+ per year

Crowdfunding:

• Rewards-based: backers receive a product or reward (Kickstarter, Indiegogo). No equity or debt — suits product launches.
• Equity crowdfunding: many small investors take equity stakes (Seedrs, Crowdcube). Accessible to SMEs without formal VC routes.
• Peer-to-peer (P2P) lending: online platforms matching borrowers with lenders (Funding Circle, Zopa). Alternative to bank finance.
• Advantages: access to finance when traditional sources may refuse; platform brings marketing benefits; community of backers
• Challenges: public failure risk if the campaign doesn't succeed; regulatory scrutiny growing

Government grants and tax incentives:

• Grants: direct funding for specific purposes (R&D, regional development, export support, green initiatives). Often competitive applications. Not repayable if conditions met.
• R&D tax credits: SME relief (up to 186% enhanced deduction or payable credit for loss-makers) and RDEC scheme for larger companies
• Patent Box: reduced tax rate on profits derived from patents
• Regional development grants and enterprise zones
• Innovate UK, British Business Bank — specific schemes

SMEs face distinctive financing challenges that larger companies do not:

The "funding gap":

• Information asymmetry: SMEs lack the track record and public disclosure of listed companies. Lenders/investors cannot easily assess creditworthiness.
• Higher risk: SMEs have higher failure rates, especially in first 5 years
• Limited collateral: asset-light businesses (especially service/tech) have few assets to pledge as security
• Small loan sizes: administrative costs proportionally higher per £ lent — banks prefer larger borrowers
• No public markets: cannot access bond or public equity markets directly
• Concentration risk: owners often have most wealth tied up in the business — cannot diversify

Solutions and sources for SMEs:

Specific SME advice — matching source to need:

• Long-term strategic investment in growth: equity (VC, angel, EIS) — long payback, high risk
• Asset purchase: asset-based finance (leasing, HP) — asset provides natural security
• Working capital needs: overdraft, RCF, factoring, invoice discounting
• Trading finance: trade credit, supplier early-payment discounts, factoring

Short-term finance (typically repayable within one year) is used for working capital needs — bridging the gap between the outflow on inventory/costs and the inflow from customer payments.

Bank overdraft:

• Facility to go into deficit on a current account up to an agreed limit
• Flexible — interest only charged on amount used
• Typically REPAYABLE ON DEMAND (unless explicitly committed) — bank can withdraw facility, creating serious liquidity risk
• Higher interest than loans; used for short-term fluctuations
• Reviewed periodically by bank (e.g., annually)

Trade credit:

• Buying from suppliers on credit (30, 60, 90 days terms)
• Usually "free" — no explicit interest, provided paid within terms
• BUT may lose an early payment discount. E.g., "2/10 net 30" — pay in 10 days get 2% discount, otherwise full payment in 30 days. The effective annual cost of not taking the discount can be very high (see worked example).
• Over-reliance risks damaging supplier relationships and supply chain

Factoring:

• Selling accounts receivable to a factor (finance company) for cash
• With recourse: factor can recover from seller if customer defaults. Seller retains credit risk. Receivables STAY on balance sheet (IFRS 9: risks/rewards not transferred — treat as secured borrowing).
• Without recourse: factor bears credit risk. Seller derecognises receivables. Higher fee.
• Factor typically advances 70-90% of invoice value immediately; balance (less fees) when customer pays
• Factor also provides collection services — customer pays factor directly, not the business
• Useful for businesses with long receivables periods or rapid growth (needs cash quickly)
• Cost: service fee (0.5-3% of turnover) + interest on advances
• Disclosure: customers see factor's name on invoices, which may suggest financial difficulty

Invoice discounting:

• Similar to factoring — cash advance against receivables
• Key difference: business retains CREDIT CONTROL (sales ledger management and collection). Customers unaware of the arrangement. Better for maintaining customer relationships.
• Usually provided on a confidential basis
• Less expensive than full-service factoring (since the factor doesn't manage the ledger)
• Typically "with recourse" — receivables stay on balance sheet

Supply chain finance (reverse factoring):

• Large buyer approves supplier invoices; a financier (bank) pays the supplier early at a discount based on the BUYER'S credit rating (usually better than the supplier's)
• Supplier gets paid sooner (improved cash flow)
• Buyer gets to hold onto cash longer (pays the financier at the original invoice due date)
• Financier makes a margin
• Growing in popularity; some accounting concerns about classification (trade payables vs debt)

Commercial paper:

• Short-term unsecured debt issued by large, creditworthy companies
• Maturity typically 1-270 days
• Cheaper than bank borrowing for eligible companies
• Sold to money market funds, institutional investors
• Market can close during credit crises (funding risk)

Worked example — cost of NOT taking early payment discount:

Terms: 2/10 net 30. Cost of not taking discount:

• Effectively, by not paying in 10 days, you get 20 extra days of credit for a 2% premium
• Annual cost = 2/98 × 365/20 = 0.0204 × 18.25 = 37.2% per annum
• This is equivalent to borrowing at 37.2% per annum — nearly always uneconomic unless the business cannot pay early
• Formula: (Discount%/Net price%) × (365/(Net days − Discount days))

Islamic finance operates under Sharia principles, which prohibit:

• Riba (interest on loans) — money should not earn money without risk-sharing
• Gharar (excessive uncertainty/speculation)
• Maysir (gambling)
• Investment in prohibited industries (alcohol, gambling, pork, adult entertainment, conventional finance)

Sharia-compliant financing replaces interest with profit-and-loss sharing, asset-backed transactions, and fees for services.

Main Sharia-compliant instruments:

Growth of Islamic finance:

• Rapid growth since 1970s; now ~$3 trillion global assets
• Major markets: Middle East (UAE, Saudi Arabia), Malaysia, Pakistan, UK (London is an Islamic finance hub)
• Appeals to Muslim investors, ethical investors more broadly, and as portfolio diversification
• Sukuk issuance by non-Muslim issuers (corporates, governments) accessing Islamic investor capital

At FM level: understand the core principles (no interest, asset-backed, profit/loss sharing) and the names/rough equivalents of the main instruments. Detailed structuring is beyond syllabus.

The financial landscape has evolved rapidly with new sources, platforms, and instruments. Key innovations relevant to FM:

Securitisation:

• Pooling illiquid assets (loans, receivables, leases) and selling them to investors as tradable securities (asset-backed securities or ABS)
• Allows originators to free up balance sheet, transfer risk, and fund further lending
• Common types: MBS (mortgage-backed), ABS (auto loans, credit card receivables), CLO (collateralised loan obligations)
• Role in 2008 financial crisis: complex securitisation of subprime mortgages amplified the crisis when defaults rose

Fintech lending platforms:

• Technology-driven lenders using data analytics and digital processes — faster decisions, lower costs
• P2P platforms (individuals lending to individuals/SMEs)
• Digital-only banks (Monzo, Starling in the UK)
• Invoice and supply chain finance platforms (MarketInvoice, Tradeshift)
• Alternative credit scoring using transaction data, social data, cash flow analysis

Cryptocurrency and digital assets (overview — at FM level):

• Cryptocurrencies: Bitcoin, Ethereum, stablecoins — decentralised digital assets
• Some companies hold cryptocurrency treasury reserves; a minority use as payment
• Initial Coin Offerings (ICOs) — novel method of raising funds via token issuance. Regulatory scrutiny.
• Central Bank Digital Currencies (CBDCs) — central banks' planned digital currencies (e.g., digital pound, e-CNY)
• Accounting: no clear IFRS treatment — typically intangible asset (IAS 38) or inventory (IAS 2) depending on use
• Highly volatile, regulatory uncertainty

Green and sustainable finance:

• Green bonds: proceeds ring-fenced for environmentally beneficial projects (renewables, clean transport, green buildings). Certified against standards (e.g., Climate Bonds Standard, EU Green Bond Standard).
• Social bonds: proceeds for social projects (affordable housing, education, healthcare)
• Sustainability bonds: proceeds for a mix of green and social projects
• Sustainability-linked loans (SLLs) / bonds: the coupon or interest rate varies depending on the issuer achieving pre-agreed sustainability KPIs (e.g., emission reduction, renewable energy %). Incentive-based.
• Transition finance: supports transition of high-emitting sectors to lower-carbon operations. Debated — some see as greenwashing if not credibly aligned with net-zero pathway.
• Carbon markets: trading of carbon emission allowances (e.g., EU ETS, UK ETS) or voluntary credits

Drivers of green finance:

• Climate risk increasingly recognised by investors, regulators, lenders
• TCFD (Task Force on Climate-related Financial Disclosures) and ISSB standards (IFRS S1 and S2) — mandatory disclosures on climate risk
• Net-zero commitments by countries and corporates
• Customer preferences and reputational considerations
• Potential "greenium" — lower yields on green bonds in some markets, reflecting investor demand

Risks in green finance:

• Greenwashing: misleading claims about environmental credentials. Growing regulatory focus (EU SFDR, UK anti-greenwashing rules).
• Inconsistent standards and definitions
• Limited historical data on performance of "green" financed projects vs conventional
• Transition risk for companies not adapting quickly to net-zero