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The 5-minute financial analyst: financial markets

We continue our corporate counsel-friendly look at finance for finance-phobes, this time exploring how your company is financed – and the role that stocks, shares and corporate debt can play.


H O W   Y O U R   C O M P A N Y  I S   F I N A N C E D

CATHERINE McGREGOR

EDITOR-IN-CHIEF

E-mail Catherine

Debt and equity are the two options a company has when choosing how to finance itself. In debt financing, the business borrows money in some form without giving the lender any ownership rights in the company. The company issues bonds which can be bought and sold in the same way as shares. Unlike a share, which is equity in the business, a bond is essentially a loan with a fixed rate of interest.

In contrast, if the organisation has chosen the route of equity financing, it will sell off a portion of the company through issuing shares.

For very small companies, or for those aiming to raise small amounts of finance, equity financing might be via a direct loan or a sale of interest to an individual. For larger amounts, the financial markets will come into play whether financing through debt or equity.

Financial markets

A company may issue debt securities or bonds in the financial markets. Debt securities are contractual obligations to repay corporate borrowing. The debt can be sold and resold so the final creditor may be completely different to the original lender.

Money markets

Money markets are the markets for debt securities that will pay off in the short term –usually less than one year, often less than 90 days and sometimes even overnight.

The money markets provide access to debt and investment potential on a short timescale for companies if they just need assistance with liquidity for a short period.

Money markets also help with maintaining liquidity in the banking sector, because they allow banks to trade their profits. Unlike the capital markets, money markets are much more liquid and can be easily converted into cash. Banks can therefore use surplus assets to create profit, but pull their exposure back as soon as needed.

Capital markets

Capital markets are the markets for long-term debt and for equity shares. Longer term debt can be traded via corporate bonds in the leading capital markets. The loan term has to be longer than one year.

Both the debt and the equity markets are comprised of primary and secondary markets.

The primary market is for the initial purchase of stock by institutions or individuals. There can only be one sale – the initial public offering (IPO).

The secondary market is where financial players buy and sell stock and bonds on a day-to-day basis, and is what is commonly referred to when we talk about markets being up or down. When a company makes an IPO, external factors (such as PR) can create anticipation around a stock and inflate the valuation.

The location of the exchange a company’s stocks are listed on is a function of the listing requirements, which are typically based on the market cap of the company and its trading volume, as well as the reputation of the exchange and the markets it serves. The New York Stock Exchange (NYSE) is still probably the most prestigious, whereas the National Association of Securities Dealers Automated Quotations (NASDAQ) is favoured by tech stocks. Companies in emerging markets will often try to list in the US or London (AIM, formerly the Alternative Investment Market, a sub-market of the London Stock Exchange) to get better exposure and stature. Companies can also have dual listings – for example, listing on a China exchange as well as the NASDAQ.

Electronic networks are a big factor affecting the evolution of exchanges as they are taking an increasing share of the market away from the floor-based human brokers traditionally used by the legacy exchanges.

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Ups and downs

Macro issues – such as the collapse of Lehman or an interest rate rise – may affect the whole market, and can influence share prices.

A company’s stock can be affected by big world events positively or negatively. Headquarters in a new war zone may be not so good for you – unless you’re making armaments, which could generate a much better scenario (for your share price, at least).

New product launches, or maybe just rumours about them, can produce upward movement. Witness the hype surrounding Apple when a next-generation device is anticipated.

Bigger trends in your sector can affect your share price negatively or positively. If you are seen to be out of step with the zeitgeist your share price might plateau until you can come up with the next iPad, or equivalent market-changing development.

“Capital markets are the markets for long-term debt and for equity shares.”

Personnel changes such as a CEO resigning or retiring can produce downward movement.

“Short selling”, where players such as hedge funds try to deflate the price of a stock to make a profit on their own positions in relation to that stock, can artificially influence a company’s position.

A proposed merger or takeover can also be a factor. Often the target company’s price will rise once rumours leak out.

In an era of information overload, bad press or PR can often have a hugely detrimental effect on a company’s shares. Manipulation of public opinion – and therefore shareholders’ opinions – is increasingly employed by “activist” investors to achieve a share fluctuation that might force change in a company.

Financial markets also seem strangely jittery and can sometimes fluctuate for no apparent reason. Those may be the days when your CFO looks the most miserable – as they just can’t figure out why their economic forecast is being trounced.

What effect does my company’s share price have on our day-to-day business?

In terms of day-to-day fluctuations of the stock market: not very much. That is unless your company has very little in the way of cash flow or assets and is reliant on outside funding to finance its operations. A depressed stock price can affect such a company’s ability to access other means of financing outside of the capital markets, such as bank loans, or even direct investment.

An ever-decreasing stock price might eventually lead to difficulties with both retention and hiring of employees. That’s because talent may be put off by a potential employer in perceived decline. But then again, that new position you thought you needed might suddenly be deemed unnecessary anyway.

If you sit on the management team, you might find yourself more vulnerable to replacement. The GC or legal head might not be immune when angry shareholders bay for blood.

These same dissatisfied shareholders might withdraw their capital altogether by selling their stock – a move which can often only push the company into a further downward spiral.

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