There are a few more terms relating to company accounts that will crop up fairly frequently in the press commentary and the best way of illustrating what they mean is with another sample balance sheet (see Table 5.1).
This time we have taken a more mature company: call it Jones Manufacturing. Its assets are in the millions rather than the thousands. It owns the properties from which it operates: note the £3m item for land and buildings included under fixed assets. And, partly because it has been ploughing back a proportion of its profits over many years, its shareholders’ funds are a substantial £11m.
We have already mentioned the topic of goodwill in a balance sheet, but without explaining what it is or how it is likely to have arisen, and it now features in the Jones Manufacturing accounts. Suppose Jones had recently taken over another business – call it Bonzo Beading – for a price of £3m. Bonzo Beading’s net assets at the time of the takeover were only £2m. Thus, over and above the price it was paying for the Bonzo Beading assets, Jones Manufacturing paid £1m for the goodwill of the business it was acquiring – in other words, it was paying extra for the company’s reputation, trading connections, profit-earning capability, and so on. After the takeover, Bonzo Beading’s £2m of net assets were incorporated in the Jones Manufacturing group balance sheet. But the £1m of goodwill in the price also had to be accounted for, so it was shown as a separate item under the general heading of fixed assets and the subheading of intangible assets.
The accounting treatment of goodwill is complex and had, in the late 1990s, been changed by a new accounting standard. Previously, goodwill acquired in the course of a takeover had normally been written off against reserves and did not show on the balance sheet. After the change, acquired goodwill of this type appears in company accounts. But there is a further complication. Tangible fixed assets need to be depreciated each year to recognize the reduction in their value from wear and tear. What about intangible assets like goodwill? Do they lose in value and need to be depreciated?
The broad answer is ‘yes’, unless it can be demonstrated that the goodwill in the acquired businesses is holding or increasing its value. So you will find a range of treatments. Sometimes depreciation of goodwill is provided out of the year’s profits, sometimes it is not.
Note that it is only ‘acquired’ goodwill that is shown in the balance sheet. Most successful businesses are actually worth a lot more than the mere value of their assets – in other words, their value (on the stock market or elsewhere) includes a large element of goodwill. But this goodwill that the business has generated internally does not normally appear in its accounts. It is up to the market to decide, in the value it puts on a company, what the goodwill of the business is worth. It is not for the company to try to estimate this in its accounts.
Note that goodwill is not the only type of intangible asset. Other items such as patents, trade marks and royalty agreements sometimes appear under ‘intangible assets’ in a company’s accounts. Investment analysts will normally exclude goodwill when calculating a company’s net asset value, which strictly ought to be expressed as net tangible asset value. They will not necessarily exclude items like patents which can have a definable market value.
The next item is investments in associated companies or interests in associates; sometimes associates are also called related companies. The definition of an associated company is open to interpretation. But in general it would be a company which was not a subsidiary, but in which Jones Manufacturing had an interest amounting to between 20 per cent and 50 per cent of the share capital and over whose affairs it exerted some management influence. In other words, Jones Manufacturing does not hold the shares in the associate simply as an unrelated investment, as it might own a holding of government stock.
There is probably some trading relationship between Jones Manufacturing and its associate. The associated company might, say, be an important supplier of components to Jones, or it might be an important customer for Jones’s products – in either case it could be of benefit to Jones to be able to exert some influence over the associate’s affairs. In accounting terms, the interest in the associated company will normally appear in the balance sheet at a figure representing Jones Manufacturing’s share of the net assets of the associate. If the associated company or companies had net assets of £10m and Jones Manufacturing owned a 30 per cent stake, the figure in Jones’s balance sheet would be 30 per cent of £10m, or £3m. An interest in an associate is different from a mere trade investment: a shareholding in a company with which there is probably no particular management involvement or influence.
Jones Manufacturing’s sources of finance are also more varied and a little more complex than those of John Smith & Co. There is a bank overdraft, though small in relation to the company’s size. But there are three types of medium-term or long-term debt under the heading of creditors due in more than one year. First comes the familiar term loan: again fairly small at £800,000.
The other two items – the debenture stock and the convertible loan stock – are in a different category of borrowings, because they are securities issued by the company rather than loans from a bank. Much as the government does when it borrows by issuing a gilt-edged stock, Jones Manufacturing has raised money by creating different forms of loan stock and selling them to investors: the familiar principle of issuing an ‘IOU’ note in return for cash (see Chapter 13). These stocks, once issued, will normally be traded in the stockmarket. Investors who paid cash to the company for them when first issued can either wait till the date they are due to be repaid by the company, or can sell them to other investors in the stockmarket. Both in this case pay a fixed rate of interest.
The debenture stock will probably be secured on specific assets of the company. Provided the assets are of good quality, it should thus be a safe form of investment for buyers. It is a form of long-term borrowing. It is not due for repayment until 2014, and when first issued it may have had a life of 25 or 30 years – possibly more.
The convertible loan stock is almost certainly an unsecured loan stock. It is not secured on the assets of the company, and to this extent it is a little less safe than the debenture. But its most important feature is that it is convertible. At some stage of its life, and probably right from the outset, it can be exchanged for ordinary shares according to a pre-arranged formula. This gives it some of the attributes of a loan and some of the attributes of an ordinary share, though in legal and accounting terms it is a loan. Until it is converted, it pays a fixed rate of interest like the debenture stock. Once it is converted into ordinary shares, the shares are identical to the other shares in issue and receive the same dividend.
Jones Manufacturing
Consolidated balance sheet as at 31 December
|
£’000 |
£’000 |
|
FIXED ASSETS |
|
|
|
Tangible assets: |
|
|
|
Land and buildings |
3,000 |
|
|
Plant and machinery |
5,600 |
|
|
|
|
8,600 |
|
Intangible assets: |
|
|
|
Goodwill |
|
1,000 |
|
INVESTMENTS IN ASSOCIATED COMPANIES |
3,000 |
||
CURRENT ASSETS |
|
|
|
Stocks |
5,000 |
|
|
Debtors |
3,500 |
|
|
Cash at bank |
500 |
|
|
|
9,000 |
|
|
CREDITORS – AMOUNTS DUE WITHIN ONE |
|
|
|
YEAR (Current Liabilities) |
|
|
|
Trade creditors |
3,000 |
|
|
Tax payable |
600 |
|
|
Dividend proposed |
400 |
|
|
Bank overdrafts |
800 |
|
|
|
4,800 |
|
|
NET CURRENT ASSETS |
|
4,200 |
|
TOTAL ASSETS LESS CURRENT LIABILITIES |
16,800 |
||
CREDITORS (AMOUNTS DUE IN MORE THAN ONE YEAR) |
|
||
Term loans |
800 |
|
|
9% Debenture stock 2014 |
2,800 |
|
|
6% Convertible Loan Stock 2010 |
1,500 |
|
|
|
|
5,100 |
|
PROVISIONS FOR LIABILITIES AND CHARGES |
500 |
||
MINORITY SHAREHOLDERS’ INTEREST |
200 |
||
NET ASSETS ATTRIBUTABLE TO JONES MANUFACTURING |
11,000 |
||
|
|
||
Equity share capital (20p ordinary shares) |
1,500 |
|
|
Non-equity share capital (£1 preference shares) |
500 |
|
|
RESERVES |
|
2,000 |
|
Share premium account |
1,650 |
|
|
Revaluation reserves |
1,950 |
|
|
Profit and loss account (revenue reserves) |
5,400 |
|
|
|
|
9,000 |
|
SHAREHOLDERS’ FUNDS |
|
11,000 |
|
Analysis of shareholders’ funds |
|
|
|
Equity |
|
10,500 |
|
Non-equity |
|
500 |
|
Table 5.1 Consolidated balance sheet.
If the stock is not converted into shares during the conversion period, it may revert to being a simple unsecured loan stock, paying the fixed rate of interest until it is eventually repaid in 2010. Whether or not holders of the stock exercise the right to convert it will depend on how successful Jones Manufacturing is. The conversion terms were probably pitched originally at a level somewhat above Jones Manufacturing’s share price at the time of issue (the conversion premium). If the share price at the time had been 80p, the terms of the loan might have stipulated that £1 nominal of the loan could be converted into one ordinary share, meaning that anyone who paid £100 for £100 nominal of the loan would be paying £1 for a share if he exercised his conversion rights – a conversion premium of 25 per cent at the time of issue. Five years later, if Jones had increased its profits and dividends at a good rate, the share price might have risen to, say, 180p. At this level there is clearly a value in the right to exchange £1 nominal of loan for a share worth 180p.
Because of this conversion value, the price of the convertible loan stock itself would have risen in the stockmarket. Investors would have been prepared to pay more than £100 for £100 nominal value of the loan, when they knew that each £1 nominal could be converted into a share worth 180p. The calculations that give the likely price of a convertible loan stock in the stockmarket, relative to the price of the ordinary shares, are quite complex. In general, a convertible loan rises in value to reflect the rise in value of the ordinary shares, but rises at a slower percentage rate than the ordinary shares. On the other hand, it normally provides a higher and more secure yield than the ordinary shares, at least in the early years until the dividend on the ordinary shares catches up.
For the company the main advantage of the convertible loan is that the interest rate it needs to pay will probably be lower than for an ordinary unsecured loan stock. Investors will accept the lower interest rate because of the possibility of capital gains if the share price rises and the market value of the convertible stock follows it. The convertible also represents a form of deferred equity. If the company had issued ordinary shares instead, its earnings and dividends would immediately be spread over a larger number of shares: the earnings would be diluted over the larger capital immediately.
Convertible stocks with considerably more complex features have also been commonplace in recent years, particularly in the case of issues made through euromarket mechanisms (see Chapter 17) and you find preference shares (see below) that are convertible into ordinary shares as well as loans that are convertible. One particular type of complex convertible needs mentioning here: the premium put convertible which also surfaced in an even more tortuous form as the convertible capital bond. The ‘premium put’ feature is an option for the investor that allows him to require the company to buy the stock back at a premium over its issue price after, typically, five years if the share price has not risen sufficiently to make conversion worth while. This feature appealed to euromarket investors who are generally bond-oriented rather than equity-oriented. The disadvantage for the issuer is that he is not sure when issuing the stock whether he is raising permanent capital or whether he will have to find the money to redeem the issue at a premium after a few years, possibly at a time when he is far from flush with cash.
By issuing the convertible loan, Jones Manufacturing can offset the interest cost (the cost of servicing the loan) against tax, whereas dividends on ordinary shares or on convertible preference shares would have to be paid out of taxed income. By the time the loan can be converted, earnings should have risen significantly and the company’s asset value should also have risen. Investment analysts, journalists and the companies themselves often refer to fully diluted earnings per share and fully diluted assets per share. This means they have calculated what the earnings per share would be on the assumption the stock was converted and current earnings (adjusted for the disappearance of the interest charge on the convertible) were spread over the larger number of shares. They have also done the same sums for the NAV (see below). As we have seen, companies may issue convertible preference shares (see above) instead of convertible loan stocks. They may convert into ordinary shares in much the same way, but the dividend on the convertible preference is not tax-deductible as the convertible loan stock interest is. On the other hand, convertible preference rank as share capital rather than debt.
There are two other unfamiliar items. The provisions for liabilities and charges of £500,000 has to be knocked off the assets figure before arriving at a net asset value. It may consist mainly of deferred tax, which is tax that might become payable in the future but is not yet a sufficiently certain liability to be provided for under current liabilities. It would also include sums the company had earmarked to meet certain known future costs, such as the cost of closing down or reorganizing one part of the business.
The second item, minority shareholders’ interest or minority interest, was mentioned in Chapter 4. Where Jones does not own all the shares of all of its subsidiaries, this figure represents the assets attributable to the shares in these subsidiaries that are held by other parties. Since this value does not belong to the shareholders in Jones it has to be deducted before reaching the figure for the net assets attributable to Jones Manufacturing’s owners.
Two further items that could affect the balance sheet in the future appear in the notes to the accounts but not in the accounts themselves. One item is capital commitments. This is expenditure on assets that the directors have authorized or contracted for but which has not yet taken place. It can be useful in giving an idea of the company’s investment plans and whether these would be covered by the cash flow.
The other item is contingent liabilities. Jones Manufacturing might provide a guarantee for the bank borrowings of one of its associated companies. Or there might be a legal case pending against Jones, in which the other side is claiming £500,000 of damages, though Jones denies liability. In both cases Jones does not expect any liability to arise, but it might. So the liabilities are not provided for in the accounts themselves but the company notes that they might arise in the future.
Back to the balance sheet itself. The make-up of shareholders’ funds is also more complex than in the case of John Smith & Co. First, Jones Manufacturing has two classes of share capital: preference shares as well as ordinary shares.
Companies with preference share capital often have it for historical reasons, though issues of preference shares (particularly convertible preference) have regained popularity in recent years. Various mutations of preference capital may also crop up in the financing of young businesses which are not quoted on a stockmarket and in the financing of management buy-outs (see Chapter 11). Preference shares usually pay a fixed dividend and in this respect are more like a loan stock than an ordinary share. But the dividend has to be paid out of profits that have borne tax, whereas interest on a loan stock is allowable against tax. Against this disadvantage, preference shares will not normally be counted in the gearing of a company whereas loan stocks will. And they are safer in that the company risks being closed down if it cannot pay interest on its loans whereas it could miss dividends on the preference shares without the same risk.
Preference shares are part of shareholders’ funds but not part of ordinary shareholders’ funds. They are share capital, but they are not equity share capital. They do not share in the rising prosperity of a company, because their dividend is fixed and does not increase with rising profits. But they are entitled to their dividend before the ordinary shareholders get anything, so the dividend is safer than that of an ordinary share. And if the company should be wound up (closed down), preference shareholders are normally entitled to be repaid the par value of their shares (usually but not necessarily £1) before the ordinary shareholders get anything. This is assuming there is something left after loans and all the other debts of the company – which rank before preference shares – have been repaid. Preference shares do not normally carry votes unless the dividend is in arrears (the payments have not been kept up). Note that if an issue of preference shares has the word cum. in its title, this stands for cumulative. It means that, if the company is not able to pay a dividend on the preference shares in some years, these dividends still roll up and must be paid when the company is able to do so. If the word red. appears in the description, this means that the shares are redeemable – they will be repaid at some stated future date.
One technicality you may come across occasionally: certain types of preference share issued by subsidiary companies rather than by the parent company, but guaranteed by the parent, may have more of the characteristics of a loan than of share capital and may need to be treated as a liability rather than as capital in the consolidated accounts.
We have only shown preference shares and ordinary shares, but there are various other less common forms of share capital that companies may issue. These are variations on the theme of equity or preference. Deferred ordinary shares probably do not rank for dividend until converted into ordinary shares at some future date. Preferred ordinary shares will get a minimum dividend before the ordinary get anything, and probably share in ordinary dividends thereafter. Participating preference shares may be similar; they get a fixed dividend plus an extra dividend on top that depends on profits. Convertible preference shares may convert into ordinary shares, and so on.
Look next at the equity share capital. Note that Jones Manufacturing has issued ordinary share capital of £1.5m, but that this is divided into units of 20p each. In other words, each pound of nominal capital is divided into five shares, so there are 7.5m shares in issue, each with a nominal, par or face value of 20p. The meaning of the par value sometimes causes problems. It has nothing to do with the price at which the shares may be traded in the stockmarket and for most practical purposes you can forget it – American companies often have ordinary shares (known as common stock) with no par value.
Many British companies have shares of 25p par value and the other common denominations are 5p, 10p, 20p, 50p, and £1. But this is relevant mainly for certain accounting purposes and for a technical Companies Act requirement that companies may not issue shares at prices below their par value. What interests investors is the price at which a share is quoted in the stockmarket, and it is perfectly possible to have a 5p share quoted at 400p or a £1 share quoted below its par value at 80p.
One other facet of a company’s capital crops up in press reports, particularly of take-over offers. As well as the figure for issued capital (the nominal value of the shares in issue) you will see references to authorized capital. This is the maximum amount of capital that the company has authorization from its shareholders to issue. Jones Manufacturing might have an authorized capital of £3m, divided into £500,000 of preference capital (all of which is issued) and £2.5m of ordinary capital. Since only £1.5m of ordinary capital is so far issued, there is £1m of authorized but unissued capital in existence, equivalent to 5m 20p shares. The directors could thus issue a further 5m shares without needing to get shareholders to vote an increase in authorized capital first. In fact, 1.5m of these unissued shares are already earmarked for the eventual conversion of the convertible loan stock.
Institutional shareholders in companies are generally a bit uncomfortable when the directors have the power to issue large numbers of new shares without consulting shareholders first. They could, for example, go on a wild takeover spending spree using new shares as currency, without needing to consult shareholders. So, quite apart from the amount of authorized but unissued capital that a company has, the institutions insist that the company regularly update its authority to issue new shares under Section 80 of the Companies Act and they impose a maximum limit on the number of new shares that might be issued. These resolutions, seeking the authority to issue new shares when required, are therefore a common feature of the agenda for company annual general meetings (AGMs). The usual rule is that the institutions will vote in favour of the authority to issue new shares provided the new shares would not add more than a third to the existing issued share capital. This amount may represent the difference between the company’s authorized and issued capital anyway, or it may mean that directors do not have permission to issue all of the authorized but unissued shares without further consulting shareholders. If directors subsequently want to go beyond the approved limit they will need to call a meeting of shareholders to approve the move. This is one of a number of ways shareholders may exercise control over the companies they invest in.
Apart from shares there is another type of quasi-security that a company may issue, which will be referred to in the notes to the accounts but which will not appear as share capital in the balance sheet. This is the warrant. A company may issue warrants which give the holder the right to subscribe at a fixed price for shares in the company at some future date. The subscription price will usually be fixed above the current price of the shares when the warrant is issued, so at this stage any value in the warrant is simply hope value.
Suppose a warrant is issued which gives the right to subscribe for one share at 180p at some point in the future. The current share price is 150p and there is no intrinsic value in the warrant. But if the share price should rise to 250p, there is a clear value in the right to subscribe at 180p for a share that could immediately be sold for 250p, and the price of the warrant itself will reflect this value. The principle is much the same as for a traded option (see Chapter 18 for a fuller explanation). But a warrant gives the right to subscribe cash for a new share the company issues. An option gives the right to buy an existing share from its present owner and does not affect the finances of the company itself. American terminology sometimes confuses this distinction, however. Warrants are traded in the stockmarket much like shares themselves.
Warrants are sometimes issued to improve the attractions of a loan stock and are often referred to as an equity sweetener or equity kicker. Fixed-interest loans are unpopular in periods of high inflation, but if subscribers to a loan are given, say, one warrant for every £3 of loan, they have an interest in the increasing prosperity of the company, as reflected in its share price. When warrants are issued in this way, they are afterwards normally traded separately from the loan. Arriving at the theoretical value of a warrant, relative to the price of the ordinary shares, is a pretty technical process and best left to the experts. The actual value at a given time is set by the balance of buyers and sellers in the market, as with a share. Note, by the way, that warrants issued by a company are a different animal from covered warrants (see glossary).
Jones Manufacturing’s profit and loss account reserves (they used more commonly to be called revenue reserves) at £5.4m are considerably larger than its issued capital. This points to some years’ worth of ploughed-back profits (retained earnings) which are added to the profit and loss account reserve in the balance sheet each year. If the company went through a temporary bad patch in which it did not earn any profits it could, if it chose, use part of these ploughed-back profits of previous years to pay a dividend (always assuming it also had enough cash as well). And in a loss-making year the revenue reserves will be depleted by the amount of the net losses plus the cost of any dividends paid.
The share premium account is part of shareholders’ funds, but needs rather more explanation. It arises when the company issues new shares at a price above their par value (and in the case of an established company, the shares will almost always be worth more than their par value and new shares will be priced accordingly). Assume that in the past Jones had decided to raise money by offering new ordinary shares to its existing shareholders (a rights issue – see Chapter 9). Its share price at the time was 110p and it issued the new shares at 80p. Since the shares have a par value of 20p, each new share was being sold at a premium of 60p to its par value. So for each new share sold the company added 20p to its nominal capital and accounted for the additional 60p by adding it to the share premium account.
The share premium account has a special position in law in that it cannot be written down without the permission of the courts (it could not be used to cover operating losses, for example, without this permission). Since it arises from the issue of capital, it is treated rather as if it were part of the company’s capital – part of the ‘cushion’ of equity that provides protection for creditors.
Revaluation reserves are usually created or added to when the company revalues some of its assets upwards, probably the properties that it holds as fixed assets. Suppose Jones had commissioned a professional revaluation of its buildings (‘Land and buildings’) which showed them worth £1.95m more than their book value of £3m. It would have increased the value of properties in the accounts by £1.95m and added £1.95m to capital reserves to show that this extra value (the surplus over book value) belonged to the shareholders. Balance sheets must balance!
The revaluation of properties is often referred to in the context of takeover bids. If a company owns properties that were last revalued ten years ago (not Jones Manufacturing in this instance), a press report might say: ‘the book net asset value [of the company being bid for] is 250p per share against the offer of 275p per share. But if properties are now worth £3m more than the book value, the net asset value would rise to 310p and the offer would look to be on the low side’. Thus the writer is mentally adding £3m to the value of properties, increasing revaluation reserves (and therefore shareholders’ funds) by a like amount, and working out his net asset value figure on the result. He would apply the same arithmetic if the company owned investments that were worth more than the figures at which they were stated in the books.
Finally, the net asset value for Jones Manufacturing. There are two complications. First, remember that goodwill is normally excluded to produce a figure for net tangible asset value. Second, the preference shares are not part of the ordinary shareholders’ funds, and also have to be excluded from a calculation of assets attributable to the ordinary shares. So the sums go as shown in Table 5.2:
|
£’000 |
SHAREHOLDERS’ FUNDS AS STATED IN THE ACCOUNTS |
11,000 |
less |
|
GOODWILL |
1,000 |
less |
|
PREFERENCE CAPITAL |
500 |
ORDINARY SHAREHOLDERS’ FUNDS |
9,500 |
|
|
Divide by the 7.5 million shares in issue |
|
NET TANGIBLE ASSET VALUE PER ORDINARY SHARE |
126.7p |
Table 5.2
The other complication is the existence of the convertible loan. As an added sophistication, we can work out the fully diluted net asset value per share for Jones – what the position would be if the loan were converted now. Take the £9.5m adjusted ordinary shareholders’ funds (after excluding goodwill and preference capital). Add in the nominal value of the convertible loan stock – £1.5m – since this will cease to exist as a liability when converted, and therefore shareholders’ funds will increase by £1.5m. Then divide the result by the enlarged number of ordinary shares: 7.5m plus the 1.5m arising on conversion. The result: £11m divided by 9m shares = £1.222 or 122.2p. So conversion of the loan stock will dilute assets per share from 126.7p to 122.2p. A fairly minor dilution as it happens, but worth bearing in mind.
See end of Chapter 3 – the same pointers apply.