External Sources of Finance Shoe Zone and Sports Direct International PLC Case Study

1.0 Introduction

Financing decisions are crucial thus making it necessary for managers to assess sources of finance carefully and understand the ramifications of implementing a specific source. Financing can be external or internal and businesses usually exploit the internal financing fully before turning to external financing. Internal financing involves reinvesting profits or contributions from the shareholders.  Internal financing is limited and this necessitates the exploitation of external sources of finance.  The form of business of business to some extent influence the source of finance a business can exploit. The law is categorical regarding the viable sources of finance and the procedures to be followed when exploiting a source of external financing. Some forms of businesses cannot utilize some forms of external financing due to some legal restrictions. For instance, only a public company is allowed to raise capital from the public. In other words, the law does not allow sole proprietorships, partnerships, and limited companies to raise money from the public. There are various external types of financing available for public companies and specific factors need to be considered when exploiting these types. Shoe Zone and Sports Direct International plc are public companies that have access to different forms of external sources of finance. Their capital structures have differences indicating that they have been relying on different sources of financing.

2.0 Context of the Chosen Companies

The decision to choose the two companies was influenced by some factors. The fact that they are public companies traded at London Stock Exchange is one of the factors.  Public companies have access to more financing avenues than other forms of businesses. Evaluating bringing these companies into consideration would therefore support comprehending different types of financing and their consequences.  Another factor that influenced the selection is the fact that they are both from the retail industry. Shoe Zone is a low cost shoe seller with over 500 shoe outlets spread across Ireland and the UK employing over four thousand people. Sports Direct International is a British sports goods retailer with over 670 stores worldwide. The two companies therefore provide an outlook of financing trends in the UK’s retail sector.  Both companies are different regarding size where Sports Direct International is much bigger than Shoe Zone. Sports Direct International revenue and net income for 2017 financial year was $3245 million and $164 respectively. On the other hand Shoe Zone’s revenue and net income for the same year were $158 million and $8 million respectively (MorningStar 2018). This big difference in profits and revenues provides a chance to evaluate the financing operations of public companies that are of different sizes. Availability of information is another factor that influenced the selection of both companies. The fact that both companies are public implies that they are compelled by the law to make their annual reports public. Their annual reports are readily available in their websites and other financial analysis sites. Lastly, the capital structure of both companies have similarities and differences and investigation the same would provide a good foundation for understanding external financing.

 

3.0 Sources of Finance Available for the Two Companies

The two companies have access to both long term and short term sources of external finance. The fitness of each source depends on the current financial position in the company and the distribution of various assets and liabilities. It is also influenced by short term and long term implications making it necessary for managers and shareholders to assess the impacts of taking a particular course as far as financing is concerned (Brown, Fazzari &  Petersen 2009). For instance, some external sources of finance give rise to a huge short-term cash obligation that can trouble companies facing liquidity problems.  Analysing each type of finance and its viability in the two companies shows the strengths and weaknesses associated with different sources of finance.

3.1 Short-term Finance

These are sources of finance that are paid before the end of the year. They, therefore, help an organization to meet its short-term financial needs thus averting cash flow problems that might impede normal operations. Sources of short-term financing include trade credit, overdraft, and factoring.

3.11 Trade Credit

Trade credit occurs when the suppliers deliver goods on credit and give the buyer some time to pay. This method of financing enables the buyer to trade with the suppliers good and make money before paying that averts short-term cash commitments (Huang 2003). Both companies have exploited this method of financing as the value of creditors in their balance sheet is substantial. Accounts payables of Shoe Zone and Sports Direct International amounts to $13 million and $219 million respectively. They account for 17.58% of the total liabilities in Shoe Zone and 9.28% of Direct Sports International’s total liabilities (MorningStar 2018). Shoe Zone has a greater potential to exploit trade credit than Sports Direct International.

3.12 Overdraft

An overdraft occurs when a company is allowed to take more money than the amount in their account. This facility is subjected to a relatively higher interest loan compared to other loans advanced by the bank due to an absence of collateral.  It is only exploited in emergencies to enable a company to continue operating. An overdraft is recognized as short-term debt on the balance sheet.  Currently, Shoe Zone has not exploited the overdraft facility and is free to use this tool of financing. On the other hand, Sports Direct International has a short-term debt worth $1 million. Both companies have an opportunity to exploit the overdraft facility when a need arises.

3.13 Factoring

Factoring involves selling invoices to a factor instead of waiting for the maturity date.  Factors such as banks are willing to give cash to companies in exchange for invoices at a fee (Van der Vliet, Reindorp & Fransoo2015). This method of financing enables companies to meet their short-term cash needs without increasing their liabilities.  The nature of the two companies puts limitations on the extent to which they can use factoring as a source of financing. These limitations stem from the fact that they sell their products on cash and this reduces the value of their invoice. Any change in their mode of operation that would lead to a high value of accounts receivables would position them favourably to exploit factoring method of financing.

3.2 Long-Term Finance

3.21 Share Capital

Share capital involves the owners injecting money into the business. Publicly traded companies have the ability to raise money from their shareholders through a rights issue.  A rights issue gives the shareholder the right but not the obligation to buy new shares the company. In case they fail to exercise the right, members of the public are invited to buy the shares (Kabir & Roosenboom 2003).  The control of shareholders who fail to exercise their right to buy the shares is diluted. Both companies are publicly traded and they are therefore allowed to give a rights issue to raise capital from owners and the public.

3.22 Long-term debt

Bank loans and debentures are the main sources of long-term debts. Companies can negotiate for a long-term loan with a bank that leads to long-term financial obligations. A company can also issue debentures which are long term securities with a fixed interest rate to potential buyers. These two types of long-term debts are available for Shoe Zone and Sports Direct International.

3.23 Mortgages, Hire Purchase, and Leasing

A mortgage is an arrangement for buying a property where monthly contributions are made over a specific number of years. This allows a company to acquire a property without making heavy short-term cash commitment. Shoe Zone and Sports Direct International need properties, especially when seeking to establish new stores. Capital requirements stemming from the need for buildings can be addressed through mortgages.  A hire purchase agreement allows a company to use a property when making monthly payments and the ownership changes hands when all the payments are made.  Leasing is where a firm pays for the usage of a facility in the long run. Leasing and hire purchase financing modes are available for both companies.

4.0 Factors to Consider When Choosing the Source of Finance

Various factors are put into consideration when deciding on the best source of financing. The best source of finance is one that gives the organization optimal results regarding the short-term profitability and the long-term survival (Berger & Di Patti 2006). Some of the factors that are considered when choosing the source of finance include the current liquidity level, the nature of expenditure, cost, risk, the amount required, and control.

The nature of expenditure is a key determinant of the choice of finance. Expenditure can be broadly classified into capital and revenue expenditures.  Capital expenditure is incurred to acquire assets such as a new factory, machines and that are aimed to be of benefit to the company for a long duration. On the other hand, revenue transactions are associated with a specific financial year where their impact is only felt in that year. The nature of expenditure determines whether a company uses long term or short term financing. Long-term sources of finance such as equity, debentures, loans, and leases are ideal for financing capital expenditures (Diamond & Rajan 2001).  Revenue expenditures are best financed using the using short-term sources of finance. Both companies have both capital and revenue finance requirements and they evaluate their financing decisions based on the type of expenditure.

The company’s liquidity level is a key determinant of the type of financing.  Companies that are illiquid would be reluctant to exploit short-term financing as it would increase the risk of default. Current ratio and quick ratio shows the liquidity of a company and this is used as a basis for determining the extent to which the company can rely on different sources of financing.  Sports Direct International’s current and quick ratios are 1.07 and 0.45 (MorningStar 2018).  These ratios reveal that stock forms a substantial part of the company’s current assets that is a common feature in the retail sector. The company’s current ratio shows potential in exploiting short-term sources of financing such as trade credit and overdraft as it is clear its current assets are more than current liabilities.  Shoe Zone’s current and quick and current ratios are 1.67 and 0.45 respectively. It is an indication that the company has a favourable liquidity that would support exploitation of short-term sources of finance.

Cost of capital is a major consideration when choosing a source of finance. The cost finance varies from one source to the other. The cost of using trade credit is the discount associated with paying goods on cash. The cost of factoring is the fees charged by factors such as banks. The cost of short-term and long-term debts is interest rate while that of using equity financing is the dividends associated with the new shares.  It is clear the two companies seek to avoid high costs of finance by creating an optimal capital mix. Short-term debts are minimized to keep the cost of capital low. According to Henry 2003, an optimal financing mix is one that does not overburden the company with the cost of capital.   Cost of capital is a major cost centre in companies and it has a major impact on the profitability.

The risk implication of a source of finance is a key factor to consider when selecting a source of external financing (Baker & Wurgler 2002).  The risk of defaulting should be put into consideration when choosing a financing method. For instance, a company that is currently facing cash flow problems may avoid exploiting a source of finance that leads to short-term cash commitments.  Analysing the balance sheets of the two companies reveal that an attempt to distribute the risk is made where both short term and long term sources of finance are exploited.

The amount requires is a key determinant of the source of finance. Huge capital requirements are financed through long-term financing methods to save the company from unattainable short-term cash commitments.  On the other hand, small capital requirements can be addressed through short-term financing methods (Baker & Wurgler 2002).   The last factor to consider when sourcing finance is organizational control. Exploiting equity financing can dilute control of the company.  In some case, key shareholders may be unwilling to lose control of the company and thus making equity financing unattractive.

5.0 Conclusions

It is a parent that choosing the type of external financing in public companies is an engagement that requires various factors to be put into consideration. Analysing Shoe Zone and Sports Direct International reveal different sources of external finance that the two companies have been exploiting over the years.   It also shows their potential to exploit different forms of finances. Sources of finance are broadly classified into short term and long term. Shirt term sources of finance relate to a period not exceeding one financial year while long-term sources relate to many years. Some of the external sources of finance available to the two companies include trade credit, factoring, overdraft facilities, long-term debt, share capital, leases, hire purchase and mortgages. Each of the sources of finance has consequences that make it necessary to conduct an assessment to mitigate the possible negative impacts of financing operations. Some factors need to be considered when choosing external financing. These factors include current liquidity level, the nature of expenditure, cost, risk, the amount required, and control. A poor liquidity position discourages a company from using short-term financing as it can compromise the ability of an organization to meet its short-term obligations as they fall due. The nature of expenditure influences financing decisions.  Capital expenditures require long-term financing while revenue expenditures need short-term financing. The cost of finance is a core factor to be put into consideration when choosing the source of external finance. Financing decisions should be directed towards minimizing the cost of capital. The risk of default is considered when choosing a source of finance where an emphasis is put on ensuring the company is able to pay its liabilities as they fall due. The amount requires influences financing decisions as companies choose long-term financing when huge amounts are needed while short-term sources of finance are given priority when seeking small amounts of capital. The level of control needed influences financing decision. Equity financing is avoided when the current shareholders are unwilling to reduce their control.

6.0 Recommendations

Based on the analysis conducted on the two companies and their respective capital structures the following are recommendations:

  • Short term financing– Shoe stock should increase its short-term financing as its current ratio is way above 1 which is the minimum requires ratio. The company can use this approach by taking credit sales to increase its ability to serve clients. Sports direct international should maintain its current short-term financing as a further exploitation of short-term financing would compromise the ability to meet short-term cash obligations.
  • Equity financing– The two companies should consider using equity financing to finance expansion activities. Rights issue can help the companies meet heavy capital requirements associated with expansions. The retail sector has untapped potential globally that require exploitation and this would require heavy capital commitments.

7.0 References

Baker, M. & Wurgler, J., 2002, ‘Market timing and capital structure.’ The journal of finance, vol.57,no.1, pp.1-32.

Berger, A.N. & Di Patti, E.B., 2006, ‘Capital structure and firm performance: A new approach to testing agency theory and an application to the banking industry.’ Journal of Banking & Finance, vol.30, no.4, pp.1065-1102.

Brown, J.R., Fazzari, S.M. &  Petersen, B.C., 2009, ‘Financing innovation and growth: Cash flow, external equity, and the 1990s R&D boom.’ The Journal of Finance, vol.64,no.1, pp.151-185.

Diamond, D.W. & Rajan, R.G., 2001, ‘ Banks, short-term debt and financial crises: theory, policy implications and applications.’ In Carnegie-Rochester conference series on public policy ,Vol. 54, No. 1, pp. 37-71

Henry, P.B., 2003, ‘Capital-account liberalization, the cost of capital, and economic growth.’ American Economic Review, vol.93, no.2, pp.91-96.

Huang, Y.F., 2003, ‘Optimal retailer’s ordering policies in the EOQ model under trade credit financing.’ Journal of the Operational Research Society, vol.54,no.9, pp.1011-1015.

Kabir, R. & Roosenboom, P., 2003, ‘Can the stock market anticipate future operating performance? Evidence from equity rights issues.’ Journal of Corporate Finance, vol. 9,no1, pp.93-113.

MorningStar 2018, Shoe Zone PLC  SHEZF. Retrieved from http://financials.morningstar.com/ratios/r.html?t=SHEZF&region=usa&culture=en-US

MorningStar 2018, Sports Direct International PLC  SPD. Retrieved from http://financials.morningstar.com/ratios/r.html?t=SPD&region=gbr&culture=en-US

Van der Vliet, K., Reindorp, M.J. & Fransoo, J.C., 2015, ‘The price of reverse factoring: Financing rates vs. payment delays.’ European Journal of Operational Research, vol.242,no.3, pp.842-853.

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