How Companies Set Their Financing

How Companies Set Their Financing

Developing a relevant financing strategy is a priority to companies which are oriented towards attaining substantial revenue and remaining competitive in the market. Financial managers encounter the challenges associated with the rapid growth of business enterprises. They need to raise significant amounts of funds to comply with such dynamic growth (Bottazzi and Da Rin 2002). The ultimate objective for companies is to maximise the value related to shareholders’ equity. Therefore, the purpose of this paper is to clarify how companies set their financing through exploring short-term and long-term policies as well as factors that companies should consider in setting their policies to raise capital.

Upon setting their financing, companies consider the opportunity to produce a cash flow ‘pie’, which refers to the total operating cash flow distributable to investors. An essential approach adopted by companies is to emphasise that the size of the cash flow pie is independent of financial policy. In this way, the important role of finance is to divide the respective pie into different slices by issuing certain types of securities (Haushalter 2000). Moreover, organisations focus on distinct ways in which financial policy would be able to increase the size of the value pie by exercising influence on both operating and investment decisions. Thus, company managers are extensively dedicated to the goal of improving stakeholder relationships and strengthening management incentives.

In the process of setting their financing, companies should consider the impact of tax factors. The uneven tax treatment of different components of financial cost represents the risk of decreasing after-tax financing costs. This occurs as a result of the initially determined governmental share of the cash flow pie (Lopez-Gracia and Aybar-Arias 2000). Therefore, some companies tend to perceive debt financing as more cost-effective than equity financing. The reason for this can be explained with the fact that interest payments are tax deductible, while dividends are paid out only of after-tax income. Undoubtedly, all companies require an initial investment to comply with their requirements (Bottazzi and Da Rin 2002). Raising capital for investment represents an essential part of the overall financial planning structure. In this relation, it is mandatory that companies should outline the sources to raise capital. Such sources may relate to loans, leasing opportunities, or investors. Large corporations are more likely to raise capital through bonds and issuing stocks. This is the case with Tesco, as its market capital is £23,002.72 million (Tesco Personal Finance PLC 2013). Compared to Tesco, the market capital of Sainsbury’s is £6,028.22 million (Kalmarova 2012). Both companies operate in the same industry, in particular food and drug retailing sector.

Raising capital for investment is an ongoing initiative based on a thorough research of the market, as illustrated in the business and marketing activities of Tesco and Sainsbury’s. The mentioned option of setting bonds may be a viable one considering that the interest rate is lower compared to loans. Yet a proper strategy utilised by big corporations, such as Tesco, is to raise capital by selling stocks. This implies that investors are able to invest in stock as they get paid substantial dividends in return.

Furthermore, while companies are setting their financing the importance of determining the level of debt equity balance emerges. Companies should maintain such level accordingly. It is apparent that changing debt will respectively change cash flow to equity (Hovakimian, Hovakimian and Tehranian 2004). Moreover, any increase of debt is associated with creating risks for equity and thus cost of equity will significantly increase. It has been indicated that the debt to equity ratio of Tesco is 65%, which describes the financial gearing of the corporation as moderate (Tesco Personal Finance PLC 2013). In comparison, Sainsbury’s 5-year average return on equity (ROE) ratio is approximately 10.5%, which is lower than Tesco’s ROE, respectively 15.5% (Kalmarova 2012). Such low returns of Sainsbury’s refer to its margins, which have been lower than those of Tesco.

Indeed, selecting between equity and debt is an important part of the debt and equity financing strategy of companies. Essential considerations should be made such as determining the exact funds needed by organisations, types of expenditures to be financed, determining the period for paying back the money and any interest or return, and existing financing mechanisms for the different stages of business development (O’Brien 2003). Both Tesco and Sainsbury’s have thoroughly considered these requirements in the process of setting their debt and equity financing strategy. In this way, the respective corporations indicate the use of short-term debt for financing assets that can quickly be turned into cash. Long-term debt refers to financing assets for a longer period, respectively capital equipment (Kalmarova 2012). An observable aspect of the financing strategy of Tesco and Sainsbury’s is that both companies tend to use long-term debt to later-stage with cash flow.

In fact, debt and equity financing represents two options for financing companies. Small businesses, unlike Tesco and Sainsbury’s, usually consider the option of taking bank loans for setting their financing. At the same time, equity financing represents a significant drawback in the sense that a company will be no longer the full owner of a business once there are other financial contributors expecting a particular share (Hovakimian, Hovakimian and Tehranian 2004). The respective financing strategy depends on ensuring a clear understanding of the overall business, the applicable business approach, and companies’ financing needs.

In this context, it is important to mention that Tesco’s capital position has remained quite strong in the period between 2012 and 2013. A significant aspect of the debt and equity financing strategy adopted by Tesco is that it converted approximately £140.0 million of dated subordinated debt with Tesco Personal Financial Group Limited to equity during the same period (Tesco Personal Finance PLC 2013). In this way, Tesco succeeded in strengthening the tier 1 capital ratio. Moreover, Sainsbury’s net debt gradually decreased during the period from 2006 to 2008 (Kalmarova 2012). Yet the same debt increased in 2009, and then in 2011 the net debt increased by approximately £265 million, which was as a result of property disposals and gearing increases by 33.4%.

Based on the examples provided from Tesco and Sainsbury’s, a basic proposition about debt and value can be indicated. In order for debt to affect value, there should be tangible benefits and costs relating to debt usage instead of equity. In case the benefits exceed the costs, the result will be an increase of value to equity investors from debt usage (O’Brien 2003). When the benefits offset the costs, debt will not influence value. In the complex business environment with taxes, debt and value are interrelated. Therefore, companies need to set their financing adequately to reflect the mentioned observations.

This paper provided a discussion of how companies set their financing through both short-term and long-term policies. In addition, certain factors in setting such policies were clarified with the purpose to raise capital for investment and determine the level of debt equity balance to be maintained (Lopez-Gracia and Aybar-Arias 2000). Two examples were used to demonstrate important assumptions and concepts related to setting a debt and equity financing strategy, in particular Tesco and Sainsbury’s. In conclusion, the process of setting companies’ financing is complex as it reflects different factors and thus organisations need to make certain considerations in order to be competitive in the global business environment.

References

Bottazzi, L. and Da Rin, M., 2002, ‘Venture capital in Europe and the financing of innovative companies’, Economic Policy, vol. 17, no. 34, pp. 229-270.

Haushalter, G. D., 2000, ‘Financing policy, basis risk, and corporate hedging: Evidence from oil and gas producers’, The Journal of Finance, vol. 55, no. 1, pp. 107-152.

Hovakimian, A., Hovakimian, G. and Tehranian, H., 2004, ‘Determinants of target capital structure: The case of dual debt and equity issues’, Journal of Financial Economics, vol. 71, no. 3, pp. 517-540.

Kalmarova, Z., 2012, ‘Sainsbury’s vs. Morrisons-an investment decision based on financial analysis’, Financial Assets and Investing, no. 3, pp. 17-28.

Lopez-Gracia, J. and Aybar-Arias, C., 2000. ‘An empirical approach to the financial behaviour of small and medium sized companies’, Small Business Economics, vol. 14, no. 1, pp. 55-63.

O’Brien, J. P., 2003, ‘The capital structure implications of pursuing a strategy of innovation’, Strategic Management Journal, vol. 24, no. 5, pp. 415-431.

Tesco Personal Finance PLC, 2013, Interim report for the six months ended 31 August 2013,

[Online], Available: http://www.rns-pdf.londonstockexchange.com/rns/4636P_-2013-10-1.pdf [16 Apr 2014].