Finance

In order to get ahead, you will also need to know a little something about finance as it relates to business. In its most basic form, when people talk about finance, they are usually talking about where a company gets its' capital from. Let's look at an example.

Using cars again, let's say you are a successful automobile manufacturer and you want to open a new factory. Chances are, you don't have the $500M it will take to build this factory and even if you did, it may not be the best use of your company's money to invest it all in this factory.

So in order to build this factory, you need to raise capital and there are four common ways of doing this.

1. Get a Loan or Line of Credit

The most straight forward way of getting some capital is to ask someone to lend you the money - in most cases this will be a bank but it also could be a private investor. At any rate, these loans come it all shapes and sizes depending on the nature of the project etc. Most lenders are not just going to sign over half a billion dollars without some collateral. Collateral is something value that you use to "back" the loan so that if you should default on the loan or be unable to pay the loan payments - the lender gets to seize your collateral.

When you use collateral to back your loan, it is often called a secured loan. As an example consider the loan you take out to purchase a car. The bank will often use the residual value of the car as collateral for the loan so that if you default on your payments - they basically seize your car and sell it to pay off their debt.

Of course there is a lot more to this but we are just covering off the basics here. So why don't all businesses use loans to fund their capital expenditures? Quite simply, these loans can be expensive. For example, an unsecured loan to a large business may have an interest rate of say 10% per year. This is very expensive money. If the business is able to secure the loan with some collateral, for example another factory that they have already paid for, then the loan is a lot less risky to the lender and thus the interest rate charged will be significantly less, say 5% per year.

In any event, most businesses will borrow money from a bank on start up where they are basically borrowing money against their business plan and perhaps some personal collateral. In this case, the bank or lender will do a risk analysis to see what interest rate should be charged to justify the lending risk. If you have a terrible business proposition a bank may not loan you the money at all! If however, you have other backers and a solid business plan - they may lend you the money you need but expect to pay significantly for it.

So if you don't want to pay huge interest, what are some other options?

2. Issue Bonds

Well the next type of debt instrument you will hear a lot about is Bonds. Bonds are also debt, in as much as someone is lending you money however bonds can be purchased by almost anyone so you are not borrowing money from one institution necessarily, but rather a whole bunch of investors. People who buy bonds, essentially do so with the understanding that they will not redeem the bonds until maturity so this gives the borrower a bit more comfort that their loan will not be called without notice. Bonds are usually sold with a maturity date and an interest rate.

Of course being debt instruments, you have to pay the bond holders an interest rate which again will be based on the amount of risk associated with the debt. Government bonds tend to offer lenders a pretty low interest rate because they are much more stable and less risky than say corporate bonds. (Governments theoretically can always issue more bonds or raise taxes to pay their debts).

Corporate bonds can offer very attractive rates of interest but of course you need to understand that this is because they are risky - there is no free lunch! Remember the law of supply and demand? Well this is also very much at play in the bond market. If a risky borrower doesn't offer bonds with enough interest to make it worthwhile, no one will buy the bonds and the borrower will not get any capital. In essence, the borrower will have to raise the interest rate until people become interested and believe the interest payments are sufficient to justify the risk.

One other funny thing about bonds is that their "market value" can change over time. How does this happen? Well let's look at an example. Let's say the Government issues $100 bonds with a five year maturity date at an interest rate of 5%. This is pretty straight forward - anyone who wants to earn 5% per year and then get their principle back after five years will buy these bonds.

However, a year later - the interest rate offered by the Government drops to 4% per year. Well given that bonds can be bought and sold (not redeemed) on the market - someone who owns a $100 bond at 5% will find that their bond is actually worth more because the locked in interest rate is better than that currently available. So the value of the $100 bond may in fact be $105 if sold on the market depending on where prospective buyers think interest rates might be headed.

The reverse also can happen. If the government raises interest rates and decides to offer bonds at 6% - then the value of your bonds at 5% in the market place has just gone down. People are not going to give you $100 for a 5% bond when they can get a 6% bond for the same price! So in order to sell your bond - you will have to discount it a bit to make it attractive.

All of this buying and selling of bonds not withstanding, at maturity the borrower will still give you back the face value of the bond having paid you its interest on an annual basis so - you are not "losing" any money by holding a bond to maturity.

3. Common Shares

Probably the most readily understood way for a company to raise capital is to issue common shares or stocks in the company. In this scenario, they are not borrowing money or taking on on debt but they are selling ownership in their company. Shares of publicly traded companies are bought and sold or "traded" on the stock exchanges, e.g. the New York Stock Exchange.

So why would anyone buy shares in a company? The only reason to buy shares in a company is to make money. There are two ways this happens. Firstly, the company earns money and grows thus making your "share" worth more. This is called capital appreciation and it is very simple - buy a share at $4 and sell it a year later at $6 and you have a capital gain of $2 per share. Congratulations, you just made 50% per year return on your investment.

The second way you can earn money from owning shares in a company is by sharing in the profits through dividends. Dividends are paid out to shareholders usually on a quarterly basis based on how much money the company has earned in that quarter. Keep in mind however that the company is under no obligation to pay you a dividend and that the amount of dividends paid out is decided by the company's board of directors.

However - most company's that have a track record of paying out quarterly dividends have attracted a shareholder base that wants these dividends and if the company doesn't pay them out - well the shareholders then sell their stocks and according to the law of supply and demand - when these stocks hit the market - there is an over supply and the price goes down. Not good for the company who is all of a sudden worth less on the market. For this reason, most large corporations that earn enough steady income to pay a dividend will continue to do so.

So what is the downside? Well, you really don't know if the value of the company you have invested in will go up or down. If it goes down, you will lose money upon selling your shares. So for example, let say you bought that share at $4 and sold it a year later for $2, then you have a loss of 50% and that's gotta hurt!

So again - the concept of risk and reward is readily apparent. Sure you might gain 50% by buying shares in a company but you could also lose your entire investment if that company does something stupid, illegal or immoral.

Voting versus Non-voting Shares There are a number of different kinds of shares issues by companies but one difference you should be aware of is the difference between voting and non-voting.

When you buy common shares in a company, you are a part owner of that company and so you get a say in how the company is run and what decisions are made. You get this say through the board of directors whom you elect for a term by proxy vote or by attending a shareholders meeting. The board of directors are supposed to act on your behalf and reflect your wishes on how the company is run. Most shareholders do not take an active interest in how their company's are being run and the board of directors often are acting without direct input by the owners of the company. It is a neat democratic process that in reality fails quite regularly to be implemented very well.

Some company's issue non-voting shares which are also common shares but they do not allow you the opportunity to vote on how the company is run. Often these shares are issued by companies that have a primary owner or are owned by another corporation. They still need to raise capital to fund their growth but they do not want to relinquish control of the company to shareholders. Again - most shareholders do not exercise their rights even when they have them, so most people are not overly concerned about whether they are purchasing voting or non-voting common shares.

4. Preferred Shares

The last financing vehicle I want to make you aware of is preferred shares. As in a lot of business topics, things are rarely that simple and preferred shares are one of those things that blur the lines between debt (loans and bonds) and equity (shares).

Preferred shares are shares in a company and are issued like equity however they behave in the marketplace as if they were debt instruments. So they tend to offer a high dividend (say 4%) but unlike bonds, they have no maturity date. They are bought and sold like common shares but the people interested in buying them do so because of their dividend not because they feel they will grow in value.

Why are these things called "preferred shares". Well - they are call preferred shares because they offer shareholders a bit more protection than common shareholders should the company go into bankruptcy. In the hierarchy of business - when a company goes bankrupt, what ever assets are left over are divided up and give to the company's creditors. In this hierarchy, lenders and bond holders get paid first, followed by preferred shareholders and finally and only if there is something left, the common shareholders get a cut although in truth - there is rarely anything left at this point.


So there are some basic facts around finance. Here are some other quick things to know.

Market Capitalization refers to the number of common shares in the market multiplied by their value. So a company with 1000 shares at $2 of value each has a market cap of $2000. This number is used to indicate the "size" of a company in the market place. Obviously as the share price appreciates, so does the market cap of the company.

Debt to Equity Ratio One of the things some analysts will use to rate the attractiveness of one company over another is their debt to equity ratio or the amount of debt they have outstanding relative to their equity or owned value. Each industry will have its own "expectations" for what is a good ratio but usually you don't want to have too high a debt load because debt is quite inflexible in terms of payments. Too much debt and a bad year can cause you to default on your payments and the next thing you know - people are asking you to repay your loans in full! Ouch!

Earnings per Share (EPS) Another ratio you will hear a lot of when people are talking about finance and a company’s health is their earnings per share ratio. This is in essence their net income or retained earnings divided by the number of shares in the market place. Over time, you want to see the EPS go up indicating that the company is earning money and has not had to dilute the stock value by issuing more shares to achieve these increases in earnings.

Multiple or Price to Earnings Ratio This is a measure of the market value of a share based on how much a company is earning. It is also called the P/E ratio and this can vary tremendously from industry to industry. So say you were looking at a company that earned $2 per share in other words their EPS was $2. If the share price for that company is $20 per share then their P/E ratio is $20(price)/$2(EPS) giving you a P/E or multiple of 10.

The multiples expected by the market vary according to the industry however you may hear that a market is "over valued" if it has a very high P/E ratio. A lot of internet and IT based companies are used to having very high P/E ratios in other words people by these company's on speculation that they will earn a lot of money in the future. A high ratio though means that the price you pay for a share of that company really isn't justified by the earnings of that company. Market speculation has been known to drive the value of a company's stock way above its real value and that is why we had the dot-com bubble!


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