Understanding How Lending Works
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Lenders normally require security for a loan in the form of a charge over some or all of the assets of the company. The principle is similar to taking a mortgage on a home. If the borrower fails to keep up his interest and capital payments, the lender — the building society — can sell the house and recover its loan from the proceeds. With a company the charge may be a fixed charge on specific assets — its machinery or buildings — or may be a floating charge on all the assets of the business including the current assets. The lender has priority for repayment out of the proceeds of selling the assets over which he has a charge.
The importance of this in practical terms is that a company, particularly a smaller company, may find it difficult to borrow further money when it does not have enough reasonably saleable assets to provide adequate security for the loan. And since banks will usually take a floating charge when they lend money to a business, the unsecured creditors (who are probably mainly the suppliers who have not yet been paid) come at the bottom of the creditors’ pile when a company goes bust. They do, of course, still rank ahead of the shareholders.
Most companies that operate as a going concern have certain known facts these are as follows: the company is likely to expand further in the current year, which earns it will need yet more money to finance higher levels of stocks and debtors and it may need to install additional machinery to meet the demand for its products. It generates a cash flow and, assuming profits continue rising, the cash flow ought to be higher in the current year.
But it is unlikely to be enough to provide all the money the company will need to expand and grow. It could probably increase its borrowings a little. But if it were a stock market-listed company, it would almost certainly be thinking of raising further equity capital by issuing additional shares for cash. This would reduce the gearing by increasing the proportion of shareholders’ money in the business. And quite apart from bringing in money for the immediate needs, by increasing the size of the equity ‘cushion’ it also prepares the way for bringing in additional borrowed money in the future.
Remember that fast-growing companies tend to use up cash faster than they can generate it from their profits. The expansion means that they have to tie up more and more cash in higher and higher levels of stocks and debtors: their working capital need rises rapidly. A company that expands too fast may be described as overtrading (trading beyond its financial resources). It can go bust simply because it runs out of cash to pay its bills, even though it may have been operating at an ‘accounting’ profit.
Investment analysts therefore check the accounts to see if a company has adequate resources to finance its business and whether it would be able to raise any additional money needed. In the short run, a rights issue to raise further money from the sale of shares often depresses the price of the shares because it increases the number in issue.
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