Funding and Corporate Government Issues
Different methods used to fund organisations and different funding structures affect the financial viability of organisations. Corporate governance has particular importance in both private and public sector organisations particular due to various accounting scandals. There is emerging use of public-private partnerships to provide improved public infrastructure without excessive use of debt finance.
Working capital is used to describe the funds immediately available to the organisation. The maintenance of an adequate amount of working capital to pay debts is an essential function of financial management. Failure to meet short-term liabilities can very easily destroy confidence in a company. As an equation is its calculated as:
Working capital = Current assets – Current liabilities
If an organisation needs to raise finance to either fund its working capital or invest, one option is to borrow capital for a specific period at a given interest rate. This is known as debt capital. There are many different types of debt capital and these may be divided into two categories; short-term debt capital and long-term debt capital.
Short-term includes overdrafts, loans and trade credit. Long-term includes mortgages, guaranteed loans (where a person or group guarantees the debt if the borrower cannot pay), debentures/bonds (security against the assets of the company for a fixed or floating interest rate and have a high priority for repayment in the case of bankruptcy), unsecured notes (unsecure debentures, lower bankruptcy priority - but higher than shareholders) and convertible notes (similar to debentures but can be converted to shares).
Equity capital is available for the life of the organisation because it is not repayable to the holders unless the company ceases to exist. There are four main types of equity capital: (a) capital provided by the owner(s) (b) retained profits (c) ordinary shares (d) preference shares.
For a company, the most important form of equity capital is the ordinary shareholding. Once the company is established, rights issues or private placements can raise equity capital.
A rights issue is one made to existing shareholders in proportion to their existing holding. For example, a one-for-four issue means a shareholder has the opportunity to acquire one further share for every four already held. The advantage of a rights issue is the shareholders retain the same ownership percentage of the company if they acquire their entitlement.
A private placement is where the company issues a parcel of shares up to 10% of capital to large institutional shareholders, which can be done without shareholder approval. The benefit of a private placement is that it is quicker and the price is usually higher but existing shareholder equity is diluted.
Issued share capital, both paid up and uncalled, differs from authorised or registered share capital. Authorised or registered share capital is the number and value of shares that can be legally issued by a company. A company that has an authorised capital of $500 000 but has only issued 5 shares with a face value of $2 has only $10 on which creditors can draw. It has authority to issue up to 250 000 shares, but has complete discretion as to when it does so, if it ever does at all.
In addition to ordinary shares, some companies also issue preference shares. Preference shares are so termed because owners of these shares receive preferential treatment over ordinary shareholders in respect to payment of dividends and repayment of capital if the company ceases operations. While the ordinary dividend can fluctuate with profitability, the preference dividend is usually fixed at the time of issue and remains unchanged each year.
Preference equity capital is less popular than debt, because it is more expensive since the preference dividend is not tax deductible whereas interest on debt finance is.
The term used to describe use of debt is gearing or financial leverage. The use of debt finance (gearing) involves risks to the borrower. By comparison, equity is not repayable to the shareholders unless the company is liquidated.
The desirability of gearing depends on whether the return generated from the investment of the funds raised exceeds the total cost of the debt capital. Excessive reliance on debt to finance operations may lead to a decline in profitability and ultimately losses.
As the interest paid on debt is tax deductible and no such benefit is available for equity, the use of debt should lead to a higher earnings per share and return on equity. Earnings per share is obtained by dividing net profit available for distribution to ordinary shareholders by the issued capital (number of shares).
The use of debt finance increases financial risk as the company has increased firm commitments to pay interest and repay loans. To allow for this, the price/earnings (P/E) ratio is used to take into account the level of risk involved.
The return on shareholders' equity is calculated by dividing the net profit available to ordinary shareholders by the average shareholders' equity (capital + reserves + appropriation)
Unfavourable gearing, as the return is less than the cost of debt and leads to a fall in earnings per share. Indifferent gearing, as the return is the same after the expansion as it was prior to the fundraising. As the return on investment equals the cost of debt, earnings per share remain unchanged. Favourable gearing as the return on investment exceeds the cost of debt and leads to an increase in earnings per share.
Corporate governance is defined as appropriate disclosures and the development of internal structures that provide for independent review of processes and decision-making within a company (Corporate Law Economic Reform Program Act 1999). The Guidance Notes to the Australian Stock Exchange Listing Rules specify the disclosures required.
Governance of a company is the responsibility of the Board of Directors. For this reason,
guides for best practice in governance focus on board structures and how they can function
effectively. The following matters are usually considered:
- the appropriate mix of executive and non-executive directors
- the independence of non-executive directors
- the oversight of the preparation of the entity's financial statements, internal controls andthe independence of the company's auditors
- the review of the compensation arrangements for the chief executive officer and other senior executives
- the way in which individuals are nominated for positions on the board
- the resources that are made available to directors in carrying out their duties.
In the United States, the Sarbanes-Oxley Act 2002 has sought to rectify past failures in performance by senior management, boards of directors and external auditors in the light of corporate collapses such as Enron and other companies. The text of this Act is available.
Public-private partnerships (PPPs) are partnerships between governments and private companies designed to provide improved infrastructure and related facilities for the benefit of the community. Infrastructure can be defined as physical assets required to satisfy the public's need for access to major economic and social facilities and services. Infrastructure assets are of a long-term nature and involve high capital costs.
Most PPPs take one of two forms:
- a private sector entity is involved in building, owning, and operating a facility (known as BOO)
- a private sector entity is involved in building, owning, operating the facility, then transferring it to the public sector at the end of the operating period (known as BOOT).
PPPs have arisen from increasing pressure placed on governments to upgrade and expand facilities, provide improved services and at the same time avoid excessive use of debt finance. Success is not guaranteed, however, and is critically dependent on stable and reliable government and private sector operators who are experienced and can deliver.
PPPs have implications for both parties in terms of financial reporting and governance. Some years ago it was recognised that accounting standards had not evolved in line with these arrangements and that existing standards do not cover the issues involved.