Introduction - Sources of Finance

Introduction to the Sources of Finance resource.

Sources of Finance

Introduction

This resource is designed for use with Accounting courses at A' level. This resource is relevant to the following:

  • AQA Module 5, Section 14.5: 'Types of Business Organisation, Sources of Finance'
  • OCR Module 2505, Sections 5.3.2 and 5.6.2

For many businesses, the issue about where to get funds from for starting up, development and expansion can be crucial for the success of the business. It is important, therefore, that you understand the various sources of finance open to a business and are able to assess how appropriate these sources are in relation to the needs of the business. The latter point regarding 'assessment' is particularly important at A2 level where you are expected to make judgements.

Internal Sources

Traditionally, the major sources of finance for a limited company were internal sources:

External Sources

Ownership Capital
In this context, 'owners' refers to those people/institutions who are shareholders. Sole traders and partnerships do not have shareholders - the individual or the partners are the owners of the business but do not hold shares. Shares are units of investment in a limited company, whether it be a public or private limited company. Shares are generally broken down into two categories:

Non-Ownership Capital
Whilst the following sources of finance are important, they are not classed as Ownership Capital - Debenture holders are not shareholders, nor are banks who lend money or creditors. Only shareholders are owners of the company.

Accounting for Changes in Capital Structure

This section explores issues such as the authorised, issued and called-up share capital together with some of the ways in which an organisation might change their proportions. It reviews such aspects of capital as the bookkeeping entries to deal with the application and allotment of share issues. It also discusses the effects on the balance sheet of changes in capital structure. The section includes interactive and printable worksheets to enable students to practise bookkeeping for share issues.

  • Authorised, issued and called up share capital
  • Bookkeeping for share issues. Shares can be issued in a number of ways, the most important aspect from our point of view being how and when shareholders pay for the shares they buy:
    • Shares can be issued and paid for in full on application, either
    • Share issues might be under or over subscribed.
    • Shares are not all issued for cash. Some issues, for example, bonus issues arise as a result of a capital restructuring of the company, sometimes called a rights issue.
    • Shares can be issued and paid for by instalments.
  • Numerical questions relating to the issue of shares. Each of these can be completed either by filling in an interactive form or on paper using a printable worksheet.

Sources of Finance

Personal Savings

Quite simply, personal savings are amounts of money that a business person, partner or shareholder has at their disposal to do with as they wish. If that person uses their savings to invest in their own or another business, then the source of finance comes under the heading of personal savings.

Although we would generally discuss personal savings as a source of finance for small businesses, there are many examples where business people have used substantial sums of their own money to help to finance their businesses. A good and very public example here is Jamie Oliver, the television chef. Jamie financed his new restaurant, 'Fifteen', using fifteen raw recruits to the catering trade and a large amount (£500,000) of his own cash.

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Sources of Finance

Retained Profit

Pie chart showing retained profit

This is often a very difficult idea to understand but, in reality, it is very simple. When a business makes a profit and it does not spend it, it keeps it - and accountants call profits that are kept and not spent retained profits. That's all.

The retained profit is then available to use within the business to help with buying new machinery, vehicles, computers and so on or developing the business in any other way. Retained profits are also kept if the owners think that they may have difficulties in the future so they save them for a rainy day!

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Sources of Finance

Working Capital

This is the short-term capital or finance that a business keeps. Working capital is the money used to pay for the everyday trading activities carried out by the business - stationery needs, staff salaries and wages, rent, energy bills, payments for supplies and so on. Working capital is defined as:

Working capital = current assets - current liabilities

Where:

current assets are short term sources of finance such as stocks, debtors and cash - the amount of cash and cash equivalents - the business has at any one time. Cash is cash in hand and deposits payable on demand (e.g. current accounts). Cash equivalents are short term and highly liquid investments which are easily and immediately convertible into cash.
current liabilities are are short term requirements for cash including trade creditors, expense creditors, tax owing, dividends owing - the amount of money the business owes to other people/groups/businesses at any one time that needs to be repaid within the next month or so.

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Sources of Finance

Office building

Sale of Assets

Business balance sheets usually have several fixed assets on them. A fixed asset is anything that is not used up in the production of the good or service concerned - land, buildings, fixtures and fittings, machinery, vehicles and so on. At times, one or more of these fixed assets may be surplus to requirements and can be sold.

Alternatively, a business may desperately need to find some cash so it decides to stop offering certain products or services and because of that can sell some of its fixed assets. Hence, by selling fixed assets, business can use them as a source of finance. Selling its fixed assets, therefore, has an effect on the potential capacity of the business - the amount it can produce.

Office buildings may be part of a firm's assets that could be sold off in times of slowdown in activity to raise finance. © Sufi Nawaz, Stock.Xchng


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Sources of Finance

Ordinary Shares

Ordinary shares are also known as equity shares and they are the most common form of share in the UK. An ordinary share gives the right to its owner to share in the profits of the company (dividends) and to vote at general meetings of the company.

Since the profits of companies can vary wildly from year to year, so can the dividends paid to ordinary shareholders. In bad years, dividends may be nothing whereas in good years they may be substantial. Some businesses may choose to pay out a dividend even if it has had a difficult trading year and has made a loss! (How do you think this is possible and why might a business choose to do this?)

Ordinary shareholders can vote on all of the issues raised at a general meeting of the company including:

  • Appointment of directors and auditors
  • Whether to accept the dividend proposed
  • Changes to the company's constitution (memorandum and articles of association)
Share certificate

The nominal value of a share is the issue value of the share - it is the value written on the share certificate that all shareholders will be given by the company in which they own shares.

The market value of a share is the amount at which a share is being sold on the stock exchange and may be radically different from the nominal value.

When they are issued, shares are usually sold for cash, at par and/or at a premium. Shares sold at par are sold for their nominal value only - so if a 10 pence share is sold at par, the company selling the share will receive 10 pence for every share it issues.

If a share is sold at a premium, as many shares are these days, then the issue price will be the par value plus an additional premium. So if a 10 pence nominal value share is issued at £1, then the par value is 10 pence and the premium is £0.90 per share. The company issuing the shares will receive £1 for each share issued.

Ordinary shares are the riskiest form of investment in a company since there may be no dividends paid and the market value of shares might fall after they have been bought. A very good example of the latter case relates to shares in Ryanair - take a look at this graph of their share price.

Ryanair share price

Data source: Yahoo Finance

The Ryanair share price fell so dramatically in mid-January 2004 because the company announced that its profits for the current financial year would probably be worse than they had previously expected.

Marconi corporation plc suffered a similar fate in terms of its share price which suddenly collapsed following announcements of serious financial problems within the group. Take a look at how their share price has since recovered:

Marconi share price

Data source: Yahoo Finance

Don't forget that the stock market is actually just a second hand share market so even though no company ever wants its share price to collapse in the ways that we have just seen, these share price catastrophes do not directly affect the business. However, with such a depressed share price, companies might find it vey difficult to raise additional finance or reassure existing creditors that they are a worthwhile risk.

If you look at the share price pages in newspapers such as the Financial Times, The Times, The Guardian and so on, the prices you will see there are mainly ordinary share prices. The importance of share prices to a business is that it gives an indication of the value placed on the company by the market - for example if a company has 10 million shares and the current price is 500p each, then the value of the company - its market capitalisation - is £50 million. If the share price plummets to 200p the company would only be 'worth' £20 million. In such cases, companies become possible targets for takeovers!

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Sources of Finance

Preference Shares

Preference shares offer their owners preferences over ordinary shareholders. There are two major differences between ordinary and preference shares:

  • Preference shareholders are often entitled to a fixed dividend even when ordinary shareholders are not.
  • Preference shareholders cannot normally vote at general meetings.

The preference dividend is fixed in the sense that preference shares are often issued with the rate of dividend fixed at the time of issue and you might see something like this:

'4% preference dividend £0.25'

This is a preference share with a nominal value of £0.25 per share that carries a dividend of 4%, that is 4% of £0.25 every year for every share issued. If a company has issued 100,000 of these shares at par then it will have received:

£100,000 x £0.25 = £25,000 from shareholders on issue

It will pay an annual dividend of:

£25,000 x 4% = £1,000 each year.

Note, that if by any chance a company cannot pay its preference share dividend then it cannot pay any ordinary share dividend since the preference shareholders have the right to receive their dividend before the ordinary shareholders under all circumstances - hence the term 'preference'.

Preference shares are usually cumulative and this means that if this year's dividend wasn't paid, then it will be carried forward to next year. So that if the £1,000 for 2004 was missed, then preference shareholders will receive £2,000 in 2005 (assuming the company is in a position to pay the dividend!).

A preference share may be redeemable which means that at some time in the future, the company will effectively buy it back. How do we know that a share is redeemable? Redeemable shares usually look like this:

'4% cumulative preference share of £0.25, 2007'

This means that the £0.25 per share preference share carries the right to a 4% dividend and it will be redeemed in 2007 - normally the date for redemption in 2007 will be agreed when it is issued so you will know well in advance when to expect your money back.

If a preference share is a participating preference share then the owner of such a share has the right to participate in, or receive, additional dividends over and above the fixed percentage dividend discussed above. The additional dividend is usually paid in proportion to any ordinary dividend declared.

Finally, preference shares may be convertible. If the shares are convertible then the shareholders have the option at some stage of converting them into ordinary shares.

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Sources of Finance

Debentures

Debentures are loans that are usually secured and are said to have either fixed or floating charges with them.

A secured debenture is one that is specifically tied to the financing of a particular asset such as a building or a machine. Then, just like a mortgage for a private house, the debenture holder has a legal interest in that asset and the company cannot dispose of it unless the debenture holder agrees. If the debenture is for land and/or buildings it can be called a mortgage debenture.

Debenture holders have the right to receive their interest payments before any dividend is payable to shareholders and, most importantly, even if a company makes a loss, it still has to pay its interest charges.

If the business fails, the debenture holders will be preferential creditors and will be entitled to the repayment of some or all of their money before the shareholders receive anything.

A debenture with a fixed charge has a fixed rate of interest and might be presented as:

'10% Debenture 2005/2008 £1,000,000'

In this case, the debenture is redeemable (will be paid back) between 2005 and 2008 and the fixed interest rate is 10%.

Debentures may be issued in units of £100 or £1 - if it is in £1 units then it will be called debenture stock.

A debenture issued with a floating charge means that the interest rate is not fixed and such debentures are usually not tied to any specific asset such as land or buildings.

You may have heard the term 'debenture holders' in relation to the financing of sports stadia. Part of the funds raised for stadium developments like those at Wembley, Arsenal, the rugby stadium at Twickenham and the cricket stadium at Trent Bridge in Nottingham are financed by debentures. The debenture holders usually also receive access to boxes at the stadium for their use throughout the period of the 'loan'.

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Sources of Finance

Other Loans

The term debenture is a strictly legal term but there are other forms of loan or loan stock. A loan is for a fixed amount with a fixed repayment schedule and may appear on a balance sheet with a specific name telling the reader exactly what the loan is and its main details.

An artist's impression of the new Arsenal stadium

Image: An artist's impression of the new Arsenal stadium. You may have heard the term 'debenture holders' in relation to the financing of sports stadia. Part of the funds raised for stadium developments like those at Wembley, Arsenal, the rugby stadium at Twickenham and the cricket stadium at Trent Bridge in Nottingham are financed by debentures. The debenture holders usually also receive access to boxes at the stadium for their use throughout the period of the 'loan'.
Copyright: Miller Hare, used by kind permission of Arsenal Football Club.

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Sources of Finance

Overdraft Facilities

Many companies have the need for external finance but not necessarily on a long-term basis. A company might have small cash flow problems from time to time but such problems don't call for the need for a formal long-term loan. Under these circumstances, a company will often go to its bank and arrange an overdraft. Bank overdrafts are given on current accounts and the good point is that the interest payable on them is calculated on a daily basis. So if the company borrows only a small amount, it only pays a little bit of interest. Contrast the effects of an overdraft with the effects of a loan:

Overdraft: Average balance owing for the year £10,000 with an average rate of interest of 10%.

Overdraft interest for the year = £10,000 x 10% = £1,000

Bank loan: Minimum loan available £25,000 repayable after three years with a fixed interest rate of 8%.

Bank loan interest for the year = £25,000 x 8% = £2,000

Interest is payable even if the company didn't actually use the whole £25,000 - we have assumed a minimum amount of loan just for the purposes of demonstration. If the company had to borrow £25,000 but only needed £10,000 on average then it could invest the balance and earn interest in it. The position would now be:

Bank loan interest payable for the year = £25,000 x 8% = £2,000
Interest earned on £15,000 of loan invested at 4% per year = £600
Net interest payable = £2,000 - 600 = £1,400

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Sources of Finance

Crane

Hire Purchase

Hire Purchase is a method of acquiring assets without having to invest the full amount in buying them. Typically, a hire purchase agreement allows the hire purchaser sole use of an asset for a period after which they have the right to buy them, often for a small or nominal amount. The benefit of this system is that companies gain immediate use of the asset without having to pay a large amount for it or without having to borrow a large amount.

Image: Cranes can be purchased via hire purchase agreements.
Source: LMZ mediaculture-online, stock xchng

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Sources of Finance

Lines of Credit from Creditors

This source of finance really belongs under the heading of working capital management since it refers to short term credit. By a 'line of credit' we mean that a creditor, such as a supplier of raw materials, will allow us to buy goods now and pay for them later. Why do we include lines of credit as a source of finance? Well, if we manage our creditors carefully we can use the line of credit they provide for us to finance other parts of our business.

Take a look at any company's balance sheet and see how much they have under the heading of 'Creditors falling due within one year' - let's imagine it is £25,000 for a company. If that company is allowed an average of 30 days to pay its creditors then we can see that effectively it has a short term loan of £25,000 for 30 days and it can do whatever it likes with that money as long as it pays the creditor on time.

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Sources of Finance

Financial Structures of Four Well Known British Companies

As a matter of interest, here are the financing structures of four companies that you can find in the database of company data. Here we can see how each company is financed by its ordinary (equity) shareholders and in three out of the four cases by preference shareholders and/or banks and other lenders - they are the creditors with amounts falling due after more than one year.

  2002
  AG Barr British Airways plc Cadbury Schweppes Marks & Spencer plc
Currency £ '000 £ million £ million £ million
Creditors: Amounts falling due after more than one year 0 7,097 1,577 2,156
         
Called-up share capital 4,865 271 257 853
Share premium 905 788 1,050 3
Other reserves 0 270 149 -4,437
Profit and loss account 50,623 687 1,564 6,662
Equity shareholders' funds 56,393 2,016 3,020 3,081

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Sources of Finance

Grants

Grants can be an attractive aspect of a company's financing structure. If a company has a specific issue that it wants or needs to deal with then it could find that there are grants available from local councils and other bodies that will help to pay for it.

Why do Councils have such grant schemes and how do they work? Here is an example from a London Council, taken at random from all London councils.

Grants of up to £13,000 per property or 25% of the cost of eligible works (£30,000 in the centre of Balham and £50,000 in Wandsworth) are available in specifically designated areas of the town centres. Frontage and building improvements, bringing vacant or underused space back into use, security and provision of disabled access are all categories of expenditure for which funding might be available.

Wandsworth Borough Council

The service aims to:

  • encourage the regeneration and maintenance of business premises and thereby High Street infrastructure in designated Town Centres and local areas.
  • make a difference to the business and add value to the property whilst adding overall benefit to the immediate local area.

Any business in an approved area is eligible for a grant/loan, although applications are subject to individual assessment and all financial assistance is discretionary. Improvements should have a life expectancy of 5 years.

Source: Wandsworth Borough Council

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Sources of Finance

Venture Capital

Venture Capital has become a vital aspect of the source of finance market over the last 10 to 15 years. Venture Capital can be defined as capital contributed at an early stage in the development of a new enterprise, which may have a significant chance of failure but also a significant chance of providing above average returns and especially where the provider of the capital expects to have some influence over the direction of the enterprise. Venture Capital can be a high risk strategy.

The British Venture Capital Association (BVCA)

With 165 members, the British Venture Capital Association represents the majority of UK based private equity and Venture Capital firms. Since 1983 additional private equity invested in UK industry has amounted to £40 billion with a further £14 billion invested in the rest of Europe. Those funds have gone to assist 25,000 UK companies. In 2002 alone £5.4 billion was invested in 1,500 companies Europe wide.

See the BVCA web site for more information (http://www.bvca.co.uk).

Business Angels are informal investors who are wealthy and entrepreneurial individuals looking to invest in new and growing businesses in return for a share of the equity. They usually have considerable experience of running businesses that they can place at the disposal of the companies in which they invest. Business angels invest at all stages of business development, but predominantly in start up and early stage businesses. The majority of them tend to invest in businesses located within a reasonable distance of where they live.

The general profile of a business angel style of relationship is that:

  • you are looking to raise between £10,000 and as much as £600,000
  • you are prepared to give up some of the equity in your business and allow an investor to take a 'hands-on' role
  • your business has the potential to grow sufficiently over the next few years to provide the business angel with a return on investment
  • you can offer the business angel an 'exit' (e.g. through a trade sale or the repurchase of their equity stake) at some future date

Business angels, then, are small business related investors who can have a major impact on the success of a start up company.

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Sources of Finance

Factoring

Factoring allows you to raise finance based on the value of your outstanding invoices. Factoring also gives you the opportunity to outsource your sales ledger operations and to use more sophisticated credit rating systems. Once you have set up a factoring arrangement with a Factor, it works this way:

Once you make a sale, you invoice your customer and send a copy of the invoice to the factor and most factoring arrangements require you to factor all your sales. The factor pays you a set proportion of the invoice value within a pre-arranged time - typically, most factors offer you 80-85% of an invoice's value within 24 hours.

The major advantage of factoring is that you receive the majority of the cash from debtors within 24 hours rather than a week, three weeks or even longer.

In return,

  • The factor issues statements on your behalf and collects payments - this includes contacting late payers by phone and pursuing outstanding invoices. Your company will, however, remain responsible for reimbursing the factor for bad debts, unless you have arranged a 'non-recourse' facility. Non-recourse means that if a debtor doesn't pay, the factoring company will either suffer the loss or will have insured themselves against the loss. Hence, with non-recourse factoring you would not suffer.
  • You receive the balance of the invoice (less charges) once the factor receives payment.
  • The factor provides regular reports on the status of your sales ledger - you should expect regular statements. Many factors can offer you instant online account information.

Not all businesses are eligible for factoring. Since factors operate to make money for themselves as well as for their clients, there are a number of things to take into account. The factor audits the potential client's books and accounts to establish that its sales ledger meets its criteria.

General Features of a Factoring Client

  • Most companies which use factoring have a turnover of more than £200,000 although some factors will consider start-ups and companies with turnover of £50,000 or less.
  • Generally, there should not be just a few customers.
  • Typically, no one debtor should account for more than 25-40% of the business.
  • Factors only provide finance to businesses dealing on trade credit terms.
  • Factors prefer businesses that offer customers the standard credit terms for the industry.
  • The company should be collecting your debts within a reasonable time frame.
  • Businesses such as builders and advertising agencies which are paid in stages, and whose bills are often questioned, may not be able to use factors.
  • Too many small invoices may make factoring uneconomical.
  • Businesses whose sales are declining could find factoring difficult to justify.
  • Where credit limits are required by the factor, you and the factor must agree how they will be handled.
  • For non-recourse factoring (where the factor protects the client against bad debts) the factor will usually set credit limits for each customer.

Factoring Charges/Fees

Finance charges should be comparable to an overdraft. Typical charges on the amount financed range from 1.5% to 3% over base rate, with interest calculated on a daily basis.

Credit management and administration charges, including the maintenance of your sales ledger, depend on turnover, the volume and number of invoices. Typical fees range from 0.75% to 2.5% of annual turnover. A company with 50 live customers, 1,000 invoices per year and £1 million turnover might pay 1%.

Credit protection charges (for non-recourse factoring) largely depend on the degree of risk the factor associates with your business. Typical charges range from 0.5% to 2% of annual turnover.

Advantages

There are many advantages to factoring, including:

  • You maximise your cash flow as factoring enables you to raise up to 80% or more on your outstanding invoices. An overdraft secured against invoices could only raise up to 50%.
  • Using a factor can reduce the time and money you spend on debt collection since the factor will usually run your sales ledger for you.
  • You can use the factor's credit control system to help assess the creditworthiness of new and existing customers - this is especially useful if you do a lot of business with companies whose turnover is lower than £1 million and who do not have to file full returns with Companies House.
  • Factoring can be an efficient way to minimise the cost and risk of doing business overseas.

Disadvantages

Of course, there are disadvantages to factoring and here are the most important ones to consider. Unless carefully implemented, factoring can have a negative impact on the way a business operates.

  • The factor usually takes over the maintenance of the sales ledger. Customers may prefer to deal with the company it is trading with rather than a factor. However, if the factor's techniques are clearly agreed beforehand, there will usually be no problem.
  • Factoring may impose constraints on the way to do business. For non-recourse factoring, most factors will want to pre-approve customers, which may cause delays. The factor will apply credit limits to individual customers (though these should be no lower than prudent credit control would suggest).
  • The client company might only want the finance arrangements and yet it might feel it is paying for collection services they do not really need.
  • Ending a factoring arrangement can be difficult where the only exit route is to repurchase the sales ledger or to switch factors and that could cause a sudden shortfall in your working capital.

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Sources of Finance

Invoice Discounting

Invoice discounting enables you to retain the control and confidentiality of your own sales ledger operations.

The client company collects its own debts. 'Confidential invoice discounting' ensures that customers do not know you are using invoice discounting as the client company sends out invoices and statements as usual. The invoice discounter makes a proportion of the invoice available to you once it receives a copy of an invoice sent.

Once the client receives payment, it must deposit the funds in a bank account controlled by the invoice discounter. The invoice discounter will then pay the remainder of the invoice, less any charges.

The requirements are more stringent than for factoring. Different invoice discounters will impose different requirements. Typically, the client company:

  • Must have an annual turnover of at least £500,000.
  • Be subject to an audit by the factor, usually every three months, to check that credit control procedures are adequate.
  • Must have a minimum net worth of at least £30,000.
  • Must be profitable.

The requirements for 'disclosed' (i.e. non-confidential) invoice discounting are generally less demanding.

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Sources of Finance

Leasing

Leasing is a contract between the leasing company, the lessor, and the customer (the lessee). The leasing company buys and owns the asset that the lessee requires. The customer hires the asset from the leasing company and pays rental over a pre-determined period for the use of the asset. There are two types of leases:

  • Finance Leases
    Under a finance lease the rental covers virtually all of the costs of the asset therefore the value of the rental is equal to or greater than 90% of the cost of the asset. The leasing company claims writing down allowances, whilst the customer can claim both tax relief and VAT on rentals paid.
  • Operating Leases
    The lease will not run for the full life of the asset and the lessee will not be liable for its full value. The lessor or the original manufacturer or supplier will assume the residual risk. This type of lease is normally only used when the asset has a probable resale value, for instance, aircraft or vehicles.

    The most common form of operating lease is known as contract hire. Essentially, this gains the customer the use of the asset together with added services. A very common example of an asset on contract hire would be a fleet of vehicles.

Residual Values

A residual value is the value of the asset at the end of the lease term. Residual values play an important role in an operating lease that is used in conjunction with equipment that retains value at the end of the contract period. The residual value will be left out of the rental calculation. Either the leasing company or a third party will take the risk that the asset will not be worth the amount of the residual value at the end of the lease.

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Sources of Finance

Authorised, Issued and Called Up Share Capital

The memorandum of association of a limited company states the amount of authorised or nominal share capital. It also says how the share capital is divided into individual shares of a set amount, such as 10p a share.

There are no upper or lower limits on authorised share capital for private limited companies, but a public limited company (plc) must have an authorised share capital of at least £50,000.

A company can increase its authorised share capital by passing an ordinary resolution at a general meeting. Equally, a company can decrease its authorised share capital by passing an ordinary resolution to cancel some shares - this is called 'diminution of capital'.

Issued share capital comprises that part of the authorised share capital that has actually been issued, released or sold by the company. Tesco plc has authorised share capital of 9.2 billion shares at a total nominal value of £460 million but its issued share capital comprises just over 6.9 billion shares with nominal value of £347 million (see table below).

The difference between the authorised and issued share capital represents the number and value of shares that the company can issue should it need to raise further capital. Tesco, therefore, could issue around 2.3 billion shares to take its issued share capital up to its current maximum authorised share capital of 9.2 billion shares. The issued share capital cannot exceed the authorised share capital although companies can increase their authorised share capital if they need to, as we have already seen.

Of the minimum £50,000 authorised share capital that a public limited company must have, at least a quarter of the nominal value of each share and any premium must be paid before it can start trading or borrowing money.

Share capital is called up once it has been issued and the company is asking for payment. The following table for Tesco plc helps to illustrate the process for a public limited company:

Called up share capital
  Ordinary shares of 5p each
  Number £m
Authorised 9,200,000,000 460
Allotted, issued and fully paid:    
Issued at 24 February 2001 6,932,225,203 347
Scrip dividend election 22,148,324 1
Share options 39,906,181 2
Issued at 23 February 2002 6,994,279,711 350

Source: Tesco Plc Annual Report and Financial Statements 2002, Page 34

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Sources of Finance

Shares Issued and Paid For in Full on Application - At Par

Worked Example

Biz/ed plc issued 10,000 ordinary shares at par for £2 per share. Applications were received for exactly 10,000 shares and these are then allocated and issued. Complete the bookkeeping requirements for this share issue.

Solution

Issue shares at par paid in full on application no premium

Biz/ed plc

Shares issued 10000  
Par value per share 2  
Received in full on application and allotted immediately  
 
Bank a/c Dr Cr
Application and Allotment a/c 20000  
 
Application and Allotment a/c  
Ordinary Share Capital a/c 20000  
Bank a/c   20000
  20000 20000
 
Ordinary Share Capital a/c  
Application and Allotment a/c   20000

For you to do

Biz/ed plc issued 25,000 ordinary shares at par for £3.75 per share. Applications were received for exactly 25,000 shares and these are then allocated and issued. Complete the bookkeeping requirements for this share issue.

You can complete this task either by filling in the interactive form below or on paper using the printable worksheet. N.B. Do not insert commas or spaces between your figures in the boxes below.

Biz/ed plc


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Sources of Finance

Shares Issued and Paid For in Full on Application - At a Premium

Worked Example

Biz/ed plc issued 10,000 ordinary shares at a price of £5 per share that have a par value of £2 per share - that's a share premium of £3 per share. Applications were received for exactly 10,000 shares and these were then allocated and issued. Complete the bookkeeping requirements for this share issue.

Solution

Biz/ed plc

Shares issued 10000  
Par value per share 2  
Issue price 5  
 
Received in full on application and allotted immediately  
 
Bank a/c Dr Cr
Application and Allotment a/c par value 20000  
Application and Allotment a/c share premium 30000  
Balance c/d   50000
  50000 50000
 
Application and Allotment a/c  
Ordinary Share Capital a/c 20000  
Share Premium a/c 30000  
Bank a/c   20000
Bank a/c   30000
  50000 50000
 
Ordinary Share Capital a/c  
Application and Allotment a/c   20000
 
Share Premium a/c  
Application and Allotment a/c   30000

For you to do

Biz/ed plc issued 25,000 ordinary shares at a price of £12 per share that have a par value of £3.75 per share - that's a share premium of £8.25 per share. Applications were received for exactly 25,000 shares and these were then allocated and issued. Complete the bookkeeping requirements for this share issue.

You can complete this task either by filling in the interactive form below or on paper using the printable worksheet. N.B. Do not insert commas or spaces between your figures in the boxes below.

Biz/ed plc


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Sources of Finance

Under or Over Subscribed Share Issues

Under Subscription

If a share issue is under subscribed, this means that fewer shares were subscribed for (bought) than were available for sale. In this case all we need to do is to deal with the issue of the shares that were subscribed. The rest of the shares may then be issued at a later date.

However, it might be the case that if a share issue is seriously under subscribed then the offer for sale will be withdrawn. In this case all money received will be returned and no further action will be taken unless the company wants to try again later.

If we imagine that 10,000 shares were offered for sale but only 9,000 applications were received then it is likely that the full 9,000 would be issued exactly along the lines demonstrated in the at par and at a premium examples.

Over Subscription

Over subscription of shares can be relatively tricky. After all, how do we decide what to do with the shares that have been applied for but that are not for sale? That is, if we wish to issue 10,000 but we received applications for 15,000 shares, what happens to the additional 5,000 shares?

The normal solution can be two fold:

  1. The company applies a cut off rule and might accept offers from the first people to lodge their application - first come first served.
  2. The company might decide that everyone who has applied will receive some shares - often in proportion to their application. So, if two people apply for a total of 15,000 by applying for 9,000 and 6,000 respectively but there are only 10,000 shares available then we could apportion their application as follows:
    • Applicant 1 receives: 10,000 ÷ 15,000 x 9,000 = 6,000
    • Applicant 2 receives: 10,000 ÷ 15,000 x 6,000 = 4,000

Let's look at a more specific example of over subscription, without the need to work out who gets what!

Worked Example

Biz/ed plc issued 10,000 ordinary shares at par for £2 per share. Applications and payments in full were received for 15,000 shares and these are then dealt with as appropriate. Complete the bookkeeping requirements for this share issue.

Solution

Biz/ed plc

Shares issued 10000  
Par value per share 2  
Applications received for this number of shares 15000  
 
Received in full on application and allotted immediately  
 
Bank a/c Dr Cr
Application and Allotment a/c 30000  
Application and Allotment a/c (refunds)   10000
 
Application and Allotment a/c  
Bank a/c 10000  
Ordinary Share Capital a/c 20000  
Bank a/c   30000
  30000 30000
 
Ordinary Share Capital a/c  
Application and Allotment a/c   20000

For you to do

Biz/ed plc issued 20,329 ordinary shares at par value of £10 per share. Applications were received for 34,011 shares and these are then dealt with as appropriate. Complete the bookkeeping requirements for this share issue.

You can complete this task either by filling in the interactive form below or on paper using the printable worksheet. N.B. Do not insert commas or spaces between your figures in the boxes below.

Biz/ed plc


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Sources of Finance

Bonus, Scrip or Capitalisation Issue

In the table that follows, we see that Tesco, along with many other companies, has had a scrip issue. A scrip issue is also known as a bonus or capitalisation issue. With a scrip or bonus issue, a company transfers profits to a fund called its capital redemption reserve and uses it to issue bonus shares to the members in proportion to their existing holdings.

One effect of a bonus issue is that it can reduce the amount of money available for paying dividends, so the term bonus is not always appropriate and that is why the term capitalisation of reserves is sometimes used. A company can also use a capitalisation issue to credit partly paid shares with further amounts to make them paid up. For example, imagine that we have the following situation:

Issued Share Capital £
100,000 Ordinary Shares of £1 part paid 75,000
Retained Profits 66,000
Ordinary Shareholders' Funds 141,000

The company now decides to transfer £25,000 from retained profits to the ordinary share capital account. The balance sheet looks like this now:

Issued Share Capital £
100,000 Ordinary Shares of £1 fully paid 100,000
Retained Profits 41,000
Ordinary Shareholders' Funds 141,000

It's just a bookkeeping transaction but the effect is that the shareholders do not now need to pay any more money into the company. No cash changes hands with a bonus issue.

A rights issue, on the other hand, is a cash transaction. With a rights issue of shares, existing shareholders are given the right, or strictly speaking the first refusal, to buy new shares that the company is issuing. The rights issue is normally made in proportion to existing shareholdings so that if I currently own, say, 10% of all issued shares, I will be offered the right to buy 10% of the newly issued shares. There is a numerical example of a rights issue below.

The following table illustrates the terms authorised, issued and called up share capital for Tesco plc:

Called up share capital
  Ordinary shares of 5p each
  Number £m
Authorised 9,200,000,000 460
Allotted, issued and fully paid:    
Issued at 24 February 2001 6,932,225,203 347
Scrip dividend election 22,148,324 1
Share options 39,906,181 2
Issued at 23 February 2002 6,994,279,711 350

Source: Tesco Plc Annual Report and Financial Statements 2002, Page 34

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Sources of Finance

Allotment of Shares

Task 1

Date Details Number Nom Value On Application
01/01/2004 Ordinary shares offered for sale 23265 3.52  
31/01/2004 Applications received for 26265   0.46
05/02/2004 Allotment 23265    

Required:

Prepare the application and allotment account to reflect these transactions.

You can complete this task either by filling in the interactive form below or on paper using the printable worksheet. N.B. Do not insert commas or spaces between your figures in the boxes below. Fill in all your answers to two decimal places.

Application and allotment a/c


Task 2

Date Details Number Nom Value On Application
01/01/2004 Ordinary shares offered for sale 12384 4.67  
31/01/2004 Applications received for 15384   0.57
05/02/2004 Allotment 12384    

Required:

Prepare the application and allotment account to reflect these transactions.

You can complete this task either by filling in the interactive form below or on paper using the printable worksheet. N.B. Do not insert commas or spaces between your figures in the boxes below. Fill in all your answers to two decimal places.

Application and allotment a/c


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Sources of Finance

Overnight Bamboo plc

Overnight Bamboo (1473) plc was formed with an authorised share capital of 142337 ordinary shares of £1 each. These shares were offered to the public on the following terms:

Total Ordinary Shares of £1 issued 142337  
 
  Shares Premium
On application: 25p 0.25  
On application: 40p premium   0.40
On allotment: 25p per share 0.25  
First and final call: the balance of 50p per share 0.50  

The following events then unfolded:

Total applications received 193438
Applications rejected 20932
Applications refunded 30169

In respect of the applications rejected, the directors allotted shares to the remaining applicants pro rata to their applications.

Required:

Prepare the accounting entries to record the issue of the shares by Overnight Bamboo (1473) plc.

You can complete this task either by filling in the interactive form below or on paper using the printable worksheet. N.B. Do not insert commas or spaces between your figures in the boxes below.

Overnight Bamboo (1473) plc

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Sources of Finance

Helford Global plc

Helford Global (8600) plc was formed with an authorised share capital of 139,818 ordinary shares of £1 each. These shares were offered to the public on the following terms:

Total Ordinary Shares of £1 issued 139818  
 
  Shares Premium
On application: 25p 0.25  
On application: 32p premium   0.32
On allotment: 25p per share 0.25  
First and final call: the balance of 50p per share 0.50  

The following events then unfolded:

Total applications received 209830
Applications rejected 22405
Applications refunded 47607

In respect of the applications rejected, the directors allotted shares to the remaining applicants pro rata to their applications.

Required:

Prepare the accounting entries to record the issue of the shares by Helford Global (8600) plc.

You can complete this task either by filling in the interactive form below or on paper using the printable worksheet. N.B. Do not insert commas or spaces between your figures in the boxes below.

Helford Global (8600) plc

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