Friday, November 16, 2007

Capital structure of companies

Time to do something about my accountings again.

Learnt more and subsequently got a bit confused over credit/debit - the details behind accountings. I guess I do not have to know that since my job is not to be an accountant but just to know enough to comment on the ratios and the main jargon surrounding accountings.

But it's interesting that the monthly statement that we get from banks for our savings account is actually based with reference to the bank, not us. What I mean is our view of credit and debit is totally different from the view of the banks, and this apparent paradox arises because we're simply on different sides of the balance sheets :) One person's account payables is another person's account receivables, one's cash is another's fixed asset, one's interest payment is another's interest received and so on. After going through the whole thick book on accountings, I think this idea is very important - the ability to think through your expense and revenue in terms of balance sheet. Opened up another aspect of my viewpoint :)

So today is going to be simple concepts - going to explore about the difference between the capital structure of a company. I used the word 'explore' because I do not know is going to be like. I'm basically thinking of hypothetical scenario and trying to fit into the financial statements. If they don't balance, something is wrong. If it does (and I have people ;P to help me proof read), most likely it's correct.


Let's take a look at the different capital structure of the hypothetical company - Bully the bear sausages.

The first is a pure private company - meaning that the owner cough out the money and use it for his own purposes. The accounts of such are normally not important to anyone except IRA :) The whole business belongs to the owner.

The second one I think can be called public company. Need some explaining to do. Suppose that the owner of a business needs $1000 to start up a business. He needs the money to buy his equipments, some cash for change, stockup his inventory, pay rent, salary and so on. The problem is that he don't have this amount of cash and does not want to beg/borrow/steal from his frens and relatives. He decided to take his company to public - so that shareholders can own a piece of the company (let's assume in this fairytale world that you don't need a track record in order to publicly list your companies, not a far off assumption considering a lot of such things happened in the IPO craze of the era).

He wants to make this is a penny stock (<$1) so that a lot more people are willing to buy ownership of his business. He decided to split up his $1000 into 10,000 shares, each having a par value of $0.10 ($1000/10,000 shares). Even if he buy 2000 shares (say) costing $200, this would have nothing to do with the company because as far as things are concerned, the business and the owner are separate entities. One cannot mix personal accounts into company accounts.

Compare this with another structure - where the owner cough up 200, then divided $800 ($1000 - $200) into 8,000 shares each having a par value of $0.10 ($800/8000 shares). The total outstanding shares is 8000. This would have a balance sheet looking like this:

Basically the company with the above structure will have a smaller float, it's a little more volatile (all things being equal) than another with a larger float. A good example is THEBV - Thai Beverage. This company has such a huge float that the price is very hard to move (either up or down). Just look at the charts, it's as stable as it can get.

The third kind is a combination of own money, stocks and long term borrowings from banks. The good thing about borrowing from banks is that the highly leverage (or highly geared) company can raise money fast and enter into opportunities fast. The downside is that in recession, the interest payment of the loan will reduce the cash holdings of the company and may raise cash flow problems as well as reduced retained earnings and profits. In this case, assuming , the par value of the stock is $0.10 each ($400/4,000 shares), with total outstanding shares as 4000.

What's important about the capital structure of the business?

1. If it's heavy in debts - it means ownership of the business belongs mainly to the banks. In the case of liquidation (or unwinding of business), the company would hold a 'fire sale' selling everything from investment holdings, accounts receivable (also called factoring), raw materials, finished goods, office equipment, patent, brand names etc, in order of most to least liquid. The amount raised together with the cash holdings would be used to pay debtors first.

So the pile of cash would be given in order of priority:

a. Debtors - banks, suppliers
b. Preferred stock holders
c. Common stock holders

Banks always get paid first. So bloody smart.

Basically, highly geared companies better have enough earnings to pay off the interests generated by the loan, otherwise in recession, these companies would be the first to face liquidity crunch. If they can't pay the bank, they would rupture the bank aka bankrupt.

2. If the company keeps issuing new shares to raise funds, then the new shares would be added to the shares outstanding of the company. This would be bad for shareholders are it would 'dilute' the value of the company of they hold the same amount of stock. Not to mention reduce the attractiveness of key ratios like Earnings per share. That's why in financial reports, sometimes there are diluted and non-diluted information - diluted ones just means the shares take into account of future dilution in the shares outstanding.

Miss out any points?

One important thing: Does the stocks under the equities in the balance sheet change in value according to the market price? NO - it doesn't change. Once IPO-ed, the stock would remain the same value unless there are other exercises which increase or dilute the stocks. The company already sold you the stocks during their IPO, so the subsequent rise in value (or fall) of the stocks have nothing to do with the balance sheet anymore.

Phew, what an adventure :) Enough for today. I think I have enough of accountings. Think next time I'll talk about key ratios. Woah, a lot more to learn :)


Touzi said...

Hi LP,

Gong Xi Fa Cai.

Do you know why "share capital" is part of the balance sheet? Most of the money received from investors would have been used ( pay loans, new plants, expansion etc ). I don't understand why they are still part of gearing calculation.


la papillion said...

Hi touzi,

Share capital is part of the equity section of the balance sheet. In the balance sheet, for every entry in the asset, there must be an equivalent amt in the liabilities section or the equity section.

The eq is Assets = Equity + liabilities.

As such, the money received from the investors that are used to pay for stuff actually comes from an equivalent amt in the equity, liabilities or a combination of both. The balance sheet must still balance. I guess it's part of the way accounting is used for reporting.

As for gearing, there are many definitions to it, not sure which one you are talking about. I suppose you're talking about the one using liabilties over equities, or some other variation of that. Share capital is part of the equities component, hence will be part of the equation.

Hope I answered your questions sufficiently!

Touzi said...


OK, die die must balance. Does that mean when the asset depreciate, an equivalent amount of share capital will be remove from the book as well ? If that is the case, for established companies that IPO'ed long ago ( and has not issue new shares, there should be no more share capital?

If gearing is borrowing over equities, and equities include money (share capital) already deployed, how can use this piece of information determine how leveraged is the company? Why is gearing so important? Shouldn't investors be looking at borrowing/cash ratio?

Hope you can clarify when you have the time. I don't want to be fooled by numbers ;-)

Many Thanks !

la papillion said...

Hi Touzi,

Must be some disclaimer here first: I'm not an accountant. At best I know a little about it from my self reading, at worst, I'm just bullshitting. Still, I'll answer to the best of my abilities.

Asset depreciation is a little complicated. There are two ways to put in assets - first is to capitalise it, second way is to expense it. Capitalisation of assets (usually long term assets like factories, buildings etc) means that the cost of the asset is spread over a usable period of the asset. So if a factory can be used, say, for 10 yrs, then the cost of the factory will be depreciated over 10 yrs. Depreciation will cause the earnings to drop, since it directly affects the net earnings. If assets value drop, it'll affect the income statement first, since there is an entry there. So, the earnings will drop a little for each year over the period of depreciation.

Second way of expensing it is for short term assets. This means that the cost of the asset is straight away deducted from that current year of revenue to derive the net earnings for that year. The difference between the two method is just how the cost of the assets acquired is deducted from the revenue.

But in both ways, the assets are using short terms assets (i.e. cash) to pay for it. Using cash will lower the assets, but the assets will also increase due to the increase of other assets. So, even if the way to account for acquisition of assets are different, the end result is the same i.e. still balance.

Not sure if I make sense here, it's rather hard to explain. The key idea is that share capital do not get decreased because of depreciation.

As for your 2nd question, there are indeed many ways to calculate leverage. Each way will contribute to a part of the puzzle, which will help an investor to decide if the company is facing solvency issues. If I'm not wrong, banks will look at the gearing to see how much they are comfortable lending too. So, for instance, if company X already have gearing of 80%, then it's quite impossible to raise capital through more borrowings. Perhaps they will have to sell more shares to raise their equity portion and hence decrease their gearing before they can use this option of borrowing from banks.

Borrowing/cash ratio also have its own problems. The ratio highly depends on the timing in which the cash outflow is scheduled. For example, in the reporting season, the company might just borrow a lot of cash but not use it yet, hence raising the top and bottom of the ratio. I'm just saying that as an example that the numbers do not tell the full story and one needs to view other things as well.

Touzi said...

Thanks for the explanation.

Touzi said...

Hi LP,

I was looking at the AR of K1 ventures and notice that the amount owed to creditors by the Company is 7 times that owed by the Group. Do you know how this is possible? I have always assumed that in the financial report, Company is a subset of the Group.