This is the first of a series of articles on financial Intelligence by the writer for the purpose of developing the awareness of financial relationships and their impact on business and investment decisions in most aspects of our daily lives. In a world that is competitive and with financial resource constraints, it becomes especially urgent for the individual to develop the capacity to understand financial relationships and issues that evolve around us all the time. Finance is an economic subject affecting both individual and the business entity, and an understanding is crucial for more effective economic management and decision-making. At an individual level, financial matters are just too important to be left to someone else to decide or even recommend a course of action.
Our financial world
Today’s environment is driven by money in business, investments and all aspects of personal lives. Income are earned and spent, surplus cash savings are invested in bonds, gold, properties and shares, or even exotic assets that some people do not understand, other than taking the assurance of their financial or investment advisors. Actually, gold is not an investment, and more discussion would be good as some people would not agree.
Saving and investing
Individuals understand enough of economics to create savings for health insurance, home acquisition, retirement, school fees and many more. The income for an individual is derived mainly from employment, and for the wealthier ones with assets, perhaps some rental income and cash dividends from their businesses, if they have one. The less endowed individuals will strive to save and invest some hard – earned money into something that can grow and create wealth. Then there is the inflation monster that will erode the value of money and wealth. So, it is the more urgent then to find some safe haven for their surplus money that can grow at a pace that beats the inflation monster.
Some think that by buying life insurance it is one way to achieve wealth in the future, just like some who thinks that buying gold is an investment. These two issues should spark off some lively debate among the less knowledgeable persons.
Business and investment
We shall begin by initiating some thinking over business and investment as most people would want to put away their extra money into ‘something’ that can grow and create wealth for the future. Buying an investment, whether a property or some shares in a company is easy. Getting into a really performing investment, whether property or shares or gold, is the critical issue. The risk is buying the wrong stuff – non-performing investment, or worse, a financial loss.
In a world with swarms of glib-tongue financial advisors and investment experts in every corner of the world, it is never difficult to get advice and investment suggestions, only to be realize later that all those that glitters are actually not gold, perhaps some have turned to stones.
We will begin with building a picture of the money around us. The money around us, is in businesses and companies we see every day. It is in the shops that we buy things from, the companies we work in, and those reputable companies where we invest our extra money in, by buying their shares. There are many more, including the airlines that we choose to fly and the hotels we checked into, as well as the electricity and telecommunication companies that sell us their services.
It will be appropriate to know how these companies or businesses get their money and, how they made profits. The journey begins with the financial picture which we shall call the financial structure of a company, or corporation – which is the same thing.
The financial structure of a company
It is common to register a business under the name of a company, which is, in turn registered with a government agency. The business is about serving its customers and markets with products or services. For instance, a 5-star hotel is built to serve international businessmen and to provide conference and banquet facilities. This hotel, as an example, needs an investment of $200 million. The picture below illustrates it. We can call it Hotel California 2020 Limited.
Since the hotel property and facilities require $200 million, the people who wish to run this business will have to bring in the same amount of $200 million, as capital, or if that is insufficient, it is supplemented by bank loans.
The decision on the amount of loans versus the amount of capital depends on the financial capacity of the owners or shareholders of the hotel company. If the shareholders are wealthy and can afford, they may put up 100% of the $200 million investment. Otherwise, they may bring in some and borrow some, subject to bank’s lending conditions. But borrowing too much is risky, especially when business is slow, or it is overly competitive. This decision is called the debt – equity decision by business and investment people. This introduces us to the financial structure of the company, or the debt equity structure. There will be some other matters to be considered as well in time to come.
Together with this comes the question on how much show be the capital and how much to be borrowed. Simple logic and wisdom is this – a borrowing has to be repaid on time to preserve the borrower’s credibility and to avoid potential legal actions for any delay. On the other hand, borrowing money to do business makes sense, if we can borrow at a lower rate while earning a higher one. For an example the hotel can potentially earning 8% a year on its investment of $200 million and it costs 6% to borrow. It would be logical to borrow $200 million and make 2% net! However, the bank would never do that, otherwise, the bank might as well run the hotel itself and make all the money then.
So, the amount of money to be borrowed will depend on the willingness of the bank-based on its assessment of the borrower’s reputation and hotel business risk. The bank might lend 50% or 75% of the $200 million. The shareholders or owners of the hotel business will now consider whether a 50% borrowing would be better than 75%. The question is resolved by looking at the following numbers –
Borrow 50% Borrow 75%
Hotel income potential 8% p.a. $ 16 million $ 16 million
Cost of borrowing $100 million @6% p.a. – 6 million
Cost of borrowing $150 million @6% p.a. 9 million
Net income after interest expense $10 million $ 7 million
Capital for the hotel from owners $100 million $ 50 million
Return on capital from the owners $(10 $(7
10% p.a. 14% p.a.
This illustration confirms that if a business can borrow more cheaply than the returns it can obtain, then it should borrow to the maximum – subject to the bank’s willingness to lend, and also the understanding of the risk of poor business at some stage. The higher the risk of business volatility, the lesser should one borrow. So, for a conservative start, the borrowing of 50% with another 50% from own capital, may be a practical suggestion.
In this discussion, we already examine the financial structure of a new business and how much its should borrow, and that is tied to the return on the investment. It is not unusual to begin with the shareholders’ expected return, and then decide how much capital and debt to be raised.
Capital structure of a company
Sometimes one may hear of the term ‘capital structure’. The capital structure refers to the way long term capital funds are obtained to do the business. Generally, the owners or the shareholders will bring in their funds before talking to the banks. A company typically will issue shares in exchange for the cash the shareholders are putting in. In our hotel company example, assume the shareholders wish to bring in $75 million as capital. The company can then issue 75 million shares of $1.00 per share to each shareholder according to his or her shareholding. The balance of $125 million will be raised from the banks and others.
Assume there are 5 shareholders of our Hotel California 2020 Limited.
Name of shareholders No. of $1.00 shares Cash paid in % ownership
John 10 000 000 $10 million 13.33
Jim 2 000 000 $ 2 million 2.67
Jane 25 000 000 $25 million 33.33
Jack 8 000 000 $ 8 million 10.67
Joe 30 000 000 $30 million 40.00
Total 75 000 000 $75 million 100.00
Jane, a major shareholder in this Hotel California 2020, is also willing pay into the company another $25 million but not as capital. This $25 million is to be treated as a loan with an interest rate which they shareholders have agreed to. If that is accepted, then the financial structure of this hotel company includes a capital structure as follows.