Understand Organizations and the Financial System

What are the chief types of financial resources available to organizations and how can these funds be used efficiently? Is one financial source always better than another? Can every type of goal be achieved by relying on the same source of financing?

In this article, Organizations and the financial system will explore these questions by discussing the sources of financing potentially available to every type of organization, including those in the public and voluntary sectors. You will also look at why different organizations might opt for different sources of financing given their specific structures and goals.

The article consists of four sections:

1. An overview of financing Small and Medium Enterprises
2. The alternative funding source for Small and Medium Enterprises
3. Company financing: stock and bond issuance
4. Decision-making in the process of business financing

The first three sections will introduce you to the different sources of finance available to business organizations. You will learn how different businesses rely on different types of finance, examining examples to gain insight into how organizations raise finance in practice.

The activities in these sections will help you to understand the various financing solutions in different contexts and identify the most appropriate source of finance given a specific business structure.

Section 4 will provide an overview of the main ways in which financial resources might be used by organizations, such as for day-to-day operations or finance expansion projects. In the final part of this section, you will have the opportunity to apply what you have learned by going through a short scenario-based adventure.

1. An overview of financing Small and Medium Enterprises

Why do organizations need finance? Given the structure of the current socio-economic system, anyone with a goal needs some form of funding, even to perform basic day-to-day activities. Just think about the pocket money that children get to fund their first small expenses, or the various door-to-door fund-raising activities carried out by non-profit organizations. Of course, just as a child growing into adulthood requires more elaborate sources of finance to sustain increasingly complex objectives, organizations, too, must evaluate ways in which they can finance their goals.

Raising finance performs three main roles:

• It provides the money necessary to start up a business (e.g. to secure premises and/or equipment).
• It provides businesses with the funds required to fulfill their payment obligations and ensure the smooth running of their daily activities (e.g. payments to suppliers or staff wages).
• It equips businesses with the resources necessary to carry out expansion plans (e.g. through long-term investments).

Although in this section you will focus on different sources of finance suitable to various forms of business organizations, most of the sources of finance discussed should be understood as potentially available to every type of organization, including those in the public sector. Some of the types of financing discussed are also available to not-for-profit organizations, although you will not cover this aspect in detail.

2. Key sources of finance for business organizations

Although there are a variety of financial resources that are available to business organizations, there is not one source of finance that is better than another. The decision about the best financing option ultimately rests on a variety of considerations, such as the business ownership structure, its stage of development, and its future goals.

It is quite intuitive to see how the financing needs of newly established businesses could differ significantly from those of a well-established company. For example, for a business in its early stages, common financing options could be funds from the owner’s family, friends, or savings.

These types of funding will not be appropriate to sustain the complex business plans of established companies. Understanding the basic sources of finance and their features is essential for successful financial decision-making and business success, since identifying the best and most appropriate available sources is a vital step in reaching the goals set.

Before going into the details of the various sources of finance, it is useful to look at the overall picture. Broadly speaking, sources of finance can be categorized according to two main features:

• whether the finance is generated internally or externally
• whether the duration of the financing is long- or short-term.

3. The space dimension: internal and external sources of finance

Sources of finance can be either generated internally or raised externally. Internal sources of finance refer to resources that are generated from within, through business activities. External sources are retrieved from third parties. Amongst external sources of finance, it is possible to distinguish between equity financing (i.e. obtaining funds for the company by issuing shares) and debt financing (i.e. obtaining borrowed funds, for example, in the form of bank loans or, in the case of Plc’s, by issuing bonds).

Debt finance, which you will look at more closely in Section 2, only implies the payment of interest on the total amount raised. It does not mean sharing any part of the business’ decision-making process or legal ownership with the lender. By way of contrast, equity finance presumes that part of the business’ ownership and control over decisions is shared with investors.

4. The time dimension: short- and long-term finance

Financial sources can also be classified according to the period over which they are made available to the organization. Accordingly, it is possible to distinguish between short-term and long-term finance.

Short-term finance typically refers to any financing that will be paid back within a year, while long-term finance refers to any financing that will be repaid over several years. Short-term financing is typically used to finance temporary deficiencies in funds, such as those arising from a delay in payments from customers. In contrast, long-term financing is better suited to finance the acquisition of long-term assets such as plants and equipment. In general, bank overdrafts are considered an example of short-term finance, while bank loans are generally categorized as long-term finance.

When choosing between short-term versus long-term borrowing, the following elements should be considered:

What type of asset will the funds be raised for?

Long-term borrowings might be more appropriate for financing non-current assets such as property, plant, equipment, or intellectual property (e.g. patents). Current assets (e.g. raw materials), which are held for a short period, would be more efficiently financed by more flexible short-term borrowings.

What is the cost of short-term v. long-term finance?

Interest payments on long-term borrowing tend to be higher relative to those for short-term borrowing. This is because the lender requires higher returns to cover the longer period over which funds are loaned, as well as the higher risk associated with long-term borrowing. Despite this, since short-term borrowing must be renewed frequently, it could carry higher indirect costs, such as arrangement fees.

Table 1, below, summarises the different sources of finance that will be discussed according to the categorization described above.

Sources of finance

Internal sources of finance

Table 2 (a) summarises the sources of finance that you will cover in this course. You will start by looking at examples of internal sources of finance (emboldened in the tale), beginning with short-term examples and concluding with the most common source of long-term internal financing.

Sources of finance

Debt factoring

Once mainly used by large companies, but nowadays spreading across all organizations, debt factoring is a very well-established form of funding. In simple terms, it is a short-term way for a business to release funds that are blocked in the form of unpaid trade receivables by selling those debts to a third-party factoring company at a discount.

Debt factoring is particularly suitable for industries in which the production process is characterized by consistent delays in receiving payments for goods sold and services delivered. Import and export, wholesale and distribution, and logistics are examples of sectors that make extensive use of debt factoring.

To illustrate how this tool works in practice, think about a situation in which customers of a trucking company named Flash Trucks take up to two months to pay their bills. A delay in receiving payments such as this could create serious issues for Flash Trucks and could ultimately affect its ability to function properly. For example, how can it continue to maintain its fleet of lorries or pay for fuel and drivers? With factoring, the organization can be assured that it will receive payment for its services and continue to operate normally between the point of sale and the point at which its customers will pay.

Invoice discounting

Another means of internal funding is invoice discounting, which is similar to debt factoring in many ways except for one important difference. In this case, the third party (an invoice discounter) will carry out a mini audit of the business and its customers upon the receipt of a copy of an invoice.

The invoice discounter will then provide an agreed percentage of an invoice’s total value. As soon as the customer pays the invoice, the business will deposit the funds into a bank account that is controlled by the invoice discounter, who will then pay the business the remainder of the invoice, less any fees.

Unlike debt factoring, with invoice discounting it is the business itself that deals with the process of requesting money from its customers. Whilst this would be a viable option if the business is equipped with a dedicated office (e.g. a debt collection department), it could be more problematic for newly established businesses.

In comparison to debt factoring, an obvious advantage is that the seller and the customer are in a clearer, more direct relationship. Also, given the simpler service provided by the discounting company, invoice discounting usually has lower fees (usually around 0.5% to 1% of the sale value).

Both debt factoring and invoice discounting are ways of raising finance that can be very flexible. However, these two types of financing come with some disadvantages.

Working capital management

Two additional ways in which finance can be raised within a business are through the management of working capital.

Working capital is the difference between a company’s current assets and current liabilities.

Working capital = current assets − current liabilities

The working capital formula measures a company’s short-term liquidity. The components of working capital can be ‘managed’ for financing purposes. There are two main ways of managing working capital to provide funds for the business:

1. Depending on the specific type and condition of the products, reducing inventory levels (that is, selling the accumulated stocks) can provide short-term funding. However, a business should be aware of the risks that reducing inventories can carry, for example not being ready to accommodate any sudden increases in demand for its products.
2. Businesses may also manage their cash flows to provide liquidity by operating with negative working capital. This is the situation when the outstanding amounts due to creditors (payables) exceed those due to be received from customers (receivables). The ability to raise liquidity with negative working capital will depend on the importance that the business places upon a reputation as businesses running negative working capital risk exposure to reputational damage. This could affect the terms on which suppliers are prepared to do business with them.

Retained earnings

Retained earnings are the portion of past earnings retained within the business itself. They are an important source of internal finance for businesses looking to finance long-term projects.

For a business to be able to rely on these earnings to fund its activities, it has to have first made profits. As a result, this method could be difficult to use for newly established businesses due to the usually limited profitability in the first stages of production caused by significant initial costs. And even for profitable companies, satisfying this first condition alone is not entirely sufficient as they will need to take into consideration how much of their profits to distribute in the form of dividends to the shareholders before accounting for profits that are retained (if any). The following formula summarises the calculation of retained earnings in a given year:

Retained earnings = retained earnings _{− 1} + income (loss)_t − dividends distributed

Where t represents the current time.

From the above formula, it is evident that retained earnings carry opportunity costs for the company, which has to carefully consider the consequences of deciding not to distribute them to investors. The higher the dividends distributed to shareholders, the lower the amount of retained earnings and vice versa.

External sources of finance

External sources of finance are funds available to business organizations that are derived from outside the boundaries of the organization itself. As discussed at the beginning these can be further divided into debt and equity finance.

A key difference between debt and equity finance is the implications they have for the ownership of the business. Utilizing debt finance to fund activities does not imply a dilution of control over the business for the owners. On the contrary, when choosing equity finance the owners should be ready to accept sharing control with the investors (shareholders) who are providing the funds by buying a portion of the company. The following sections illustrate the main sources of external financing available to business organizations.

Sources of finance

Bank finance

Banks are the key suppliers of external finance to the business world, helping businesses to turn future sales into ready cash. For this reason, one of the traditional ways in which finance can be raised is by establishing financial relationships with the banking system.

Bank loans

A bank loan is money advanced and borrowed for a given period with an agreed schedule for repayment. The lender (the bank) and the borrower (either an organization or an individual) also agree on the repayment amount and the rate of interest (i.e. the cost of the lending service).

Even though it is quite a simple instrument, lenders generally seek a low exposure to risk, so they will evaluate the creditworthiness of the loanee. As a result, bank loans may not be accessible to all business organizations; rather, they are suitable mainly for well-established businesses with a solid track record of an ‘ability to repay.

The lender usually tends to protect itself from the risk of not receiving loan repayments by asking for collateral. Businesses lacking collateral could find it quite difficult to borrow funds from banks. In addition to this, arranging a loan with a lender can sometimes be a rather lengthy process.

Interest rates on bank loans tend to be low, although the borrower will have to pay the interest rate calculated on all the outstanding debt. As you gradually pay off your loan, interest will be paid on a smaller amount of the principal. Conversely, the share of principal payments increases gradually as you repay the loan.

Bank overdrafts

Another way in which a business can use the banking system to fund its short-term activities is through bank overdrafts. Overdraft facility schemes can be arranged with a bank to obtain short-term funding within an agreed limit. As in the case of bank loans, there will be a cost for this service (the interest plus a fee) and a period within which the repayment must be made. Owners of smaller businesses may be required to provide security (collateral) against these overdraft agreements, usually in the form of property, although this is not a requirement for all overdraft facilities.

For businesses searching for some flexibility in funding, for example, due to seasonal fluctuations in sales that might result in cash shortages, a bank overdraft would be preferable to a bank loan, as the latter is fixed both in terms of time and size. Moreover, in the case of bank overdrafts, the interest is calculated and paid only on the amounts borrowed (or overdrawn) each time because there is no outstanding principal.

Using an overdraft as a form of financing can be risky. The lender can demand that the overdraft is repaid or reduce the overdraft limit at any time. It could also be expensive for a business as a higher rate is charged by the lender to compensate for making funds available ‘on tap’ and, as a result, the business could lose other investment opportunities.

The table summarises the main advantages and disadvantages of bank loans and bank overdrafts.

Advantages and disadvantages of bank loans and bank overdrafts

Financial lease and hire purchase agreements

Financial leases are another common way for business organizations to raise long-term debt finance. A lease is a relationship, or a contract, between a lessor (the provider) and the lessee (the receiver). The lessee agrees to a series of payments to the lessor for the right to use an asset (e.g. a portion of land, a building, or a vehicle) for a fixed period, or lease term. The agreement is usually mediated by a leasing or financing company. At the end of the lease, the asset either returns to the lessor or the lease are renewed.

The key advantages of financial leases are flexibility and the fact that the business can avoid a large outflow of cash and smooth the expenditure over a longer period (i.e. the asset’s life). Leasing is a form of financing used across all sectors and represents a consolidated source of finance, particularly in transportation and manufacturing. Leasing, though, comes with some disadvantages. For example, in the case of missed payments, the assets may be repossessed, and the business’ credit rating can be compromised.

Cases, where the agreement stipulates that the asset will be purchased at the end of the period, are referred to as hire purchase agreements. In such arrangements, at the end of the lease term, the lessee becomes the legal owner of the hired assets. This is a form of credit used to buy an asset, which is usually mediated by a financial institution.

5. Alternative funding sources for Small and Medium Enterprises

Some business organizations can find it difficult to raise funds through the approaches described so far. As you have seen, the constraints related to the different sources of finance can be quite harsh, especially for a newly established business. However, alternative methods of raising finance have emerged in recent decades. Although these methods can be traced to their embryonic forms in previous centuries, they can be shown to have developed in response to the Great Financial Crisis in 2007/08 to overcome the obstacles presented by the sources of funding discussed so far. Equally, advances in modern technology, particularly the internet, mean alternative types of finance are commonplace in today’s economic landscape.

Crowdfunding

One solution to the limitations posed by traditional means of financing has been to rely directly on the public to search for potential funders. Crowdfunding is the process of raising short-term funds in the form of small contributions to help businesses (or individuals) turn an idea or a project into a reality through the direct connection between investees and a large number of potential investors. Although especially useful for newly established businesses, crowdfunding has also been utilized by larger, more established companies. For example, Lego used crowdfunding to engage consumers in testing some newly developed products before launching them onto the market.

The crowdfunding process is mediated by dedicated online platforms, which have specialized in different business areas (for example see Fundable or AngelList ). There are two types of crowdfunding:

• Reward-based crowdfunding is perhaps the most common type. Individuals contribute small amounts of money to projects in return for a reward that reflects their contributions. This reward can take many forms, such as vouchers, tickets for a showcase event, or even a prototype of the new product once available. In this case, crowdfunding falls under the category of debt finance, since no ownership control is shared with funders.
• With equity crowdfunding, the ‘crowd’ invests in a business in exchange for a portion of its capital, namely a share. If the business does well and is profitable then the funders will receive a share of the profits. If, on the contrary, the business fails then investors can lose part, or all, of their investment. Equity crowdfunding can be seen as a system aimed at expanding the number of people that can fund the early stages of business goals – a system once dependent on wealthy individuals.

Crowdfunding has expanded worldwide. However, it comes with risks from both the investor’s and the investee’s perspectives. Although crowdfunding provides an easy way to raise finance for a niche opportunity, the system provides little or no protection for the investor, which, in the extreme, means it could be a victim of fraud. Moreover, even though this can be a way to test the potential of a project, the idea could be stolen by other businesses.

Peer-to-peer lending

Peer-to-peer (or P2P) lending is a method of raising funds like crowdfunding. It is a form of borrowing and lending between ‘peers’ without the involvement of a bank or other financial institution. As with crowdfunding, the process is intermediated by an online platform that tries to match individuals willing to lend to those that need funds. These platforms allow the prospective borrower to access a pool of lenders after a credit check, which can lead to competitive interest rates in cases where the borrower has an excellent credit history.

The risks associated with this practice are the potential inability of the borrower to repay the lender and the fact that money lent through P2P is not guaranteed by governments, as in the case of banks. Current accounts in most countries are protected (up to a certain amount) from the potential bankruptcy of the bank in which they are held. With P2P lending, if the borrower defaults on their debt then the lenders will lose all their funds.

Currently, P2P lending is by far the largest type of alternative finance worldwide, while reward-based and equity crowdfunding remain limited, accounting for approximately a quarter and a tenth of P2P lending volume, respectively.

Business angels

Business organizations with ambitious and, thus, risky projects (think for example about a start-up, or an early-stage investment) might need to rely on other unconventional forms of external long-term funding: they could need the help of ‘venture captains’ or even ‘angels’.

According to the UK Business Angels Association (UKBAA), business angels (or BAs) are certified wealthy individuals with an income of around £100,000, or net assets above £250,000 excluding pension and residence. BAs make use of their private funds to invest a variable amount of money (usually between £10,000 and £150,000) in small businesses in which they see strong potential for growth.

In general, when BAs decide to invest in a project, they buy some share of the business, thus becoming part of the ownership structure. This is why funding from BAs falls under the category of ‘external equity finance’. The ‘angels’ do not usually sit on a business’s board, but they do provide continuous support and consultation to help the company grow.

In the European context, currently, the UK system stands out as the major beneficiary of BA involvement in the funding of growing businesses. Also, in Spain, Germany, Turkey, France, and Russia, BAs account for a considerable amount of investment.

Venture capital

Venture captains in the business environment are called venture capitalists (or VCs). VCs are structured firms that invest previously collected funds in an ambitious project (i.e. a venture). VCs differ from BAs, as the former invest their funds through a managed fund (called a Venture Capital Trust), which is established using either private or public resources. The fund is managed to make a return for the fund’s investors.

Compared to the structure of BA investment, VC investment carries substantial administrative costs, such as management fees, and organizational expenses, like consulting and research. Also, the fund needs to sustain a consistent return for the investors. For these reasons, VCs will be more selective and prefer projects with a track record of good performance. Hence, VCs generally become involved with projects that are more mature than the ones targeted by BAs.

VCs usually invest sums above £1 million and expect high returns, as well as direct and constant involvement in the decision-making process within the business. As in the case of BAs, businesses agreeing to VC funding should be prepared to lose part of their equity control over the business. In Europe, the UK stands out as the major market for VC funding that finances growing businesses.

A comparative view of different sources of finance

So far you have seen the reasons why different types of financial resources might be suitable for different business organizations, but it is also useful to place them into the context of their prevalence in the real world. By taking a comparative view and examining the relative weight of each source of finance in different countries, you can develop a picture of how important different sources of finance are across the economies of today.

6. Company financing: stock and bond issuance

Compared to other forms of business organizations, public limited companies (Plc) have the additional opportunity to build relationships with financial markets. Public limited companies (called ‘corporations’ in the United States) are those offering portions of their capital to the general public. The public buyers of this capital have ‘limited responsibility, meaning that they cannot be held responsible for losses over the amount they have invested into a specific company.

Plus can raise finance by offering their shares for sale on a recognized stock exchange to raise capital or issue bonds. But what is a financial market and how can it help Plc to find the financial resources they need?

A financial market can be defined as a place in which operators with excess funds (lenders or investors) exchange their resources with those who lack funds (borrowers). Broadly speaking, the financial market comprises two key markets: the capital market and the money market.

The capital market

The capital market is where long-term financial securities are traded. Public limited companies, as well as governments, can issue (sell) securities on the capital market to raise funds. As you will see later, companies can issue both stocks and bonds in their respective markets to raise long-term finance, while governments can issue sovereign bonds.

The money market

The money market defines the second component of financial markets. Money markets are concerned with the buying and selling of short-term assets characterized by a high level of liquidity. As the name suggests, the financial assets exchanged in this market resemble money or cash. Commercial papers, certificates of deposit, inter-bank loans, Treasury bills, cash deposits, and sale and repurchase agreements are the six major categories of money-market funding. The money markets are the entities in which mainly central banks and financial institutions deal with short-term lending and borrowing. The various money markets are less relevant in terms of most businesses’ financing strategies.

The stock and bond markets

A large portion of the capital market is represented by the stock market, where companies’ stocks are traded. Although the terms ‘stock’ and ‘share’ are nowadays used interchangeably, it is more appropriate to use the former when referring to the company as a whole (e.g. the stock of a manufacturing company), while the latter refers to the parts in which the company stock is divided.

The size of a stock exchange is measured by the market capitalization of its listed companies. It is easy to see how the USA, and especially the city of New York, currently dominates this type of market. In terms of market capitalization, in 2018, the NYSE and the NASDAQ alone accounted for more than the other eight stock markets in the top-ten ranking together.

Primary and secondary markets

The stock and bond markets are subdivided into primary and secondary markets. The primary market, or ‘new issue markets’, is where newly created financial assets (for example a company that issues a bond certificate or a stock) are put on the exchange. The secondary market deals with the trading of previously issued financial assets, where transactions between investors occur. The secondary market is where the highest volume of trading takes place.

Over-the-counter markets

A special type of secondary market is the ‘over-the-counter (OTC) market’. In contrast to the stock exchange, OTC markets are not physically recognizable: they are better described as networks of trading relationships between dealers. Moreover, unlike exchanges, OTC markets are not subject to strict regulation about the quantity and quality of the assets traded, and all the contracts are bilateral, i.e. only between two parties. Given these characteristics, OTC markets lack transparency compared to the ones discussed so far.

Financial instruments, such as stocks, debt securities, derivatives, and commodities can be traded OTC. Typically, small companies lacking the resources to be listed on formal stock exchanges trade their stocks OTC. However, even larger companies might decide to trade their stocks OTC.

Stock issuance

One common way in which lobbies and PLCs raise finance is through a share issue. Shares represent the portions in which a company’s capital is divided. They entitle the holder to receive a portion of future profits in the form of dividends, usually paid yearly or half-yearly at the discretion of the company, subject to approval by shareholders.

There are two types of shares: ordinary and preference shares.

• Ordinary shares (or common shares) have no special rights or restrictions attached to them. Each share provides the shareholder with equal rights to vote at general meetings (each share typically entitling its owner to cast one vote), receive a share of the company’s profit in the form of dividends, and receive a share of any remaining capital or assets should the company be wound up.
• Preference shares (or preferred shares) typically do not give shareholders voting rights. However, these shares come with an advantage over ordinary shares in terms of dividend distribution. Preference shareholders, who are entitled to a fixed-rate dividend, have a preferential claim to dividends over ordinary shareholders, even if the company enters liquidation. Further, in case of insolvency, preferred shareholders have a higher priority claim to the company’s assets.

Shareholders expect a return on their investment. One way in which the ownership of shares gives a return is through dividends, which are paid at the company’s discretion. Most shareholders, however, hope to gain an additional return in the form of capital gains, that is, an increase in the value of the company. Any capital gain will be realized when the shares are sold to another party for a higher price at a later date. Investors’ expectations about the performance of these two components vary across countries and sectors of operation.

Issuing shares in the practice

How can a company issue shares to raise funds? Limited liability companies can be classified as either private (Ltd) or public (PLCs); a key difference between them is that Ltd cannot sell shares on a recognized stock exchange whereas PLCs can.

Issuing shares as a private limited company

Even though Ltd cannot sell shares on a recognized stock exchange, this doesn’t mean that there are no options for private limited companies to raise funds through the sale of shares. Broadly speaking, there are two options for Ltd looking to raise finance through the sale of equity:

1. Ltd can sell its shares without the mediation of a stock exchange. Shares in private limited companies can be bought and sold, usually to existing shareholders, but also to other private investors, such as venture capitalists
2. Ltd can decide to ‘go public. Such a decision can be relevant to companies that plan to grow significantly. Going public is a decision that entails huge organizational efforts since the management has to spend time on the preparation of the public offering of the company’s shares. Moreover, after going public, the company will regularly have to make information about the business, such as financial records and remuneration policies, publicly available.

Issuing shares as a public limited company

PLCs have the great advantage of being able to raise a large amount of capital by offering shares to the wider public, hence reaching a larger number of investors compared with Ltd. When a company is listed on a stock exchange it can also attract the interest of large-scale investors such as mutual funds and hedge funds. Selling extra shares after the ‘initial offering’ will need the resolution to be voted on by the company shareholders. Nonetheless, issuing new shares will further dilute the control of the company.

Initial public offerings

The usual method for Ltd to go public is to offer its shares via an initial public offering (IPO). The process of an IPO can be summarised in three steps.

Bond issuance

Along with the issuance of stocks, PLCs can issue debt securities to raise finance. With the issuance of stocks, companies are searching for partial owners; with the issuance of bonds, they are searching for partial lenders. The financial markets provide the means for companies to borrow money by the issuance of debt securities in the form of bonds.

From an investor’s point of view, owning a company’s debt is different from owning its stock in three main ways:

1. Bondholders have no right to vote and are not entitled to receive dividends. Instead, they receive interest payments (known as coupons).
2. A bondholder’s capital is paid back in full at maturity, as compared to shares, of which the value is contingent on the current share price when the shares are sold.
3. Bonds outrank stocks in seniority, meaning that in the event of the liquidation of a company, bondholders are among the first to be repaid. Thus, bonds establish a more secure financial relationship with a company as opposed to stocks.

Regulating and documenting the issue of bonds

Companies can raise funds both in the financial market of their home country (domestic bond) or in that of a foreign country (foreign bond). In either case, they have to comply with the regulations of the market in question – for example, those laid down for issuance by the Securities and Exchange Commission (SEC) apply to both US and non-US companies raising funds in the USA. In the UK, the regulatory body is the Financial Conduct Authority (FCA). Public issues of bonds in the international markets still need to be listed on an appropriate stock exchange: for example, Eurobonds are listed on either the London or Luxembourg stock exchanges.

Bond issues need to be accompanied by the documentation specified by the regulator and the listing authority for the relevant market if the bond is to be entered into the official list of the local stock exchange. As with equity issuances, usually, companies are required to produce – and have approved by the regulator and the listing authority – a prospectus to support bond transactions. Prospectuses also have to be submitted to the credit-rating agencies that provide ratings for the bonds.

Debt and credit ratings

Bond issuers will normally have to secure a rating to enable them to issue their bonds on the world’s financial markets. A credit-rating agency is a private company that assigns ratings for issuers of certain types of debt, such as bonds. The three major global credit-rating agencies are Standard & Poor’s, Moody’s, and Fitch Ratings Inc.

The function (and business) of rating agencies is to provide (supposedly) independent information to investors about the financial reliability of bond issuers. This information is called a ‘rating’. The higher the rating of the issuer, the lower the assessed credit risk of investing in it. The specific credit-quality rating assigned varies between agencies. Ratings with a relatively low risk of default correspond to ‘Investment grade. According to Standard and Poor’s classification, to be included in this category an issuer should be rated BBB or higher.

The mechanics of bonds

All bonds have a face value (or par value), an interest rate (coupon rate) paid on the bond by the borrower, and a maturity date. Let us examine each of these elements in more detail.

A company issues bond certificates with a single face value (FV), which is the value that appears on the certificate. This is usually equal to £100 or £1000, while the total value of the bonds issued at a certain time could be millions (or even billions) of pounds. For convenience, bonds are often referred to in units of 100, though investors can buy smaller or larger sums and part units.

The market value of the bonds is the price at which the bond market, which is where issued bonds are traded, is selling or buying the bond. When the market value (MV) is higher than the FV, it is said that the bond is trading at a ‘premium’; by way of contrast, when the MV is lower than the FV, it is said that the bond is trading at a ‘discount’. Finally, if the MV and FV are equal, the bond is trading at ‘par’.

Bond trading prices

The positive or negative difference between MV and FV value is given by the fact that the bond is traded, hence the fluctuations in buying and selling are reflected in its value.

In a primary offering, an investor buys the bond for par value from the issuer. The issuer pays interest to the investor periodically (usually annually), which is calculated by multiplying the face value by the coupon rate. For example, a bond with a fixed coupon issued at a face value of £100 with a 5% annual coupon rate will pay a coupon of £5 (i.e. £100 × 0.05) each year, or two semi-annual coupons worth £2.50 each. When the bond matures, then the bondholder will get back the par value of the bond.

A bond typically has a maturity date on which the bond expires, and the principal is paid back to the investors. For example, a 10-year corporate bond issued in June 2019 will mature in June 2029. Bonds typically have maturities in the range of 1 to 30 years. Updated or perpetual bonds, with no defined maturity date, can also be issued, although such issues are infrequent. The bulk of funding activity in the bond market is in maturities of up to 10 years.

If bondholders decide to hold a bond until the maturity date, then they can expect to receive a return commonly referred to as ‘yield to maturity (YTM), which equals the total interest payments to the investor plus any gain (or loss) between the price the bond was purchased at and the repayment price. For this course, you do not need to know how to calculate the YTM, you just need to note that a bond’s YTM considers its face value, purchase price, coupon rate, duration, and compound interest.

Common types of bonds

Along with fixed coupon bonds, referred to in the previous example, there are other types of bonds that pay interest rates differently. The table describes the most common types of bonds.

Common types of bonds

The secondary market for bonds

As you have seen, a bond has a second price component besides its initial face value. This is the price of the bond as it trades in the secondary market, or its market value (MV).

Bonds trading in the secondary market will usually be priced either higher or lower than their original issue price. Changes in a bond’s price are linked to the following factors:

• i.prevailing interest rates
• ii.inflation
• iii.the bond’s credit rating.

Prevailing interest rates

Assume, again, you have purchased a bond at par with a face value of £1000 and an annual coupon rate of 5%. The annual coupon payment will be equal to £50 (i.e. £1000 × 0.05). However, after your purchase, the market value of your bond might fluctuate as a result of changes in interest rates. Suppose the prevailing (or the market) interest rate rises to 6%. Since new bonds are now being issued with a 6% coupon, your bond is no longer worth as much as it was when you bought it with a 5% coupon. Your bond becomes less attractive to other investors as they can invest £1000 to purchase a bond with a higher coupon rate. In this case, the market value of your bond will be less than £1000, the bond will be trading at discount.

By way of contrast, if the market interest rate falls from 5% to 4% after your bond purchase, the market value of your bond will rise, as investors will not be able to buy a newly issued bond with a coupon rate as high as yours. In this case, the bond’s price will increase to £1,250 (£50/0.04), hence it will be trading at a premium to par. This can be summarized by saying that the price of a bond fluctuates inversely with the prevailing interest rate, as shown in Table

Bond pricing on the secondary market

In either scenario, the coupon rate loses meaning for a new investor. However, it is possible to roughly estimate the bond’s current yield by dividing its annual coupon payment by its market value. For example, if you purchased a bond on the secondary market that had an FV of £1000, with a 5% annual coupon rate, for £1200, the current yield would be equal to 4.2% (i.e. (£50/£1200) × 100). By way of contrast, if you purchased that same bond for £900, the current yield would be 5.6% (i.e. (£50/£900) × 100). These changes in the current yield are summarised in Table

Purchase price and the current yield on a bond

Inflation

Corporate bonds are also vulnerable to inflation. Bondholders receive interest set at a predetermined rate that is fixed on the issue. As a consequence, if inflation rises, the return a bondholder will earn at maturity will be worthless in today’s pounds. Rising inflation often causes interest rates to increase, which in turn reduces the price of a bond. Conversely, deflation usually results in decreasing interest rates and, therefore, in increasing bond prices.

Credit ratings

Credit ratings also affect a bond price. The lower the credit rating, the higher the risk the issuer will not meet its payment obligations. Consequently, if the issuer’s credit rating goes up, the bond price will rise. Conversely, if the issuer’s credit rating goes down, the bond price will fall.

A bird’s-eye view on public-sector financing

The public sector is that part of the economic system that is controlled by the government. It consists of organizations, such as the National Health Service, which provide services free of charge or below cost price that benefit society as a whole. In the UK, the size and scope of the public sector have varied over time, featuring prominently during the period from the end of the Second World War to the late 1970s. After this, various rounds of privatization generally reduced the scope of influence of public agencies.

From the late 1990s, especially in the UK and Australia, the public and private sectors established a specific form of public/private partnership, named ‘private finance initiative’ (PFI): a scheme that enables private organizations to fund major public projects. Under this scheme, the private company covers the up-front costs of a project and then leases the services to be provided to the government, which then pays the private company a regular amount for its provision.

The public sector remains a very well-integrated and important part of the economic system. Given the specific goals of public sector entities, their process of raising finance is quite different from that of private-sector organizations.

To understand the basic role and functioning of the public sector, the starting point is to clarify the main functions of the ‘state’. Government activities range across all spheres of the economy, from the provision of social protection (such as benefits and pensions) to health, transport, and defense. Governments spend money to supply goods and services that are not provided by the private or not-for-profit sectors. To fund their spending, governments mainly rely on revenue from taxation (public revenues). However, depending on whether the government spends more or less than what it can raise in public revenues, either a budget deficit or a budget surplus can arise. When the total expenses in a given year exceed total revenues, the government will need to borrow funds to cover the difference. This means that the government will issue bonds (government bonds), which are debt securities very similar to corporate bonds and are also subject to evaluation by the same rating agencies discussed previously. One major difference between bonds issued by companies compared with those issued by governments is that, given the usually lower risk of bankruptcy for an entire country, government bonds are usually rated more highly.

By directly producing goods and services (and thus employment) through the public sector, the state directly intervenes in the economic sphere. One of the most direct ways in which the public sector intervenes within the economic sphere is through the establishment and management of state-owned enterprises (SOEs). SOEs can be entirely or partially owned by the government; it is used to translate government policies into the practice of commercial activities. In the UK, examples of this type of enterprise include the British Broadcasting Corporation (BBC), Network Rail, and the Post Office.

This article has provided an overview of the tools available to raise financial resources in the case of Public limited companies. Stock and bond issuance involves establishing relationships with financial markets. The last part of the section introduced some important issues in the case of public sector financing. You now have a fairly comprehensive overview of the main ways in which different organizations can and do raise financial resources.

The next article focuses on how these resources can be employed to support organizations’ goals.