CS 302 Professional Issues

Chapter 3 - Finance: Funding & Legal Requirements

§3.0 Necessities! §3.2 Legal Requirements
§3.1 Sources of Funding

Previous Reading: Finance: Costing & Cash Flow

§3.0 Necessities!

In case there were any previous doubts, a company needs money!

Why? Why do we need money at the start of development of some product, or of our company?

Even when the company is selling its product ...

... there is a long gap between issuing an invoice and actually being paid

It is jumping out of context somewhat, but when we are the debtor rather than the debtee (in other words, when it is we who owe the money) there is an ethical requirement to settle the debt with reasonable speed; remember how there were times when financial considerations were not the only things that drove us to decide what to do?

When we are concerned with a single, big contract - for example, a piece of bespoke software, or a major piece of consultancy - there are similar problems, but we can ease them by making use of "stage payments"

a technique which can considerably ease our financial need.

But the general question remains ... whence the money necessary to fund us through the period before adequate sales revenue starts to flow in?

§3.1 Sources of Funding

For any company, the very first source of funds is likely to be through the sales of its shares

But as a source of funds this is somewhat restricted

Note that the initial sale price of shares cannot legally be below their nominal (face) value, although only part of the value can be initially asked for

So if you have, say, £10 shares, you can if you wish initially claim only £1 (though the buyer would then be committed to supplying the other £9 when you sought it). What you can't do, is to sell that £10 share for perhaps £5. This makes sense, if you think about it, because the holder of that £10 share is acquiring rights in the company in proportion to the face value of their share holding.

This restriction applies when a company is being set up (or when it is issuing additional shares to raise further equity capital). Subsequent movements in share price are a totally different matter! So you can begin to see why one company can make a lot of money by underwriting a new issue of shares ... committing to buying the shares at their nominal value, with a view to selling them a a subsequent higher, market value! Or, indeed, how the stock market works, with people backing their judgements on how well companies will perform - unless you know what you are doing, a form of high class gambling!

The snag with equity capital, particularly if we are talking about a new company in a rather unknown area of business, is that the initial capitalisation is likely to be small. We are thus usually limited in the amount of capital we can raise!

Loans are another major source of funding ... provided you can charm the bankers, typically by constructing a sound "business plan".

In effect, a business plan is a discounted cash flow statement, but one

But even with a good business plan it will usually be necessary to provide some necessary and appropriate financial "security". In particular, it is likely that those providing the loan will, if things go wrong, have first call on the company's assets.

The provision of loans is of course a commercial exercise in its own right. But under the right circumstances they can be relatively cheap (i.e. subsided!)

Considerations of employment are vital to governments subject to free election, and so to the foundability of companies!

The ratio between loan and equity capital is called gearing or, if you live on the wrong side of the Atlantic, leverage.

Bott, Coleman, Eaton & Rowland illustrate the importance of the concept very simply. They give the unrealistic example of a highly geared company with £10,000 loan and £100 equity (the sort of funding pattern which could easily appeal to some carefree engineer wanting to start a small company):

There is another and very different comment to be made in the context of loans. With the rise in the numbers of trained scientists and engineers with ideas to exploit, so there has been a rise in the ranks of those who have developed the skills and knowledge to exploit the technical opportunities - "exploit" not being in this context a pejorative word! "Venture Capitalists" are essentially private financial judges, advisors and funders who fulfill an important role in the context of starting up new companies. Very often the individuals concernmed will themselves have generated their capital by going through a similar phase of developing at the right time a sound technical idea.

The third possibility for funding provision is that of a grant.

The possibility of a grant (and perhaps an associated, low interest loan) is particularly likely to be relevant within political regimes practising economic planning

- for example, within EU (the European Union) or ASEAN (the economic confederation of countries in South East Asia)

- or where for political or social reasons there is a desire to encourage local employment.

An example of the latter is the former Highlands & Islands Development Board, superseded by the Scottish Development Agency and the various (county level) local development enterprise units. Scottish Enterprise has recently (particularly in the period from 2003) come under very unfavourable financial comment, but it stands in succession to a fifty year stream of highly successful Scottish economic development agencies.

In the United Kingdom, as in many parts of the world, recent and present government policy favours the development of "Small and Medium Sized Companies"

To set the SME concept in context, by taking analogies from two charities, the University of Strathclyde is clearly too large an organisation to be included ... and the Scottish Youth Hostels Association would only scrape in because of the relatively low turnover associated with its not-for-profit level of charges, being otherwise too significant a commercial organization.

§3.2 Financial Requirements on Companies

To comply with the law, a company must produce (and file with the Registrar of Companies for public access) an "Annual Financial Statement" comprising

In principle all three of these are straight-forward, but in practice experience and expert advice are essential. Even reading them, let alone preparing them, is not a matter for the faint hearted! Further, all financial statements must meet the appropriate "SORP" - Statement of Recommended (Accounting) Practice.

Balance Sheets, the first of our necessary triple, show the value and commitments of a company.

In a commercial balance sheet, both assets & liabilities have to be sub-divided according to some very tightly defined rules. We can leave the details to those who have to deal with them (which, remember, will include all the directors of a company) but everyone should be aware of some basic divisions, including these for assets and liabilities:

Note that there are firm rules for valuing fixed assets (in essence, use the lowest of several possible costs!) ... but note also that where a particular asset or liability should go in the balance sheet may vary depending on the purpose associated with the item (and so may vary from one balance sheet to another).

One potential complicating factor is worth explicit comment:

This looks strange at first sight, but makes sense if you think about it: what we are doing is placing a "permanent" value on all the effort - and so all the money - put into that R&D work.

The final items in the balance sheet - the ones which make it balance! - comprise

  1. the value of issued shares - their nominal value, not their market value
  2. the profit element built up in the year or period under report

The Profit & Loss Account (or, for a non-profit body, the equivalent Income & Expenditure Account) details the company's trading activities in a given period.

The concepts of income and expenditure are both fairly obvious, although the moment you get away from the obvious - for example, by trying to offset directly some elements of income against some element of expenditure - you need a very clear head not to make amistake in what you are doing.

But then we come to taxation issues, and to the bringing and carrying forward of accumulated profits - more issues which are not for the faint hearted! But if you are required yourself to prepare accounts to that level of detail ("prepare" as opposed to reading and understanding) then you have reached the point where you need to buy in professional acounting skills.

Lastly in this triple we come to the Auditor's Statement.

As a matter of good practice, on any occasion when you are handling money for a third party, it is wise to have someone other than you report on what you have done. In that context, as in the relatively unofficial context of many clubs and societies, an auditor's statement will probably be short and simple - "these accounts properly reflect the available documentary evidence" - but it should be present. However, although it is not immediately relevant to the material of our present class, do note that if your body is recognized in Scotland as a charity then significant extra complications come in to play, and you will need to meet requirements laid down by the "Office of the Scottish Charity Regulator", OSCR. One particular complexity arising from new charity legislation (both in Scotland and in other parts of Britain and Ireland) is a detail of nomenclature; built into the associated charity SORP, and escaped from there into more general usuage, is a tighter definition of the role of an auditor; the details need not trouble us, but do be aware that for a body which is not a public company, and which has a turnover below - 2008 limit - £100,000, then the accounts are subject not to audit but rather to "independent examination"; the difference between the two is in the level of professional qualification required of the examiner and the depth of the examination - and the examination fees you will be required to pay!

In company (and charity) accounts, however, the auditor's statement will extend to many pages of detailed notes and will follow from extensive investigations of the company's books and discussions with its relevant personnel ... all at a substantial charge, as one would expect for a professional service!

In particular the statement will include summaries of the accounting policies followed, for example:

and will also give explicitly

Auditors are there to hear what a company has to say - the root meaning of the Latin word - and to express an opinion on it. Note that they do not make any statement about the overall financial health of the company ... they simply comment on whether the financial report made is fair.

These days company accounts also require a Statement of the Source and Application of Funds, which in effect provides an easy to read summary of changes in assets and debts. The detailed requirements on this are varying from year to year. These requirements, though, are things which follows from the SORPs - the statements of accounting practice, which it is highly desirable but not quite obligatory to follow.

© Paul Goldfinch 2008 Next Chapter Return to CS 302 Menu