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Selecting Financial Strategies

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Some ways to raise finance

Internal External

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Some ways to raise finance

Internal ExternalRetained profits

Working capital

Asset disposals

Sale & leaseback

Issue shares

Bank loan / overdraft

Debentures

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Retained profits

The most important and significant source of

finance for an established, profitable

business

Retained profits – main advantages

• Cheap (though not free)– The “cost of capital” of retained profits is the

opportunity cost for shareholders of leaving profits in the business

• Very flexible– Management control how they are reinvested – Shareholders control the proportion retained

• Does not dilute the ownership of the company

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Possible downsides of retained profits

• Danger of hoarding cash

• Shareholders may prefer dividends if the business is not earning a sufficient ROCE

• High profits and cash flows would suggest the business could afford debt (higher gearing)

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Working capital as a source of finance

• Reducing working capital– A one-off benefit from lower working capital– The question – can it be sustained?

• Finance often wasted in excess stocks and trade debtors

• Look for very low stock turnover ratio or high debtor days

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Asset disposals

• Potentially another one-off boost to finance

• Good examples: spare land, surplus equipment

• Note – not all businesses have spare assets

• Often occurs after acquisitions

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Example of assets sale

• Retailer JJB Sports has said it may be heading for a full-year loss of up to £10m after seeing sales fall in "extremely difficult" trading

• JJB is looking to sell its Fitness Clubs business

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Sale and leaseback

• Specialist method of raising cash

• Involves selling fixed assets and then leasing them back from new owner

• Tends to involve business properties (e.g. hotels, supermarkets, offices – popular when property market was booming

• Note: can only be done once!

Example of sale & lease back

• Sorry – another football link!

• Leeds football club are trying to raise funds by selling off Elland Road football ground for £6m and then lease back.

• They are trying to sell to Leeds council.

• The negotiations are still underway.

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Issuing shares

Company issues new shares

1

Shareholders buy the new shares

2

Company has:More cash

More shareholders

3

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Examples of issuing share rights

• Working lunch great visual example of what share rights involve…

• HSBC bank share rights issue

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Methods of issuing shares for a plc

Flotation Share issued on Stock Exchange for the first time

Opportunity for existing shareholders to realise profits on their investment

Costly + time-consuming process

Aims to raise at least £25-50million + of new capital

Rights issue

Fresh issue of new shares to existing shareholders

Shareholders have the “right” to subscribe for the new shares, usually at a significant discount to the existing share price

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Share issues – benefits and drawbacks

Benefits Drawbacks

Able to raise substantial funds if the business has good prospects

Can be costly and time-consuming (particularly flotations)

Broader base of shareholders Existing shareholders’ holdings may be diluted

Equity rather than debt = lower risk finance structure

Equity has a cost of capital that is higher than debt

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Raising Loan Capital

Bank overdraft

Bank loan

DebenturesCovered in BUSS2

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Debentures

A debenture is a form of bond or long-term loan which is issued by the

company, usually with a fixed rate of interest

Debentures – key features

• Long-term: often 10-20 years

• Issued by the company (not a bank)

• Fixed rate of interest

• Usually secured against the assets of the company (provides some protection for debenture holders)

• Can be traded

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Cost Minimisation Strategies

Cost minimisation aims to achieve the most cost-effective

way of delivering goods and services to the require level of

quality

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Cost minimisation• What strategies can a business take to minimise costs?

(although this is a financial question the answer could come from any functional area or even a corporate solution)– Marketing

• Low cost strategy– Operations Management

• Relocation• Lean production

– Human Resources• Changing organisational structure• Workforce plans

– Corporate• Close unprofitable branches

Cost minimisation is a recurring theme

in BUSS3

What financial strategies has Ryanair taken to achieve its

objective of growth?What other factors have

influenced these strategies ?

Possible sources of cost reductions• Eliminating waste & avoiding duplication (lean production)• Simplifying processes and procedures• Outsourcing non-core activities (e.g. transaction processing, payroll

administration, call handling)• Negotiating better pricing with suppliers• Improving communication• Pruning product ranges and customer accounts to eliminate

unprofitable business• Using the most effective methods of training and recruitment• Introducing flexible working practices• Aggressive control over non-essential overheads (e.g. banning first or

business class travel unless essential)

Potential problems with cost minimisation

• Business left with insufficient capacity to handle unexpected or short-term increases in demand

• Cost reductions by one department may surprise and/or annoy other functions if they are not properly communicated and coordinated

Your go…

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Textbook – p 55

• Sainsburys - mini activity • VW - mini activity Q 1&2

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Profit Centres

A profit centre is a separately-identifiable part of a business

for which it is possible to identify revenues and costs

(i.e. calculate profit)

Examples of profit centres

• Individual shops in a retail chain

• Local branches in a regional or nationwide distribution business

• A geographical region – e.g. a country (for multinationals) or county

• A team or individual (e.g. a sales team, a team of installers)

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Benefits and drawbacks of profit centresAdvantages DisadvantagesUseful insights into where profit is earned within a complex business

Can be time-consuming to both set-up and monitor

Supports budgetary control at a detailed level, including setting profit objectives

Difficulties in allocating costs (particularly) and revenues (occasionally)

Can improve motivation of those responsible for the profit centre

May lead to conflict and competition rather than cooperation within the business

Comparisons can be made between similar profit centres (e.g. shops in a chain)

Potentially de-motivating if profit centre targets are too tough, or if unfair cost allocations are made

Improves decision-making at a local level (likely to be closer to customer needs)

Profit centres may pursue their own objectives rather than those of the broader business

Finance can be allocated more efficiently – where it makes the best return

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Plenary Q’s• Why might a car manufacturer need to raise large

sums of money?

• What options are available internally & externally to raise such sums to a car manufacturer in today’s economic climate?

• What are the benefits of using retained profit for a major investment? What are the opportunity costs of using your retained profits too? (consider the ratios that will be effected)

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Hwk

• Textbook – read info on Profit centres – p56 to 58

• Make key revision notes:• What is a profit centre?• Benefits & limitations of profit centres.• Implications of profit centres.