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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.

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Internal Sources

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

Personal savings

Retained profit

Working capital

Sale of assets

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:

Ordinary shares

Preference shares

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.

Debentures

Other loans

Overdraft facilities

Hire purchase

Lines of credit from creditors

Financial structures of four well known British companies

Grants

Venture capital

Factoring and invoice discounting:

o Factoring

o Invoice discounting

Leasing

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:

o Shares can be issued and paid for in full on application, either

at par , or

at a premium .

o Share issues might be under or over subscribed.

o 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.

o 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.

o Allotment of shares

o Overnight Bamboo plc - accounting entries to record the issue of shares

o Helford Global plc - accounting entries to record the issue of shares

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

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!


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.


Sources of Finance

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


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)

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 soldat 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.

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:

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!


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.


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'.


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.

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.


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


Sources of Finance

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


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.


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


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.

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


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.


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.


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.


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.


Sources of Finance

Authorised, Issued and Called Up Share Capital

The memorandum of association of a limited company states the amount

ofauthorised 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


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


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


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


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

Shares issued

Par value per share


Bank a/c Dr Cr




Bank a/c



Now look at the answers page...


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


Issue price 5


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



Share Premium a/c 30000

Bank a/c 20000

Bank a/c 30000

50000 50000



Share Premium a/c


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





Biz/ed plc

Shares issued

Par value per share

Issue price


Bank a/c Dr Cr

Application and Allotment a/c par value

Application and Allotment a/c share premium

Balance c/d



Share Premium a/c

Bank a/c

Bank a/c



Share Premium a/c




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:

o Applicant 1 receives: 10,000 ÷ 15,000 x 9,000 = 6,000

o 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


Applications received for this number of shares 15000


Bank a/c Dr Cr


Application and Allotment a/c (refunds) 10000


Bank a/c 10000


Bank a/c 30000

30000 30000



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





Biz/ed plc

Shares issued

Par value per share

Applications received for this number of shares


Bank a/c Dr Cr


Application and Allotment a/c (refunds)


Bank a/c


Bank a/c





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 itscapital

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:


Scrip dividend election 22,148,324 1

Share options 39,906,181 2


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


Sources of Finance

Allotment of Shares

Task 1

Date Details Number Nom ValueOn 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.



figures in the boxes below. Fill in all your answers to two decimal places.

Application and allotment a/c

Date Details Dr Cr

01/01/2004

Share Capital a/c

31/01/2004

Cash book: applicants' money

05/02/2004

Cash book: refund of oversubscriptions

05/02/2004

Balance c/d


Task 2

Date Details Number Nom ValueOn 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.



figures in the boxes below. Fill in all your answers to two decimal places.

Application and allotment a/c

Date Details Dr Cr

01/01/2004

Share Capital a/c

31/01/2004

Cash book: applicants' money

05/02/2004

Cash book: refund of oversubscriptions

05/02/2004

Balance c/d



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.




Overnight Bamboo (1473) plc

Bank a/c Number per share


application


application premium


allotment

First and Final Call a/c

call


allotment rejected: shares and premium


allotment refund: shares and premium

Balance c/d


Dr Cr


application


allotment

First and Final Call call

Balance c/d

Share Premium a/c





Share Premium a/c

Bank a/callotment rejected: shares and premium

Bank a/c application

Bank a/capplication premium

Bank a/c allotment

Bank a/callotment refund: shares and premium



Bank a/c



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.




Helford Global (8600) plc

Bank a/c Number per share


application


application premium


allotment


call


allotment rejected: shares and premium


allotment refund: shares and premium

Balance c/d


Dr Cr


application


allotment

First and Final Call call

Balance c/d

Share Premium a/c





Share Premium a/c

Bank a/callotment rejected: shares and premium

Bank a/c application

Bank a/capplication premium

Bank a/c allotment

Bank a/callotment refund: shares and premium



Bank a/c



Submitted by bized on Thu, 01/07/2004 - 12:00

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