bnp finance unlocked brochure dec 2015

FINANCE UNL CKEDYOUR GUIDE TO FINANCE & LEASING

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Business is ON

FINANCE IS IMPORTANT TO ALL ORGANISATIONS This guide is an introduction to how businesses are financed, ways of raising finance and how performance is measured. It also looks at the ways leasing can help to finance new assets.

01 THE UK ECONOMY 04

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02 THE ROLE OF FINANCE AND HOW BUSINESSES CAN GET IT

03 TYPES OF BUSINESS – THE PRIVATE AND PUBLIC SECTORS

04 MEASURING FINANCIAL PERFORMANCE

05 INTRODUCTION TO LEASING FOR BUSINESS

06 HOW LEASING WORKS

07 THE DECISION MAKING PROGRESS

08 LEASING – THE LAW AND COMPLIANCE

09 GLOSSARY OF TERMS

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01 THE UK ECONOMYTHE WAY OUR COUNTRY’S ECONOMY PERFORMS AFFECTS US ALL.

A successful economy creates jobs, increases wealth and supports high-quality public services; an unsuccessful one leads to unemployment and a lower standard of living. So it’s no wonder it’s such a hot topic in the government and in the media.

MODULE 1 The UK Economy

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In the 20th century there were two opposing major styles of economy – communism in Russia and China, and capitalism in western Europe and the USA. More recently, former Soviet countries and China have moved further away from their centrally-controlled economies to embrace capitalism more widely. While they still have very different political systems from the west, it’s seen them become major powers in the global markets.

Of course, the western capitalist model has always meant the state had to play some part in providing important services like health, education and welfare, to make sure everyone got the quality of care needed at the right price.

In the UK, the economy encourages businesses to establish, grow, employ people and create wealth, so that they and their employees pay government taxes to support public services. But how much of money should be spent on them from the taxes raised is a political hot potato.

To increase public spending without putting up taxes, many western economies began to borrow heavily to pay for it – which set the scene for the near-collapse of the global financial system in 2007.

ECONOMIC BASICSWe tend to measure the success of an economy by its Gross Domestic Product (GDP), which is a total of most of the economic transactions that happen in a country’s economy. The UK’s GDP is around £3,002 trillion and the growth rate is published quarterly. Because GDP has such importance attached to it as a measure of an economy’s success, it’s worth noting that:

• It only includes goods and services produced and consumed in the UK – not imports, domestic production, intermediate goods used to produce other goods, or used goods.

• GDP figures are published around a month after the end of each quarter and are estimates – so they can change over time.

• GDP growth isn’t distributed evenly, as it takes time for increases in wealth to trickle down to all sections of society. Even if it was measured per person, it wouldn’t increase proportionally if the population was growing at the same time.

Government consumption

Exports minus

imports

Investment made by industry

Consumer spendingGDP


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SO WHAT IS THE UK DOING?These tables show the relative size of the world’s leading economies in 2014 and shows a steady increase in UK GDP until the world economic crisis hit between 2007 and 2010. It’s hard to understand the total UK figure because it’s so large, so we tend to focus on the GDP growth rate over short periods of time, which is measured as a percentage.

If it starts to shrink, the reverse is true and when it falls for two quarters in a row, we go into a recession. During recession, governments have to borrow more money as more people lose their jobs and need state support, but there are less taxes coming in.

1948

–

1952

–

1956

–

1960

–

1964

–

1968

–

1972

–

1976

–

1980

–

1984

–

1988

–

1992

–

1996

–

2000

–

2004

–

2012

–

1.6 –

1.4 –

1.2 –

1.0 –

0.8 –

0.6 –

0.4 –

0.2 –

0.0 –

£trillion

RANK

1

2

3

4

5

6

7

8

9

10

COUNTRY

United States

China

Japan

Germany

United Kingdom

France

Brazil

Italy

India

Russia

GDP (000,000,000)

$17,528

$10,028

$4,846

$3,794

$2,828

$2,827

$2,216

$2,127

$1,996

$1,932

GDP PER HEAD (RANK)

4

121

10

12

17

16

74

20

140

55

GLOBAL GDP TABLE 2014

WHAT AFFECTS GDP GROWTH RATES?All governments are looking to sustain their growth rate over a long period of time – this tends to be a higher rate for developing economies like China and India. Sustainability is important to help living standards improve, without growing so fast that it actually causes recession through over-correction.

In the UK, there’s a political consensus that a 2% GDP growth rate is the right target, given the size of the economy and population. The government is responsible for controlling this and the table below shows how respective leaders have fared since the end of the second World War.

Several factors affect how well the government performs, particularly as no country can operate in isolation from the global economy. This chart shows the environment the UK has been operating in since 1999. Governments try to generate sustainable growth by creating the right conditions for consumers and businesses to have the confidence to spend money and help the economy to grow. At the heart of this is maintaining stable prices so that people can plan ahead with a relative degree of certainty.

In 1997, the UK government decided to give its central bank, the Bank of England (BOE) a much higher degree of control over the economy, by setting it objectives based around inflation.

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IN SIMPLE TERMS, THE HIGHER THE GROWTH RATE, THE BETTER OFF WE FEEL AS A NATION.

1974/75 1980/81 1991

2009 -5.2%

1973 +7.4%

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8

6

4

2

0

-2

-4

-6

-1

-2

0

1

2

3

4

GDP GROWTH

WORLD GDP ANNUAL CHANGES BETWEEN 2000 – 2014

UK GDP 1974 TO 2012

Clement Attlee

Harold Wilson

Margaret Thatcher

Harold Macmillan

WinstonChuchill

Anthony Eden DavidCameronEdward

HeathJohn Major

GordonBrown

TonyBlair

UK GDP ANNUAL CHARGES BETWEEN 1949 – 2014


2000

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2001

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2002

–

2003

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2004

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2005

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2006

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2007

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2008

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2009

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2010

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2011

–

2012

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WHAT IS INFLATION?In a nutshell, inflation is how much the price of a selection of goods and services increases (or decreases) over time, normally shown as a percentage change against prices 12 months before.

For example, if inflation is 1% it means prices are 1% higher than they were at the same time last year.

It’s based on an index of over 100,000 common items that we buy and sell, such as bread, beer and cinema tickets. There is a weighting system too, based on how much of our money we spend on each, so fuel has a higher weighting than postage stamps. All prices are updated each month.

In the UK we use two indices; the Consumer Prices Index (CPI) and the Retail Price Index (RPI). The main difference between the two is that RPI includes housing costs, such as mortgage interest payments and council tax, while CPI doesn’t. In addition, CPI calculates prices using a formula which takes into account that when prices rise, some people will switch to products that have gone up by less. This also explains why the CPI produces inflation figures about 1% lower than RPI.

The government uses the CPI to drive policy, such as changes in welfare payments.

This is important because the BOE has been set a 2% annual inflation rate to match the historic annual growth rate in the UK, and means goods and services won’t get any more expensive in real terms. Inflation under 2% causes problems, because consumers and businesses lose one of the incentives for spending money – prices will get more expensive unless they buy things now. When enough people think like this, the economy slows and recession begins to be a possibility. Similarly, inflation above 2% means people on fixed incomes will see their savings destroyed and those working will ask for a pay rise to compensate, leading to a wage and price spiral that can get out of control.

Although the BOE is responsible for reaching the 2% CPI target, it’s hard to control prices in a global market, particularly commodities. In April 2015 the UK had negative inflation for the first time since 1960, but it’s generally felt that the main trigger for this was oil prices halving from 12 months earlier. As individuals, the major benefit of no inflation is that we don’t need any increase in income to maintain our living standards.

IN APRIL 2015 THE UK HAD NEGATIVE INFLATION FOR THE FIRST TIME SINCE 1960

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CONTROLLING INFLATIONThe BOE’s main weapon for controlling inflation is setting interest rates. If higher inflation looks likely, the BOE will increase interest rates to put individuals and companies off borrowing money, and slow down economic activity. The reverse is also true – lowering rates increases borrowing.

Since March 2009, the bank base rate set by the BOE has been kept at a record low level of 0.5% which confirms that in recent years there has been a much greater risk of economic stagnation than an inflationary spiral. Although the BOE sets base rates based on predicted future inflation trends, outside influences come into play too, and we’ll look at these later.

PART OF A GLOBAL ECONOMY

There are other factors which affect how the UK economy performs. The GDP growth formula (GDP = consumer spending + investment made by industry + excess of exports over imports + government con-sumption) shows there’s a direct relationship between balance of payments (excess of exports over imports) and GDP growth. So we should look at how the UK performs in trading with the rest of the world.

Since 1997, the UK has run an increasingly large current account deficit with trade partners, which has acted like a brake on the economy. Yet between 1997 and 2007 the UK economy grew quite strongly. How?

UK CURRENT ACCOUNT POST WAR

THE INFLUENCE OF DEBT ON GDP GROWTH SINCE 1997

While countries like China and Germany grew their economies throughout the 1990s and early 2000s on the back of a strong balance of payments surplus, in the UK and USA governments, businesses and consumers all borrowed money to fund economic growth. Unfortunately, the short-term benefits provided by higher debt led to the near collapse of the world’s financial system – and the effects will be felt for some time to come.

Debt began to increase rapidly from the early 1990s when developing countries, particularly China, grew the export of goods to the west at very low prices. This significantly reduced the rate at which prices in the developed world increased and saw dramatic cuts from the very high interest rates of the 1970s and 1980s, when high inflation was the overwhelming risk. In turn, this created the perfect environment for all sections of society to make large increases in borrowing.

SINCE MARCH 2009...THE BANK BASE RATE HAS BEEN KEPT AT A RECORD LOW LEVEL OF 0.5%

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www.economicshelp.org Source ONS

BALA

NCE

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Trade in Goods + Services Trade in Goods

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-80000

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1950 1960 1970 1980 1990 2000 2010 2020

20000

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GOVERNMENT DEBT

Governments in most countries, even Germany and particularly Japan, borrow money. With western governments borrowing to provide their citizens with good public services and low taxes, the financial crisis of 2007/2008 called this policy into question when economies stopped growing.

Countries such as Greece, Ireland, Portugal and Spain, which had particularly high borrowings as a percent-age of their GDP and, as members of the Eurozone couldn’t simply print money, were particularly vulnerable to a loss of confidence from those who had lent them money.

To borrow money, governments issue bonds (or gilts) to individuals, pension funds, insurance companies or foreign countries. The bonds give the purchaser fixed interest payments every year, for a fixed period of time (often 10 years), after which their bond will be redeemed in full. As governments don’t normally go bust, gilts are considered safe and governments can normally borrow money at relatively low rates of interest. Very few countries actually have sufficient money to repay bond holders when their bonds reach maturity so they simply issue more bonds (i.e. borrow more money) to make repayments as they become due. It all works well if governments can borrow new money at the same, or lower, interest rates than before. But it can quickly go very wrong if the opposite happens.

ON TO AUSTERITY

Bond holders are much less willing to buy government debt if they feel there’s a real chance they won’t get their money back. At the very least they’ll demand high and often unsustainable rates of interest for any loans they make. For example, the financial markets were unwilling to roll over the debt of some countries at acceptable interest rates after the financial crash, which meant a lender of last resort had to step in, such as The International Monetary Fund or the European Central Bank. The price of their ongoing support is that countries concerned must take steps to get their finances into shape. These are the austerity measures we hear so much about in the media.

So the key to managing government finances is making sure bond holders are confident the country can make repayments, which is why the UK is very keen to show it has clear plans to reduce the national debt growth rate. Confidence in Greece was destroyed not by the size of it’s debt, which is actually smaller than that of the UK, but by the size of debt relative to the size of its economy – a ratio which got worse as the Greek economy shrank at a faster rate than the size of its debt.


02 THE ROLE OF FINANCE AND HOW BUSINESSES CAN GET IT

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MODULE 2 The role of finance and how businesses can get it

WHY DO BUSINESSES NEED FINANCE?Finance is the money a business has to spend on what it needs.

From the moment someone thinks of a business idea, there’s a need for cash. As the business grows, there are inevitably greater calls for more money to finance expansion, while the day-to-day running of the business also needs money.

Finance requirements can be categorised as either short-term – finance needed to simply keep the business going – or long term, where a business requires injections of finance to take strategic action.

FINANCING BUSINESSThere are basically two sources of finance; debt and equity.

• Debt finance: borrowing money from a third party at an agreed rate of interest and repayment.

• Equity finance: where a business uses its own money to fund operational and investment requirements.

Most established businesses use a combination of both equity and debt finance.

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Starting a business: costs such as buying assets and materials, and employing people. There will also need to be money to cover the running costs. It may be some time before the business generates enough cash from sales to pay for these costs.

Investing in new products and services: money to research, develop and market new products or services.

Takeover or acquisition: funding the buy-out of another business.

Entering new markets: research, marketing and setting up to target new locations or customer groups.

Moving premises: everything from relocation packages and new machinery to removal vans.

Investing in equipment to grow capacity: buying new technology to cut unit costs, increase output and keep up with competitors. This can be relatively expensive to the business and is long term because the costs will outweigh the money saved or generated for a considerable period of time.

LONG-TERM FINANCE REQUIREMENTS The long-term financial needs of a business can include:

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DEBT FINANCE

Following the global financial crash of 2008 and the demise of Lehman Brothers, new regulations have been applied to the banking sector. Banks deemed ‘too big to fail’ are being forced to adopt the latest of a number of new regulatory standards known as Basel III, which requires banks to hold 4.5% of common equity (up from 2% in Basel II) and 6% of Tier I capital (up from 4% in Basel II) of risk-weighted assets (RWA).

This means their lending is restricted to a level which ensures that shareholder funds represent at least 10.5% of their loan book. As a result, many banks have had to increase their profitability by charging higher interest rates, reduce the number of new loans and in many cases sell off certain risk-weighted assets, and often a combination of the three. This has made it difficult for certain businesses to obtain bank finance on acceptable terms.

In the UK, the government has tried to ease business credit a number of times. First, in January 2009, came the Enterprise Finance Guarantee scheme, which offered banks a government guarantee worth 75% of loans to small businesses, lowering the risks faced by the banks. Lending continued to plummet.

Next, in 2011, the Project Merlin agreement between the Treasury and the biggest lenders aimed to provide £190 billion of new credit to businesses. But the reduction of old loans outweighed the new ones; despite £215 billion in new loans, net lending declined again. Then came the National Loan Guarantee Scheme, which uses government guarantees to lower the cost to banks of borrowing from markets—and yet more lending contraction.

The Bank of England and the Treasury activated a further scheme – the Funding for Lending Scheme (FLS) in August 2012. If banks sign up to this scheme they can borrow funds cheaply from the Bank of England, on the proviso that they are lent out again to consumers and small business, in the form or mortgages and business loans. The scheme proved very successful for accelerating mortgage lending and was subsequently withdrawn, but at the time of writing FLS is still available for bank loans to business.

As a result of banks becoming less accommodating in meeting the funding requirements of their customers, other forms of debt finance have increased in popularity, the most significant of which involves businesses going direct to the public to borrow money. Large companies achieve this through the bond market while smaller businesses take advantage of the growing number of peer-to-peer options.

TYPES OF DEBT FINANCEDebt finance can include several different types of raising capital.

BANK LOANSA short-term overdraft or a longer-term loan, usually with lending secured against the business assets. The loan agreement will have a fixed or a floating charge.

• Fixed charges: where the lender providing money to buy an asset like a building or vehicle. The company can’t sell it without the lender’s permission. A mortgage is a good example of this kind of charge.

• Floating charges: used when it’s not practical to place a fixed charge over every item of stock. The charge ‘floats’ until converted into a fixed charge (crystallisation), at which point the charge attaches to specific assets. Typically, default by a borrower triggers crystallisation.


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CORPORATE BONDSA fixed-price bond sold to investors, usually through a bond market. It pays the investor a fixed interest rate and repays the loan at the original price at the end of the loan period, usually 10 years. The investor risks the company ceasing trading during the period and the interest rate reflects this. Bonds can be traded on the second-hand market, but this raises no new cash for the company.

Bonds are typically broken into three time categories: short-dated, medium-dated, or long-dated. Known as a fixed interest security, bonds typically have at least one year’s life span – anything shorter is known as commercial paper. A bond’s main features are usually presented in its title, so a Tesco 10-year bond paying 5.5% would be called: Tesco 5.5% 06/11/2025.

Bonds are usually priced in percentage terms to their issue price, or ‘par value’. So if a bond is trading at par value, it will be priced at 100, while if it is trading at a price of 80 it means it has fallen in value and is

currently at a discount. Conversely, if it is trading over 100 it has gained value. Investors who buy at par are likely to see their bond price change over time and have the potential to make capital gains on it by selling it at a premium before it matures. Bonds typically move back towards par price as they near maturity. Market expectations relating to inflation and interest rates are the major factors influencing the price of bonds. Rising inflation is bad for bonds as it erodes the value of money over time and reduces purchasing power. If inflation is expected to rise, rates are also expected to be raised to combat this and keep inflation at, or near, target level.

If the outlook is for interest rates to rise in future, new corporate bonds issued by the same company will be likely to offer a higher premium to investors. As a result, older issues – paying coupons that are below inflation– will be less attractive, pushing their price down. Conversely, this will raise the actual quoted yield of the bond.

If the outlook is for rates to fall, then the existing issue is likely to be more attractive compared to future issues paying less interest, so the price would rise to reflect this. The yield will move lower, until the price is similar to any new issues. As well as interest rate risk, investors also need to consider issuer risk and the impact of any changes in government bond yields. Ratings agencies score corporations on their likely ability to return an investor’s capital in full on the day

a bond matures, by assessing them on a variety of factors. Investors will typically accept a lower return on their investment from higher-rated, more secure institutions, and demand more from riskier companies.

UK corporate bond issuance hit an all-time high in 2014, with net issuance over £20billion. These figures underline the importance of bond markets as a source of finance, particularly for large UK companies.

At its par value of £1,000, and paying £60 per annum, the yield is 6% as stated, but if the value of the bond fell below par to £800, then the £60 is now worth 7.5% of the overall price. So the yield would rise to 7.5% although the overall pay out hasn’t changed.

£1,000BOND VALUE

£800BOND VALUE

6%YIELD

7.5%YIELD

£60PER YEAR

£60PER YEAR


AS AN EXAMPLE, LET US TAKE A 10-YEAR BOND WITH A PAR VALUE OF £1,000 WHICH PAYS 6% PER ANNUM, GIVING A TOTAL FIXED PAY OUT OF £60 PER YEAR.

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PEER-TO-PEER LENDING

Increasingly important to business, peer-to-peer loans through online finance brokers such as Funding Circle allow people to lend directly to businesses without going through formal trading systems. This is attrac-tive to all parties because the interest rates paid by borrowers are often similar to that charged by banks, but the loans are much easier to arrange. The same interest rate provides a better return for investors than depositing their money in banks and building societies. The risk is often higher, however, and needs full consideration.

Funding Circle has recently made business headlines by attracting funds direct from Lancashire County Council to support local businesses and, from April 2016, it’s proposed that savers can include any funds lent through peer-to-peer lenders within ISAs.

ASSET-BASED FINANCE AND LEASING

Asset-based financing involves a contractual agreement between the lessor (owner) and the lessee (user) for a specified asset, which can be property, office equip-ment, industrial plant or vehicles. The lessee receives the right to total ownership for a certain period of time and conditions in return for payments. Leasing is different from a rental, although these words are often confused. A true rental is for a short period of time, such as a month, where the agreement is renewed or the terms are changed often. Leasing takes a longer-term view, which allows businesses to budget better.

EQUITY FINANCE

This allows the business or the business owners to use their own money to provide funding. The costs of running a business, such as paying wages and expenses or buying stock, are normally funded from ongoing profits. This is short-term equity finance. For larger and more strategic equity funding requirements, businesses normally need to become limited companies and attract investors by issuing shares.

PRIVATE EQUITY, VENTURE CAPITAL AND HEDGE FUNDS

Certain types of investors operate differently from normal shareholders. In the case of private equity, venture capital and hedge fund investors, the objective is to invest in businesses with a high level of short-term growth potential, which once realised will enable the sale of shares at a good profit.

The investor completes the initial transaction with a clear idea of their exit strategy. These investors are often classed together as specialised types of investment, often managed by large banks on behalf of their clients. While private equity and venture capital are broadly similar, hedge funds have very different objectives and tend to involve stock market, rather than corporate, risk and reward.

This table outlines how each type of investment operates:

1. Initial public offerings/new shares: where a company wishes to increase its share capital by placing new shares on the market. The price is determined by supply and demand and doesn’t reflect the actual value of the share to the company, so a £1 share will raise £1 for the company even if it subsequently trades at £5 on the market.

2. Second-hand market: this accounts for the vast majority of trading within stock exchanges and is simply a market where existing shares are traded at a price which reflects supply and demand. No new share capital for the companies involved is raised.

THE STOCK MARKET – THERE ARE TWO TYPES OF MARKET FOR SHARES:

VENTURE CAPITAL PRIVATE EQUITY HEDGE FUNDS

Invest in growing businesses

No development of the business or alignment

with managersAim to create value

Objectives aligned to management

Invest in new companies with little or no track

record of profitability

Invest in mature companies with growth potential

(look to unlock value)

Very short-term investment strategy

designed to benefit from share price movement

Normally look to exit within three

to five years

Typically look at investing for about

five years

Complex trading strategies such as

selling stock ‘short’ and using options and

derivatives

Often seek director guarantees

Normally take a controlling interest


THERE ARE NOW OVER 100 ACTIVE VENTURE CAPITAL FIRMS IN THE UK.

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PRIVATE EQUITY

A process where a specialist fund manager acquires a significant shareholding in a business. As the name implies any such business will stay or become a private rather than public limited company.

VENTURE CAPITAL

An important source of equity for certain companies, provided by specialist companies who invest equity in a business for a relatively short period of time, usually between three and seven years. All such funding involves an ‘exit route’ in which the venture capitalists aim to recover their money and a good premium when their shares are re-sold to either the public or the owners of the business.

Venture capital companies are skilled at identifying businesses which can provide rapid growth, providing they’re given the finance needed to expand.

Venture capital in the UK originated in the late 18th century, when entrepreneurs found wealthy individuals to back their projects on an ad hoc basis.

This informal method of financing became an industry in the late 1970s and early 1980s when a number of venture capital firms were founded. There are now over 100 active venture capital firms in the UK, which provide several billion pounds each year to unquoted companies, mostly located in the UK.

By providing long-term, committed share capital, it can help unquoted companies grow and succeed. If an entrepreneur is looking to start up, expand, buy into a business, buy out a business, turnaround or revitalise a company, venture capital can help do this.

Obtaining venture capital is substantially different from raising debt or a loan from a lender. Lenders have a legal right to interest on a loan and repayment of the capital, irrespective of the success or failure of a business. Venture capital is invested in exchange for an equity stake in the business. As a shareholder, the venture capitalist’s return depends on the growth and profitability of the business.

The terms of investment are often linked to the growth profile of the business. Investments in more mature businesses, where the business performance can be improved more quickly and easily, are often sold sooner than investments in early-stage or tech-nology companies, where it takes time to develop the business model.

Typically, venture capital loans (as distinct from equity) are entitled to interest and are usually, though not necessarily, repayable. Loans may be secured on the company’s assets or may be unsecured. A secured loan will rank ahead of unsecured loans and certain other creditors of the company. A loan may be con-vertible into equity shares, or it may have a warrant attached which gives the loan holder the option to subscribe for new equity shares on terms fixed in the warrant. They typically carry a higher rate of interest than bank term loans and rank behind the bank for payment of interest and repayment.

Venture capitalists prefer to invest in entrepreneurial businesses, based on the investment’s aspirations and potential for growth, rather than its current size. Such businesses are aiming to grow rapidly to a significant size. As a rule of thumb, unless a business can offer the prospect of significant turnover growth within five years, it’s unlikely to be of interest to a venture capital firm, where investors want companies with high growth prospects, managed by experienced and ambitious teams capable of turning their business plan into reality.


03 TYPES OF BUSINESS – THE PRIVATE AND PUBLIC SECTORS

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MODULE 3 Types of business – the private and public sectors

Most UK businesses are in the private sector, which includes businesses that are directly or indirectly owned by private individuals, from one person businesses to large companies. Public sector organisations, on the other hand, are directly or indirectly controlled by the government.

BUSINESSES ARE EITHER IN THE PRIVATE SECTOR OR THE PUBLIC SECTOR.

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TYPES OF PRIVATE SECTOR BUSINESSA private sector business is either unincorporated or incorporated and there’s a significant legal difference between the two. An unincorporated company has no independent legal identity and the owners of the business are liable for any debts incurred. Once a business becomes incorporated, normally by registration with the relevant regulatory body, it has its own legal identity.

UNINCORPORATED BUSINESSESThere are three main types of unincorporated business in the UK.

1. SOLE TRADERSA sole trader is a person trading in his or her name, or under a trading name. Over half of the UK’s 5 million businesses are formed as sole traders. These businesses are small, generally one person working on their own.

By law a sole trader is liable for all the debts of the business. This means that if the business fails the sole trader will have to repay personally all the business debts, and may have to sell their personal belongings to pay off those debts.

2. PARTNERSHIPSA partnership is two or more people running a business together. They share control of the business, and own it between them. Examples of partnerships include groups of builders, doctors, dentists, accountants, and solicitors.

A partnership is the next step up from a sole trader business, but is no more than a group of sole traders working together in a more organised framework. There are approximately 700,000 partnership businesses in the UK.Each partner is liable for all the debts of the partnership, so if one partner runs up a big debt, each or all of the other partners could be asked to pay it off.

3. UNINCORPORATED ASSOCIATIONS

INCORPORATED BUSINESSESFormed by registration with a regulatory body, incorporated businesses have to comply with the ongoing regulation put in place by that body.

Common examples are:

REGULATORY BODY

Companies House Financial Conduct Authority(Mutual trading styles) Charities Commission

• Limited Companies

• Companies limited by guarantee

• Community Interest Company

• Limited Liability Partnerships

• Mutual Building Societies

• Credit Unions

• Co-operatives

• Housing Associations

• Charitable Incorporated Organisations

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LIMITED COMPANIES

A limited company is a business:• owned by shareholders• run by directors• set up as a body which is separate from its owners

(the shareholders).

A limited company is very different from a sole trader or partnership business. The sole trader or partner is the business – if the business goes then so does the owner. The shareholder owner of a limited company stands apart from the business, which is a body in its own right. So if the company goes bust the shareholder is protected by limited liability and doesn’t lose all their money, just what they’ve invested in the shares of the company.

Limited companies can be classified in two ways:• private limited company (Ltd)• public limited company (Plc)

Most small or medium-sized businesses which decide to incorporate (become a company) become private limited companies; they’re often family businesses with shares held by family members. Private companies can’t offer their shares for sale to the public at large, so may find it difficult to raise money.

Public limited companies are larger than private companies – some of them are household names. They can usually offer their shares for sale on the stock market to raise money. To become a plc the company has to place some or all of the equity in their business up for sale in an initial public offering (IPO) on the stock market or for smaller companies the alternative investment market (AIM).

An IPO is also known as a stock market flotation. Most private company owners would consider an IPO as a means of generating significant capital for further investment in the business, like acquiring a competitor, or expanding into a new market.

SMALL, MEDIUM AND LARGE COMPANIESA limited company is also recognised (for accounting and taxation purposes) as either large, medium or small.

Companies which qualify as small or medium-sized can often obtain exemptions in the type and format of their annual statutory accounts.

These relate to both their main accounts provided to their shareholders and those which are available for public inspection at Companies House.


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DISADVANTAGES OF A LIMITED COMPANY

Small businesses such as sole traders and partnerships require relatively little in the way of paperwork. Setting up a limited company, on the other hand, requires more red tape. Companies have to register with a regulator, Companies House, a government-owned agency. At registration, they’re given a Certificate of Incorporation – the company equivalent of a birth certificate.

In addition, a company will also need:• the Memorandum of Association, which states what

the company can do.

• the Articles of Association, an internal rulebook for the directors.

All limited companies have to file accounts and a company return every year, the former often requiring audit by independent professional advisors. If annual statements do not reach Companies House within a specified period the company is trading illegally and will be subject to fines and eventual closure.

Companies will generally employ the services of a merchant bank or corporate advisory business to navigate through all the necessary steps in taking a company public, who charge a percentage of the flotation as fees. Once the company goes public, its shares are freely traded on whichever exchange the shares are floated.

Additional regulation applies to public companies, such as further reporting, AGMs etc. In addition, public companies need to spend a good proportion of their time with market analysts to make sure the company’s activities are well represented.

In situations where a company meets the criteria necessary to be classed as either small or medium sized in a particular year, it automatically qualifies for that same status in the next year, whether or not the company still meets the current requirements.

SMALL COMPANIES To be classed as small, a company must meet two of the three following criteria in a given accounting period :

It must not employ more than 50 people.

Turnover must be £6.5million or less.

Have gross assets of less than £3.26million (£2.8million before 6 April 2008). Gross assets are defined as the total of the balance sheet assets before the deduction of any liabilities.

A medium company must meet two of the three following criteria in a given accounting period :

The total of both fixed and current assets must be £12.9million or less (£11.4million applicable before 6 April 2008).

MEDIUM COMPANIES

Turnover must be less than £25.9million.

It can employ up to 250 staff.


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DIRECTORS

When an individual is appointed a director of a company, they become an officer with extensive legal responsibilities. For a director of an incorporated body, the Companies Act 2006 sets out a statement of their general duties. This statement codifies the existing common law rules and equitable principles relating to the obligations of company directors that have developed over time.

The Act highlights the connection between what constitutes the good of their company and a consideration of its wider corporate social responsibilities. It requires that directors act in the interests of their company and not in the interests of any other parties (including shareholders). Even sole director/shareholder companies must consider the implications by not putting their own interests above those of the company.

LIMITED LIABILITY PARTNERSHIPS (LLP)

Limited liability partnerships became available in the UK in April 2001 as a half-way-house between a partnership and a limited company. They aim to combine the flexibility of partnerships with the protection of limited liability. Although still not widely used, many professional partnerships have chosen to convert to an LLP.

There must always be at least two members (partners), who can form an LLP by registering it at Companies House. New members can be added through Companies House, too. Members of an LLP should not be liable for claims against the LLP, such as business debts, employee claims, or public liability.

An LLP must file financial statements at Companies House, but these can be so brief that they tell an outsider very little about the business. The tax rules are the same as an ordinary partnership, where the members are self-employed. The LLP will file an annual tax return, but each partner will report their share of the profit on their personal tax return. The individual partners will pay income tax and class 4 National Insurance on their profit share. Unlike a limited company, there are no tax charges on changing the profit sharing arrangements in an LLP and members can review the division of the profits as often as they like.

The main reason for the increase in popularity of LLPs over recent years has been the search for limited liability on the part of large partnerships in a way that provides fiscal flexibility for changes in partner circumstances.

COMPANIES LIMITED BY GUARANTEE (LBG) AND COMMUNITY INTEREST COMPANIES (CIC)

In British and Irish company law, a private company limited by guarantee (LBG) is an alternative type of corporation used primarily for non-profit organisations that require a legal personality. An LBG company doesn’t usually have share capital or shareholders, but instead has members who act as guarantors who agree to contribute a nominal amount (typically very small) in the event of the winding up of the company. It’s often thought such companies can’t distribute profits to its members, but this isn’t always true.

Converting a limited company to a Community Interest Company (CIC) removes this doubt entirely, as CICs feature an asset lock which prevents profits from being taken out. However, a company limited by guarantee that distributes its profits to members (not CICs) would not be eligible for charitable status.

As a footnote any public sector school that converts from Local Education Authority control to academy status normally becomes a company limited by guarantee.


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MUTUALSMutuals are businesses which are set up and run for the benefit of a community.

CO-OPERATIVES

The term co-operative refers to two types of business:

• retail co-operative societies which sell goods and services to the public.• a co-operative group of people clubbing together to produce goods or to provide a service.

RETAIL CO-OPERATIVE SOCIETIES

This dates back to 1844 when a group of 28 Rochdale weavers, suffering from the effects of high food prices and low pay, set up a society to buy food wholesale, i.e. at the same price as it was sold to the shops. They then sold it to the members at prices lower than shop prices, and the profits were distributed to the members as a dividend, the level of which depended on the amount of food they had bought.

The number of these self-help co-operatives grew during the 19th century, but declined in the later 20th century, largely because of competition from the big name retailers such as Tesco, Sainsbury’s and Asda.

Owned by its members, anyone can become a member of a retail co-operative society by filling in a form at their local Co-op store and buying a share, normally for £1. Members have voting rights (one vote per member) and can often obtain discounts at the society’s retail shops, along with other facilities such as funeral services.

CO-OPERATIVE VENTURES

The term co-operative also applies more loosely to co-operative ventures. There are approximately 2,000 co-operatives which carry out a number of different functions:

• Trading co-operatives: groups of individuals, such as farmers, who don’t have the resources in terms of capital and time to carry out their own promotion, selling and distribution, may club together to store and distribute their produce. They may also set up co-operative ventures to buy machinery and equipment.

• Workers co-operatives: these can often be found where the management of a business is not succeeding and a shut-down is proposed. The workers step in, with the consent of the manage-ment, and take over the ownership and running of the business with the aim of making a go of it and safeguarding their jobs.

CLUBS

Many clubs, such as social clubs, are set up as co-operatives, owned by their members.

CHARITABLE INCORPORATED ORGANISATION

A form of legal entity designed for non-profit organisations in the UK, charitable incorporated organisations (CIOs) became available in 2013.

The main benefits of a CIO are that it has legal personality, the ability to conduct business in its own name and limited liability, so its members and trustees won’t be liable in the event of financial loss. Charities can be formed as limited companies, but then they must be registered with both Companies House and the Charity Commission. In contrast, a CIO only needs to register with the Charity Commission, which aims to reduce bureaucracy for the charity.


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PUBLICLY-OWNED BUSINESSESBy contrast, public sector organisations are directly or indirectly controlled by the government. They include:

CENTRAL GOVERNMENT

• Government departments and agencies• Public corporations

CENTRAL GOVERNMENT STRUCTURE

LOCAL GOVERNMENT

• Local authority enterprises

NHS ENGLAND, ENVIRONMENT AGENCY ETC.

BBC ETC.

OFSTED, OFWAT, HM REVENUE AND CUSTOMS, ORDNANCE SURVEY ETC.

MET OFFICE, HIGHWAYS AGENCY, UK BORDER ETC.

HEALTH, DEFENCE, EDUCATION ETC.

PUBLIC CORPORATIONS

Public corporations are established by Acts of Parliament, and owned and financed by the state. Examples include, the Bank of England and the BBC.

Public corporations are run by a board of management, headed by a government-appointed chairperson. In the 1980s and 1990s a number of public corporations were privatised, such as British Gas, BT and British Airways. This allowed members of the public to buy shares in the companies.

LOCAL AUTHORITY ENTERPRISE

Local authority is a term applied to local governing councils which operate both in county and also city areas. Local Authorities administer a wide range of services, including education, environmental health, planning, refuse collection, social services, transport, fire services, libraries and leisure facilities.

They finance these from various sources:

• central government grants• local taxation (Council Tax)• income from local authority enterprise,

such as sports centres and golf courses• public transport• car parks• local lotteries.

MINISTER

GOVERMENT DEPARTMENT

EXECUTIVE AGENCY

NON-MINISTERIAL DEPARTMENT

NON-DEPARTMENTAL PUBLIC BODY

PUBLIC CORPORATION


04 MEASURING FINANCIAL PERFORMANCE

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MODULE 4 Measuring financial performance

BUSINESSES MEASURE PERFORMANCE BY RUNNING SYSTEMS THAT ALLOW THEM TO PREPARE FINANCIAL ACCOUNTS.

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Sole traders and partnerships don’t have to make their financial accounts public, while limited companies must have their accounts audited (if over a certain size) and send them to Companies House, normally within nine months of their year end.

Financial accounting is governed by both local and international accounting standards and is used to prepare financial statements for decision makers, such as stockholders, suppliers, banks, employees, government agencies, owners, and other stakeholders.

Financial accountancy is also used to prepare accounting information for people outside the organisation or not involved in the day-to-day running of the company. Management accounting provides accounting information to help managers make decisions to manage the business.

In short, financial accounting is the process of summarising financial data taken from an organisation’s accounting records and published as annual (or more frequent) reports for the benefit of people outside the organisation.

There are three elements to most UK limited company accounts:• profit and loss• balance sheet• cashflow statement

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PROFIT AND LOSS (P&L)This account shows whether a business has made a profit or loss over the accounting period, and how it was made.

A P&L account starts with the trading account and then includes all other business expenses. The trading account shows the income from sales and the direct costs of making those sales. It includes the balance of stocks at the start and end of the year.

The trading account now has all the other expenses deducted. It looks like this example:

£’000 EXAMPLES

Turnover (sales) revenue 1,200 The amount of money

generated by sales e.g. 400 cars at £3,000 each

Cost of sales (400) The cost of making the goods or buying them

Raw materials

Cost of labour working directly on each product

Cost of running the machines/equipment

Gross profit 800 Turnover minus cost of sales TRADING ACCOUNT

Overheads or expenses (320)

Costs not directly involved in the production process (indirect costs)

Cost of premises e.g. rent, insurance, repairs

Office costs e.g. stationery, postage, computer mainte-nance, staff salaries and wages

Sales and marketing costs e.g. salaries of salesmen, advertising

Depreciation of fixed assets

Operating or Trading Profit 480 Gross profit

minus overheads

Interest (200)The money that is due to be paid in interest on loans.

Tax (56) The money that is due to HMRC as tax

Net profit after tax and interest 224

The money available that can be distributed to shareholders

Dividends (170)Money paid to share-holders as a reward for holding shares

Retained profit 54

The money left for the business to reinvest or distribute in dividends at a later date.

The cost of sales includes the deduction of stock shown in the balance sheet for the previous year from that shown in the balance sheet for the current year.


£12,000

£2,000

£2,000

£2,000

£2,000

£2,000

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DEPRECIATION AND AMORTISATION

These terms relate to loss of value over time of a business’ assets. The assets are shown in the balance sheet and will be covered later, but their loss of value is shown as a charge on a balance sheet.

Depreciation is the term applied to fixed assets and amortisation to intangible assets.

There are various ways to calculate the cost of a depreciating asset. Perhaps the simplest is the straight line method, which involves deducting the anticipated residual value of an asset from its original purchase price and dividing that figure by the number of years over which the asset is likely to be employed.

ACCRUALS AND REPAYMENTS

The income statement, or profit and loss account, has to include the expenses relating to the period, whether or not they have been paid. The figures in the trial balance will usually be the amounts paid in the period, and they need adjusting for outstanding amounts and amounts paid which relate to other periods, to obtain the income statement charge.

Unpaid balances relating to the period should be included in the balance sheet as current liabilities. If the expense has been paid in advance, the prepaid amount is included in the balance sheet as a current asset. In the income statement/profit and loss account, the total expense is needed, with a working showing the detail.

UNDERSTANDING PROFIT MARGINS

Profit margin is profit shown as a percentage of turnover. It’s an important measure of the trading performance and efficiency of any business.

As mentioned above, there are three measures of profit:

• gross profit

• operating profit (also known as net profit or profit before interest and tax – PBIT)

• profit after tax.

So it’s important to understand which figure a company is referring to when it provides profit figures.

A final term that might be used when discussing profitability is commonly referred to as P/EBITDA, which is profit (earnings) before interest, tax, depreciation and amortisation. It’s often considered the best guide to a company’s true trading position, as subjective and mandated elements of the P&L account are removed.

FOR EXAMPLE: A vehicle costing £12,000 has an economic life of 5 years and a residual value of £2,000.

The difference (£10,000) would be charged to the profit and loss account at £2,000 a year (£10,000 divided by 5 years).


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BALANCE SHEETThe purpose of a balance sheet is to show any reader the value of a business and how much its operations are funded by equity and debt. The ultimate value of a business is calculated by subtracting everything it owns from everything it owes, which gives the ‘net worth’ of the business, also shown as Shareholders’ Funds.

Everything owned is called an asset and everything owed a liability. When looking at the balance sheet of a limited compa-ny it’s important to remember that the shareholders (owners of the business) are different from the business itself and any shareholder funds within a company don’t actually belong to the company, so should be treated as a kind of liability.

A BALANCE SHEET IS MADE UP OF THE FOLLOWING AREAS:

FIXED ASSETS

Assets that provide a benefit for the business in the long-term (normally at least a year), such as buildings and machinery, which the business intends to keep.

Fixed assets depreciate over their useful life.

CURRENT ASSETS

Assets that will be used up or sold within the next year, plus the cash balances kept in the business.

The main categories are:

• stocks: finished goods, work in progress and raw materials, also called inventories

• debtors: people who owe the business money (customers who owe money are known as trade debtors)

• cash: in the bank and in the cash box.

INTANGIBLE ASSETS

An asset that isn’t physical, such as corporate intellectual property like patents, trademarks, copyrights and business methodologies. It also includes goodwill and brand recognition.

Goodwill is shown where a business buys another business and reflects the cost above net book value that was paid by the acquiring company.

Intangible assets can be either definite or indefinite, depending on the specifics of that asset. For example, a company brand name is an indefinite asset, which stays with the company as long as the company continues operations. However, if a company enters a legal agreement to operate under another company’s patent, with no plans of extending the agreement, it would have a limited life and would be classified as a definite asset. Intangible assets depreciate (amortise) over time.

Intangible assets are often discounted from the overall value of a business by potential creditors since their value could not be easily realised if the business ceased to trade.


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CURRENT LIABILITIES

Current liabilities are what the business owes in the short run. The main categories are:

• creditors – money owed by the business in the short term (suppliers who are owed money by the business are known as ‘trade creditors’)

• bank overdraft – amounts due within the next 12 months.

The total of current assets minus current liabilities is known as working capital. This is how much money is available for the day-to-day running of the business. A negative figure can be a problem for some businesses that may need to pay for outstanding debts, but don’t have enough spare cash to do so.

SHAREHOLDER FUNDS

The share capital and reserves added together.

PROFIT AND LOSS RESERVES

The profits due to the owners that haven’t already been paid out in dividends. This money isn’t necessarily held in cash, but may have been used to buy more stock or fixed assets.

SHARE CAPITAL

The money invested in the business by the owners.

LONG-TERM LIABILITIES

This means money the business has borrowed for a period of more than a year, such as bank loans or finance leases.

BALANCE SHEET EXAMPLE

A balance sheet might look like this:

FIXED ASSETS £1,800 Likely to show sub-totals for buildings, equipment and vehicles Current assetsStock £300 balanceDebtors £250 Any money owed by customers (invoices outstanding)

Cash £150

Total current assets £700 Stock + debtors + cash Current LiabilitiesCreditors £300 Unpaid invoices from suppliers

Bank overdraft £100

Current Liabilities (£400) Bank overdraft + creditorsNet current assets (Working capital) £300 Current assets – current liabilities Net assets employed £2,100 Fixed assets + net current assets Financed by:Long-term liabilites £700 E.g. loans from banks, finance leases or director loans.Share capital £1,000 Amounts invested by shareholdersProfit and loss reserves £400 The profit that the business has retained Shareholder funds £2,100 Long-term liabilities + share capital + profit and loss reserves


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WHY BALANCE SHEETS BALANCE

Accountants use bookkeeping systems to prepare company accounts. In the double-entry system, debit and credit are the two core aspects of every financial transaction and have to balance at all times. Debits are entered on the left-hand side of a ledger, and credits on the right-hand side.

Whether a debit increases or decreases an account depends on what kind of account it is. In the accounting equation Assets = Liabilities + Equity (A = L + E), if you increase an asset account (by a debit), then you also need to decrease (credit) another asset account, or increase (credit) a liability or equity account.

In short, an increase to an asset account is a debit while an increase to a liability account is a credit. Conversely, a decrease to an asset account is a credit and a decrease to a liability account is a debit.

THE IMPORTANCE OF CASHFLOW

Around 60% of failed businesses say that most of their failure was due to cashflow problems. Making a profit is very important, but cashflow is vital, so managing cash is the key to business success.

It’s possible to trade at a continual loss and remain in business, providing that more cash comes into the business than leaves it. Equally, profitable businesses will cease to trade if they fail to manage their cash flow.

Further cashflow alone can fund expansion, and businesses such as large supermarket chains benefit greatly from cashflow because their customers pay for goods with cash and pay their suppliers many weeks in arrears.

CASH AND PROFIT

So cashflow and profit are not the same thing.

Financial accounting doesn’t focus on cashflow but on net income or profit. Over the long term, profit and cashflow are approximately the same, but the crucial difference is timing.

When a small business makes a sale to a credit customer, they recognise that sale immediately on their income statement, which is called accrual accounting. But because they don’t get the money immediately, their cash budget and statement of cashflows don’t show that credit transaction until they actually receive payment. This is an example of making a profit ahead of receiving any income.

For all organisations, the gap between profit and cashflow can be very large. If they have rapid growth in credit sales, for example, profit could far exceed actual cash received. This sort of situation makes new companies very vulnerable to running out of cash and is also known as over-trading.

LIQUIDITY

The word liquidity is often used together with cash management. Liquidity is a firm’s ability to pay its short-term debt obligations. In other words, if the firm has adequate liquidity, it can pay its current liabilities such as accounts payable. Usually, accounts payable are debts they owe their suppliers.

There are methods commonly used to measure liquidity. Financial ratio analysis will help determine how liquid a firm is or how successful it will be in meeting its short-term debt obligations. The current ratio will help determine the ratio of current assets to current liabilities. Current assets include cash, accounts receivable and inventory.

Ideally, a business will have more current assets than current liabilities on their balance sheet at all times. The quick ratio will allow a business to determine if they can pay their short-term debt obligations, or current liabilities, without having to sell any inventory.


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THE CASHFLOW STATEMENTIn financial accounting, a cashflow statement shows how changes in balance sheet accounts and income affect cash and cash equivalents, and breaks the analysis down to operating, investing, and financing activities.

Essentially, the cashflow statement is concerned with the flow of cash in and out of the business. The statement captures both the current operating results and the accompanying changes in the balance sheet. As an analytical tool, it’s useful to see the short-term viability of a company, particularly its ability to pay bills.

The cashflow statement is split into three segments, showing cashflow from:

The money coming into the business is called cash inflow and money going out is cash outflow.

OPERATING ACTIVITIES

These include producing, selling and delivering the company’s product, as well as collecting payment from its customers.

Operating cash flows include:

• receipts from the sale of goods or services • receipts for the sale of loans, debt or equity

instruments in a trading portfolio • interest received on loans• payments to suppliers for goods and services• payments to, or on behalf of, employees • interest payments • buying merchandise

To arrive at cashflows from operations, the following items are often added back to (or subtracted from, as appropriate) the net income figure:

• depreciation (loss of a tangible asset value over time) • deferred tax • amortisation (loss of an intangible asset value

over time) • any gains or losses associated with the sale of a

non-current asset, because associated cashflows don’t belong in the operating section

• dividends received • revenue received from certain investing activities

INVESTING ACTIVITIESInvesting activities can include:• buying or selling assets, such as land, building,

equipment or marketable securities• loans made to suppliers or received from customers • payments relating to mergers and acquisitions

FINANCING ACTIVITIESThese include cash that comes in from investors, as well as the outflow of dividends to shareholders as the company generates income. Other activities which impact the long-term liabilities and equity of the company are also listed in the financing activities section of the cash flow statement.

They include:• dividends paid • sale or repurchase of company stock • net borrowings • payment of dividend tax

1 OPERATING ACTIVITIES 2 INVESTING ACTIVITIES 3 FINANCING ACTIVITIES


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ASSESSING FINANCIAL PERFORMANCEBy comparing the figures on a P&L account and a balance sheet to one other, through calculations known as key financial ratios, you can work out how well a business is performing.

There are four main areas for assessing most businesses:1. Profitability – is the business generating enough profit?2. Efficiency – how efficiently is the business using its fixed assets and working capital?3. Liquidity – is cash flow likely to be a problem in the short-term?4. Stability – has the business got the right capital/finance structure to prosper in the long-term?

Each of these is measured using ratio analysis, as follows.

Profitability ratiosThese tell us whether a business is making profits and, if so, whether at an acceptable rate.

The key ratios are:

The capital employed figure is usually made up of share capital + retained earnings + long-term borrowings (the same as equity + non-current liabilities from the balance sheet).

It’s a good measure of the total resources that a busi-ness has available, although it’s not perfect. For exam-ple, a business might lease or hire lots of its production capacity (machinery, buildings etc.) which would not be included as assets in the balance sheet.

With ROCE, the higher the percentage figure, the better.

The figure needs to be compared with the ROCE from previous years to see if there it’s rising or falling. It’s also important to make sure the operating profit figure used for the top half of the calculation doesn’t include any exceptional items which might distort the ROCE percentage and comparisons over time.

To improve its ROCE a business can try to do two things:

• improve the top line (i.e. increase operating profit) without a corresponding increase in capital used

• maintain operating profit but reduce the value of capital employed.

Ratio Calculation (%) Comments

Gross profit margin

(Gross profit /revenue) x 100

This ratio shows the business’ ability consistently to control its production costs or to manage the margins it makes on products it buys and sells. While sales value and volumes may move up and down significantly, the gross profit margin is usually quite stable (in percentage terms). However, a small increase (or decrease) in profit margin can produce a substantial change in overall profits.

Operating profit margin

(Operating profit /revenue) x 100

Assuming a constant gross profit margin, the operating profit margin shows a company’s ability to control its other operating costs or overheads.

Return on capital employed (ROCE)

Net profit before tax, interest and dividends (EBIT) / Capital Employed x 100

A measure of how efficiently a company uses its resources to generate profits. Sometimes referred to as the primary ratio, ROCE shows what returns management has made on the resources available to them before distributing any of those returns.

EXAMPLE OPERATING PROFIT£280,000

CAPITAL EMPLOYED£1,400,000 ROCE = £280,000 / £1,400,000 = 20%


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EFFICIENCY RATIOSThese show how efficiently a business is using its resources invested in fixed assets and working capital.

LIQUIDITY RATIOSShowing how capable a business is of meeting its short-term obligations, liquidity ratios are calculated as follows:

STABILITY RATIOSThese focus on the long-term health of a business, particularly the effect of the capital/finance structure:

Companies which are highly geared are vulnerable to increases in interest charges, but in a low interest rate environment, external borrowings can actually be a relatively low cost way of funding business activities.


Stock turnover

Cost of sales / average stock value

Stock turnover helps see if a business has too much money tied up in inventory. An increasing stock turnover figure, or one which is much larger than the average for an industry, may indicate poor stock management. The answer is the number of times per year stock turns over.

Credit given / debtor days

(Average trade debtors / sales) x 365

The debtor days ratio shows whether debtors are being allowed excessive credit. An above-average figure may suggest general problems with debt collection or the financial position of major customers.

Credit taken / creditor days

(Trade creditors + accruals) / (cost of sales + other purchases) x 365

A similar calculation to that of debtors, it shows whether a business is taking full advantage of its available trade credit.


Current ratio

Current assets / current liabilities

A simple measure that estimates whether the business can pay debts due within one year from assets it expects to turn into cash during that year. A ratio of less than one is often a cause for concern, particularly if it persists for any length of time.

Quick ratio (or acid test)

Current assets – stock/current liabilities

Not all assets can be turned into cash quickly or easily. Some, like raw materials, must first be turned into final product, then sold and the cash collected from debtors. The Quick Ratio therefore adjusts the Current Ratio to eliminate all assets that are not already in, or near, cash form. Again, a ratio of less than one would be a warning sign.


Gearing

Borrowing (all long-term debts + normal overdraft) / net assets (or shareholders’ funds)

Gearing (also known as leverage) measures the proportion of assets invested in a business that are financed by borrowing. In theory, the higher the level of borrowing (gearing) the higher the risk to a business, since the payment of interest and repay-ment of debts aren’t optional in the same way as dividends. However, gearing can be a financially sound part of a business’ capital structure, particularly if the business has strong, predictable cashflows.

Interest cover

Operating profit before interest / interest

This measures the ability of the business to service its debt. Are profits sufficient to pay interest and other finance costs?


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HOW READING ACCOUNTS CAN HELP INCREASE SALESAs the amount of time that sales people spend with their customers becomes more limited, it’s more important than ever to use time with prospective customers as effectively as possible. So being prepared is an essential requirement.

PREPARING A SALES APPROACHWhile a web page might describe the emotional drivers of a particular business, and a social networking site can add further information, a set of financial statements will help complete the picture. All of this information is often in the public domain and can be cross-referenced and used at every stage in the sales process.

The more we know about our customers, the more professional our approach will be.

10 QUESTIONS TO ASK BASED ON KEY SALES INFORMATION FROM FINANCIAL STATEMENTS

01. 02. 03. 04. 05.Who owns the business?

How many directors are there and what is their shareholding in the business?

Is the known contact a part-owner of the business, or could other avenues be available if one route is closed?

Are the directors or owners of an existing customer associated with any other businesses – is there an opportunity for referral?

How long has a prospective customer been trading and when does their financial year end?


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06. 08. 09. 10.07.At what rate is turnover and profit growing or shrinking? This information will help pitch a proposal – save money or invest in growth.

Is a prospective customer ‘cash rich’, and could they get a better return by investing in your product or service?

Does a prospective customer borrow money as a normal method of investing in assets? If so, are they likely to consider leasing?

How stable is the business? It could be a waste of time and effort dealing with a business that is struggling to survive.

Are employee numbers growing or shrinking?


05 INTRODUCTION TO LEASING FOR BUSINESS

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MODULE 5 Intrduction to leasing for business

WHAT IS LEASING? It’s important to understand the difference between leasing and a loan:• A loan is an agreement which allows a lender to borrow money to buy an asset. • A lease is an agreement which allows an individual or business to use an asset

which belongs to another party.

Under a leasing agreement, the lessee (user of the asset) agrees to hire or rent an asset for a period of time in return for regular payments (rentals) to the lessor (owner of the asset).

The terms and conditions of any lease agreement will show the length of the hire period, the payments due and whether the user has the option of owning the asset outright at the end of the agreement. The duration of the lease may be fixed, minimum or periodic.

The lessee makes rental payments at an agreed frequency, normally monthly, quarterly or annually, and the rental payable might be fixed or subject to change, depending on fac-tors like the Bank of England interest rate (although this normally only applies to very large transactions).

A term of fixed duration ends auto-matically when the agreed period expires, and no notice needs to be given. Some agreements specify a minimum period of hire, after which either party can cancel it.

A periodic agreement is one which is renewed automatically, usually on a monthly or weekly basis.

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THE HISTORY OF LEASINGANCIENT BABYLONIA AND GREECEThe earliest leases can be traced back as far as 5,000 years ago. In Babylonia in around 1800 BC, an officer or soldier who didn’t want to cultivate the land they received in return for service to the monarchy could lease it to a leasing specialist, who made payments to the soldier in advance and then leased the land to farmers.

Ancient Greece was the first to develop mine leases, where the state leased mines of various sizes in Athens to mining companies for three to seven years. Ancient Greece also pioneered the concept of bank leasing, with the first one signed in 370 BC for assets including the name of the bank, its deposits, offices, and staff.

LEASING IN THE UNITED KINGDOMOne of the first laws to refer to leasing in the UK was the Statute of Wales written in 1284. This used existing land laws as a legal framework for leasing immovable property like farming equipment. The arrival of the railways in the mid-19th century saw small enterprises investing their capital in coal wagons and in turn leasing them to mining companies. Leasing agreements often gave the lessee the right to purchase the equipment at the end.

Large-scale finance leasing in the UK gained a substantial boost during the period of high first year capital allowances (a significant tax benefit to lessors), which began around 1970 and ended for most types of asset in 1984.

This investment incentive through the tax system, coupled on occasion with economic recession, meant capital- intensive businesses often found themselves tax exhausted and unable to benefit from the first year and other incentive allowances due on their investment in fixed assets. At the same time, financial businesses like banks didn’t enjoy these reliefs.

Finance leasing offered a means for the surplus first year allowances to be transferred away from businesses without current taxable profits to banks and others able to use them. In the process, the users of the equipment obtained a significant part of the benefit of the tax allowances they couldn’t use directly. This was achieved by leasing rates which reflected, often explicitly, the fact that the lessors could use the first year allowances.

Companies trading as finance lessors surrendered their tax losses under the group relief rules to fellow group members with trading profits, typically banking profits, which would otherwise have been exposed to tax.

EFFECTIVE FINANCINGThe key objective of all businesses is the generation and effective use of finance. Any sales proposition has to be made within this context and the use of a finance solution (e.g. leasing) provides the best possible way of illustrating the financial benefits that the acquisition of new products and services can offer.

As all businesses need one or more sources of finance to become established and remain viable, external funding in the form of debt is a very important element in their requirements. Leasing is one such form of this debt.

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HOW DOES LEASING COMPARE TO OTHER FORMS OF DEBT?Businesses need to compare leasing to other forms of lending when deciding the best way to finance their operational requirements.

The alternatives are:

Unlike most forms of business loan, a leasing or hire purchase agreement normally relates only to the asset being financed. In most cases, the lessor has no charge over any other assets held by the lessee, which isn’t usually the case with other forms of loan. This gives lessees a greater degree of certainty than from other types of lending, because as long as rental payments are being made the agreement won’t be cancelled by the lender. Perhaps equally importantly, repayments are normally fixed and not subject to changes in interest rates or circumstances of either the lender or the customer.

At a time when it can be difficult for some organisations to obtain loans, a leasing agreement is relatively easy to obtain and can be seen as an additional source of finance that leaves existing credit lines unaffected.

The advantages of leasing

Businesses have to consider several things when deciding whether to use cash resources to buy an asset or to lease it instead.

Some of the advantages of leasing include:

• Leasing lets businesses preserve precious cash reserves instead of buying a costly new piece of machinery or equipment.

• Smaller, regular payments enable businesses with limited capital to manage their cashflow more effectively and adapt quickly to changing economic conditions.

• Businesses can upgrade assets more frequently, so they have the latest equipment without having to make further capital outlays.

• The flexibility of the repayment period matches the useful life of the equipment.

• Leasing agreements can be structured to include additional benefits such as servicing of equipment or variable payments.

• Rental payments for leased assets are normally deemed an operational expense, so can be tax deductible, which cuts the real cost of any leasing agreement.

Types of asset-based finance agreements

The accountancy profession treats the different kinds of leasing available in different ways.

To make company accounts understandable and comparable across international boundaries, accountants work to International Accountancy Standards (IAS) and more recently International Financial Reporting Standards (IFRS). They are progressively replacing the many different national accounting standards.

The rules governing the accountancy treatment of leasing are currently covered by an International Accountancy Standard known as IAS 17, although it’s likely it will be replaced by a new International Financial Reporting Standard in the next few years, leading to changes in the way leases are classified. This is partly to allow operating leases to be more readily identified within company accounts.

LENGTH OF BORROWING

SHORT TERMLENGTH OF BORROWING

MEDIUM TERMLENGTH OF BORROWING

LONG TERMBANK OVERDRAFT

BANK LOAN, LEASE, HIRE PURCHASE, GOVERNMENT

GRANTS, PEER-TO-PEER LENDINGBANK LOAN, MORTGAGE,

CORPORATE BONDS


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What does IAS 17 do?

The objective of IAS 17 (1997) is to prescribe, for lessees and lessors, the right accounting policies in relation to finance and operating leases. It applies to all leases, except for minerals, oil, natural gas, and similar regenerative resources and licensing agreements for films, videos, plays, manuscripts, patents, copyrights, and similar items.

Lease classifications

Classification is made at the start of the lease and there are two types:

• Finance leases transfer substantially all the risks and rewards incident to ownership

• Operating leases covers all other types of lease.

Whether a lease is a finance lease or an operating lease depends on the substance of the transaction rather than the form.

FINANCE LEASES

A lease would usually be classified as a finance lease for one of the following reasons:

• The lease transfers ownership of the asset to the lessee at the end of the lease term.

• The lessee has the option to purchase the asset at a price which is expected to be sufficiently lower than fair market value at the date the option becomes exercisable and, at the start of the lease, it’s reasonably certain the option will be taken.

• The lease term is for the major part of the economic life of the asset, even if title is not transferred at the start of the lease.

• The present value of the minimum lease payments amounts to most of the value of the leased asset.

• The leased assets are specialised so that only the lessee can use them without major modifications being made.

• If the lessee is entitled to cancel the lease, the lessor’s losses associated with the cancellation are borne by the lessee.

ACCOUNTING BY LESSEES

In the financial statements of lessees:

• At the start of the lease, finance leases should be recorded as an asset and a liability at the lower of the fair value of the asset and the present value of the minimum lease payments (discounted at the interest rate implicit in the lease, if practicable, or else at the entity’s incremental borrowing rate).

• Finance lease payments should be shared between the finance charge and the reduction of the outstanding amount.

• The depreciation policy for assets held under finance leases should be consistent with that for owned assets. If there’s no reasonable certainty that the lessee will obtain ownership at the end of the lease, the asset should be depreciated over the shorter of the lease term or the life of the asset.

• For operating leases, the lease payments should be recognised as an expense in the income statement over the lease term on a straight-line basis.


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TYPES OF LEASEIn summary, the various leasing agreements offered are as follows:

The most significant element of the above is the difference between the two types of agreement:

• Under a credit agreement, the lessee enters into the agreement in the knowledge that an option exists to acquire title to the asset upon termination.

• Under a hire agreement, no such option exists.

Hire agreements can be classified as either an operating lease or a finance lease.

TYPES OF ASSET FINANCE (Accountants Definition)

IAS 17 – Accounting for Leases

FINANCE LEASE

Credit Agreement

Hire Purchase Lease Purchase Purchase Plan

Hire Agreement

Rental Plan Lease

Contract Hire

ON BALANCE SHEET OPERATING LEASE

Hire Agreement

Rental Plan Lease

Contract Hire

OFF BALANCE SHEET

(WITH OR WITHOUT MAINTENANCE)


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Hire purchase

IAS 17 Finance Lease – Finance Lease/Contract Hire/Rental Agreement

IAS 17 Operating Lease - Finance Lease/Contract Hire/Rental Agreement

FACTS BENEFITS

• Leasing company recovers full cost of asset and charges• Agreements can range from 12 to 84 months• Deposits can be variable• Payments normally made monthly, quarterly or annually• Customer has the option to acquire title to the asset upon

termination of the agreement• Asset (and sum due on finance agreement) is shown on the

customer’s balance sheet• VAT on machine cost paid (and reclaimed) at the outset of

any agreement

• Payments fixed for the duration of the agreement, ensur-ing accurate budgeting and protection from inflation and interest rate rises

• Terms and payment profiles can be tailored to meet budgetary requirements

• Tax write down allowances can be claimed, including any Annual Investment Allowance

• Interest charges are tax allowable• Spreads the cost of ownership, which conserves capital

FACTS BENEFITS

• Leasing company recovers full cost of the asset and charges• Agreements can range from 12 to 84 months• Deposits can be variable• Payments normally made monthly or quarterly• A balloon payment might be payable by the customer at the

end of an agreement which will reduce the preceding rental payments

• Asset (and sum due on finance agreement) is shown on the customer’s balance sheet

• VAT is not paid on the machine cost at the outset but collected on each rental payment

• Payments fixed for the duration of the agreement, ensuring accurate budgeting and protection from inflation and interest rate rises

• Low capital outlay • Terms and payment profiles can be tailored to meet

budgetary requirements• Rental payments can be charged as a business expense,

reducing pre-tax profit and the amount of income or corporation tax paid by the user

• Spreads the cost of acquisition, which conserves capital

FACTS BENEFITS

• Present value of all rentals due is less than the market value of the asset at start of the lease

• Lessor calculates rental payments on the basis of recovering a residual value for the asset at the end of the agreement. The lessee is not liable for any residual payment

• Lease duration is normally less than the economic life of the asset

• No option to acquire title to the asset• Asset and lease obligations are not shown on the

customer’s balance sheet• VAT is collected (and reclaimed) on each instalment as it

falls due

• Payments fixed for the duration of the agreement, ensuring accurate budgeting, protection from inflation and interest rate rises, and the ability to conserve capital by spreading the cost of acquisition

• Rental payments can be charged as a business expense which reduces pre-tax profit and therefore reduces the amount of income or corporation tax paid by the user

• Removes residual value risks from the customer• Rental payments don’t need to cover the full purchase

price of the asset so are lower than other forms of leasing agreement during the period of hire

• Off-balance-sheet funding


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LEASING AND TAXATIONAs long as businesses make a profit they will pay either income tax if they are unincorporated, or corporation tax if they trade as limited companies. The amount of tax is based on their marginal tax rate and calculated as a percentage of pre-tax profits.

Acquiring capital equipment can reduce the amount of tax paid, as the cost of it can be deducted from taxable profits. There are three ways to acquire capital equipment:

APRIL 2015 APRIL 2016 APRIL 201720% 20% 19%

APRIL 2018 APRIL 2019 APRIL 202019% 19% 18%

UK CORPORATION TAX RATES

CREDIT AGREEMENT/OUTRIGHT PURCHASE HIRE AGREEMENTAsset cost is written off for tax purposes during the period of use.Rate of tax allowances variable:• Accelerated AIA• Deferred WDA Interest allowance for HP agreements

Rental payments can be classed as an operating expense, reducing taxable profit.

SUMMARY OF UK TAX TREATMENT OF ASSET ACQUISITION


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CREDIT AGREEMENTS (HIRE PURCHASE)Businesses often use debt finance to buy capital equipment, which can include credit agreements that transfer ownership to the hirer upon expiry. Such agreements are often referred to as lease purchase or hire purchase.

Businesses can claim tax allowances (writing-down allowance and/or AIA) for credit agreements in the same way as if they had bought the equipment outright. Plus, any interest charges on the finance agreement or bank loan can also be charged as an expense to reduce tax liability further.

CASH PURCHASEWhere equipment is bought rather than rented, HMRC recognises that the business making the investment has to bear the cost of the assets, and that these reduce in value through depreciation. As such, a charge for depreciation can be included as a deduction when computing taxable profits and the amount of tax paid.

The tax allowance available to businesses that purchase assets is known as writing-down allowance (WDA), and this currently stands at 18% of any unclaimed allowance a year. So for the year in which the asset was purchased, 18% of the purchase price can be deducted from taxable profits, and the tax bill will be reduced accordingly.

In the second year, allowances are calculated on the basis of the original purchase price minus the allowance previously claimed – this becomes the new figure on which an allowance will be applied as a deduction in the second year.

This is repeated for as long as the business retains the asset. The percentage allowance is often subject to change within government budget statements, depending on the degree to which a chancellor wishes to stimulate business investment.

A relatively new development has been the introduction of the Annual Investment Allowance (AIA). This offers accelerated tax benefits up

to a specified level of annual investment. Once the allowance has been used, the business qualifies for a writing-down allowance as described above for any further expenditure.

For each of the years 2014 and 2015, the AIA was set at £500,000. This entitles a business to acquire up to £500,000 of qualifying assets and charge the full cost of the investment as an operating expense in the year the equipment was purchased. The allowance has been frequently changed since it’s introduction in terms of size and qualifying assets, but it can still significantly reduce the amount of tax paid in the short term.

HIRE AGREEMENTS (RENTAL)Hire agreements, which include contract hire, leasing and rental agreements, involve a business simply hiring equipment for a period of time. Once the agreement comes to an end, the equipment is returned. In such cases HMRC allows the hirer to class all rental payments as a business expense, which reduces pre-tax profits and the amount of tax paid.

Such allowances are available on an annual basis for the length of the leasing agreement. Specific rules apply to classify a lease as an operating lease, also known as ‘off-balance-sheet’ funding.


06 HOW LEASING WORKS

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MODULE 6 How leasing works

LEASING IS A COMMON WAY FOR ALL TYPES OF BUSINESSES TO ACQUIRE EQUIPMENT

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The benefits of sales finance

Also known as sales-aid leasing, this is where equipment suppliers and finance companies make finance an easy, attractive and, in many cases, integral part of the supplier’s sales process.

BENEFIT REASON

INCREASED SALESA weekly or monthly cost can make equipment far more attractive to a prospective customer as the benefits of the product are positioned against a lower perceived cost than is the case with cash.

INCREASED ORDER SIZECustomers are much more likely to acquire a higher spec when the price of an asset is shown monthly, because it’s easier to justify a small increase to a proposed monthly rental rather than a significantly larger cash invoice.

IMPROVED CASHFLOWSupplier invoices are normally paid by finance companies within 24 hours of receipt. With average UK debtor payment times in excess of 45 days, sales finance provides a big boost to cashflow.

BESPOKE SUPPORTFinance companies often provide leasing agreements to a supplier that include the ability to collect monies for maintenance, giving the customer a bespoke, one-stop shop for acquiring their equipment.

EASY EQUIPMENT UPGRADE

Finance companies often make it very easy for businesses to upgrade their leasing agreements upon, or before, expiry of existing agreements, which helps drive future sales.

EQUIPMENT ACQUISITION FUNDED FROM REVENUE

By using sales finance, it’s often possible for suppliers to sell to businesses who have no capital budgets for the equipment. In such cases, the lease might be met through a revenue budget instead, because payment is made through relatively small rental payments rather than a much larger lump sum.

ONGOING SUPPLIER SUPPORT

Once a trading agreement is in place, the supplier can rely on the finance company holding mutual customer data confidentially and helping them to repeat sales with these customers (e.g. discounted settlement figures for upgrade business).

ROUTES TO MARKETThe finance industry has three main routes to market:

Direct finance: Agreements are negotiated directly between the finance company and customer.

Broker finance: Agreements are introduced to finance companies by specialist intermediary companies commonly referred to as brokers.

Sales finance: Agreements are introduced to the finance companies by retailers, dealers, manufacturers or suppliers.

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2

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Leasing products are continually being tailored to meet the requirements for the equipment they finance. Examples from the business technology market include:• agreements that combine equipment rental and

maintenance and show the combined price as a ‘cost per unit of use’ rather than a monthly or quarterly sum. This is designed to show in a transparent way the true cost of ‘ownership’ of a particular product.

• agreements with an end point based on use rather than time.

• soft cost finance that includes initial consultancy costs within future rental payments, avoiding the need for up-front payment by the customer.

• payment profiles and initiatives to help sell particular products in selected markets, such as deferred payments, low-start rentals, seasonal payment frequencies, balloon rentals and interest-free finance through manufacturer subsidy.

SALES FINANCE – CREATIVE ADDITIONS TO PRODUCT POSITIONING

A supplier’s finance company gives them a leasing rate schedule and documentation.The transaction works like this:

HOW SALES FINANCE WORKS

FINANCE COMPANY PROVIDES SUPPLIER WITH PRICING (LEASE, RATES, FLAT RATES, CALCULATOR)

DEAL PROPOSED TO FINANCE COMPANY

EQUIPMENT DELIVERED AND INSTALLED BY SUPPLIER

FINANCE COMPANY PAYS SUPPLIER IMMEDIATELY

RENTAL PRICE CALCULATED BY SUPPLIER

LEASING AGREEMENT COMPLETED BY SUPPLIER AND SIGNED BY CUSTOMER

INVOICE RAISED TO FINANCE COMPANY

FINANCE COMPANY COLLECT RENTALS FROM CUSTOMER

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Understanding lease rates

A lease rate is the price per £1,000 payable to rent equipment for an agreed period of time. It’s basically a finance company’s price list, shown in monthly, quarterly or annual terms depending on the frequency of payment.

Finance companies base their lease rates on the:

• cost of funds to them

• risk of bad debt

• size of deal

• fixed costs of processing agreements and providing sales support.

Where sales finance is used and deal values are below £20,000, simplicity is a major objective and as such rate schedules are prepared and issued to suppliers. As most finance companies deal with a large number of suppliers they try to avoid changing lease rates as much as possible, so prices don’t normally differ when there are short-term changes in the cost of funds.

Large deals are often subject to a bespoke quotation, with the finance company reserving the right to change its price should there be a change in cost of funds before the deal is done.

Most rate schedules take payments quarterly or monthly. A 1+11 schedule over 36-months means there’s an initial payment of one quarterly rental followed by 11 further quarterly rentals. It’s not uncommon to see a 2+11 profile where the initial payment is two quarterly rentals followed by 11 more. Once a supplier has a lease rate schedule they can work out the costs of renting the equipment they sell.

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Understanding flat interest rates

Suppliers might be given a flat interest rate instead of a rate sheet, which the leasing company will use across different deal values. This is quite common for credit agreements.

For example, a flat rate of 3.5% might apply to a particular deal, which is the annual finance charge payable as a percentage of deal value.

To work out the amount of rent payable, a supplier uses a four-stage calculation:

1. Interest per year Deal value x flat rate

2. Total interest paid Interest per year x length of agreement in years

3. Total amount repaid Total interest + deal value

4. Rental Total amount repaid/number of repayments

There are three calculations which are commonly used in the industry: If it’s just a question of providing a customer with a quote based on a particular piece of equipment, then only calculation 1 will apply. Usually it’s necessary to be flexible with equipment pricing, though, to make sure that rental quotations meet customer expectations, especially for upgrades. So it’s important to understand all three calculations.

1. RENTAL PAYMENTDeal value

(equipment cost) x lease rate/1,000

2. DEAL VALUE

Rental/rate x 1,000

3. LEASE RATE

1,000/deal value x rental


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FACTORS WHICH AFFECT LEASE RATES

LENGTH OF TERMThe longer the term, the lower the rate, but the term will be restricted to the anticipated useful economic life of the asset. You’ll also pay more overall with a longer term.

PAYMENT FREQUENCYThe more often you make payments the lower the rate, but again the total payment amount will be higher.

ADVANCED PAYMENTS OR DEFERRALBy making advanced payments you’ll reduce the rate because it reduces the amount of money on which interest is charged. Deferring payment of first rental or collecting all rental payments in arrears has the opposite effect of extending the period over which money is repaid, increasing the rate charged.

RESIDUAL-BASED LEASINGWhere little or no value is placed on the value of an asset upon expiry of the agreement, residual values aren’t normally applied, so have no relevance to the rate charged.

In certain cases however, where the asset involved has a significant value at the end of an agreement and/or the customer wishes to account for an agreement as an operating lease, the finance company bases its lease rate on the assumption that it will recover a certain percentage of its original outlay at the end of the lease. In this case, a lower lease rate will apply.

UPGRADES

UNDERSTANDING UPGRADESIn finance industry terms, an upgrade sale is where equipment under a leasing agreement is replaced with new leased equipment, and the new leasing agreement includes not only the cost of the new equipment being supplied but also the settlement cost of the new agreement.

DO UPGRADES MAKE SENSE?In markets where technology changes quickly, the actual cost of equipment tends to reduce over time and its capability increases significantly. For example, the latest laptops are much cheaper than their predecessors but their functionality is many times greater.

IF BUSINESS EQUIPMENT IS BOUGHT WITH CASH IT CAN BE TEMPTING TO RESIST UPGRADES BECAUSE IT WILL ‘WRITE OFF’ THE ENTIRE COST OF AN INVESTMENT MADE A REASONABLY SHORT TIME AGO. BUT WITH LEASED EQUIPMENT, THINGS ARE DIFFERENT.


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07 THE DECISION-MAKING PROCESS

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MODULE 7 The decision-making process

This will include:• equipment details• equipment cost• details of any lease settlement

included within the deal

• details of any maintenance included within the deal

• term• payment frequency• rental amount.

The amount of customer details required will depend on what type of business they run:

LIMITED COMPANIES/CHARITIES SOLE TRADERS/PARTNERSHIPS LOCAL GOVERNMENT ORGANISATIONS

• Full name or registration number

• Postcode

• Full name and address of business

• Business type

• Number of years trading

• Full names, addresses and dates of birth of all business principals (this can be waived when dealing with large professional firms)

• Full name and address of organisation

• Confirmation of trading entity

Underwriting

Underwriting is the process a financial service provider uses to assess the creditworthiness or risk of a potential customer for a particular transaction.

Lending always has an element of risk, so banks or leasing companies try to select the right borrowers through comprehensive investigation of the available facts.

SUBMITTING PROPOSALSOnce a leasing deal has been agreed between the supplier and the customer, the supplier submits a ‘proposal for finance’ to the finance company, either by phone, email or online. Simplicity is the key to sales finance, and finance companies usually only need a minimum amount of information to make a credit decision.

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THE PRINCIPLES OF LENDINGIt’s a fundamental principle of lending everywhere that advances are made to customers on the basis of a promise to repay, rather than relying on any security held. So funders need to develop safe and sound lending policies to keep the risk to a minimum. As such, funders follow certain principles of sound lending, as shown in this table:

To carry out these checks, the finance company will call and analyse a series of credit reports (using some of the ratios described earlier). Information about limited companies is normally in the public domain and can be accessed (in the first instance) without contacting the business owner. Partnerships and sole traders don’t have to file financial information and, because their businesses aren’t separate legal entities from themselves, it’s necessary to call credit reports on the individuals themselves. Should financial information be required, the only source will be the individuals who own the business.

LENDING PRINCIPLE EXPLANATION NOTES AND SOURCES OF INFORMATION

Safety Advances are made with the expectation they’ll come back in the normal course. The repayment of an advance depends upon the borrower’s capacity and willingness to pay.

The capacity depends upon the tangible assets of the borrower.

The willingness to pay depends upon the honesty and character of the borrower and the ‘value for money’ involved in the transaction.

A balance sheet will show the net worth of a borrower relative to the size of transaction requested. Length of time trading and credit history (including CCJs) will also enable a funder to assess the capacity for all repayments to be made.

The willingness of a customer to make full repayments might be determined by the ‘value for money’ represented in the transaction. So it’s important to confirm that any equipment or service involved is relevant to the needs of the borrower and supplied at a fair price.

Liquidity Liquidity is the availability of funds to the borrower at short notice. The borrower must be in a position to make repayments as and when required under the terms of any finance agreement.

A ‘profit and loss’ account and cashflow statement will give the best guidance to whether sufficient funds are being generated often enough to make repayments.

Liquidity can also be assessed by referring to items within a balance sheet (current assets – current liabilities).

Profitability A funder must make sure the terms of any transaction will generate the required level of profitability.

All set-up costs and interest payments made by a funder must be recovered by repayments from the borrower.

Security Security serves as a safety valve for an unexpected emergency. The security offered for an advance is a cushion to fall back upon in case of need. An element of risk is always present in every advance, however secure it might appear to be.

Banks tend to take a charge over assets owned by a borrower as the most important form of security.

In other cases where there is a high residual value in an asset being financed, sufficient security might lie in the asset itself, particularly if the transaction involved payment of a large deposit.

Director guarantees are sometimes requested when advances are made to limited companies not considered sufficiently strong enough for a particular transaction.

Spread/diversity Most funders take a portfolio approach so their risks are spread as widely as possible.

Funders need to continually audit the nature and location of their customers so they’re not over-dependent on a particular market.

Regulatory compliance

All transactions must comply with the demands of the relevant regulatory authorities.

Know Your Customer (KYC) procedures must be followed before a transaction is agreed, to minimise money laundering risk. If a transaction involves an introducer, that source must be fully authorised to offer credit facilities.

Transactions which have a direct or indirect association with certain specified countries aren’t allowed under international regulations.

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Personal searches

For sole traders and partnerships, personal searches on the business owners are usually needed.

There are three leading credit reference agencies in the UK providing credit decisions; Experian, Equifax and Callcredit. The UK’s Fraud Prevention Service (CIFAS.org.uk) is another potential source of information.

Credit reference agencies build a picture of every individual’s credit history every time anyone makes (or misses) a monthly payment on a loan, mortgage, credit card or a mobile phone bill. That forms a credit record, along with lots of other data like home address, date of birth, and court judgements against them for debt.

Under rules covered within data protection, individuals must consent to any information about them being supplied to third parties, in one of two ways:

• signing credit agreement paperwork at the beginning of an agreement, which states that credit reference agencies will be used as a point of reference and that payment history will be submitted to credit reference agencies

• providing leasing companies with a full name, date of birth and current address, which might be used as confirmation that ‘permission to search’ has been agreed.

DOCUMENT CHECKLIST

Completing documents

A leasing agreement is a legally-binding contract and has to follow certain legal principles. These differ depending on whether or not the customer is regulated by the Consumer Credit Act (CCA).

The Consumer Credit Act

Designed to afford a degree of protection to individuals from finance companies, the CCA defines individuals not only as a single person but also as two or three people trading as a partnership. Under current rules, individuals cease to be covered by the CCA where credit exceeds £25,000 on a hire purchase agreement or total repayments exceed £25,000 on a rental or hire agreement.

The trading entity must be identical to the proposal acceptance.

Payment (by invoice or Direct Debit) must be from the entity that appears on the document.

Most finance companies insist on rental payments being paid by Direct Debit. If a customer wants to pay by invoice, it’s important that the credit clearance confirms this is acceptable – a higher lease rate normally applies.


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Sales finance documents are designed to be simple to complete for equipment supplier employees who aren’t finance experts. The following should act as a check list for a legal document:

Suppliers need to be aware of the CCA and its main implications for their business:

• It’s illegal for a supplier to offer finance to regulated customers unless they have a valid CCA licence, supplied by the Financial Conduct Authority (FCA).

• Many finance companies don’t accept credit agreements (hire purchase) for organisations covered by the CCA, since it gives such customers certain rights of cancellation.

• No finance agreement with an organisation covered by the CCA can be subject to variation, which means that certain types of agreement aren’t available to regulated customers.

• For regulated agreements, the customer must be given a pre-contract proposal before they sign any documents, and a copy of any signed leasing agreement.

• Any alterations to a document (even if initialled by a customer) makes a regulated agreement unenforceable.

If a business sells goods or services on credit, offers goods for hire or provides debt counselling or debt adjusting services to consumers or businesses regulated by the CCA, they almost certainly need to be licensed by the FCA. Each service is covered by a specific category and it isn’t normally necessary for an equipment supplier to have all categories included within their licence.

Engaging in licensable credit activities without a credit licence is a criminal offence, and can result in a fine and/or imprisonment.

The document signatory must be authorised and more than one signatory is provided where needed (e.g. partnerships). For limited companies and public sector organisations, the seniority of signatory and number of signatories required will depend on the size of business and size and structure of the deal.

If the location of the equipment is different from a business’s head office, it should be stated on the document. It’s essential that any equipment subject to a lease agreement is located in a building the trading entity operates from.


08 LEASING – THE LAW AND COMPLIANCE

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MODULE 8 Leasing – the law and compliance

The law of contract:• Elements of a contract• Performance• Reps and warranties• Factors which make a contract

unenforceable• Sale of Goods Act (1979)

Other considerations:• The Data Protection Act (1998)• The Bribery Act• The Consumer Credit Act 1974 (2006)

THE LEGAL ASPECTS OF LEASINGLaws affecting leasing agreements

The law of contract

UK contract law is based on the principle of the Latin phrase ‘pacta sunt servanda’ which translates roughly as ‘agreements must be kept’. The purpose of contract law is to allow individuals and businesses to enter into legally binding agreements without the need to always take legal advice and draw up formal agreements.

Contract law applies to many activities, ranging from everyday transactions such as buying a bus ticket to much more complex business-to-business contracts, which generally need more bespoke arrangements.

Contracts are widely used in commercial law, and form the legal foundation for transactions around the world. Recent e-signature laws have made electronic contracts legally valid, allowing a greater reach and less administration than with paper copies.

The elements of a contract

A contract must contain certain legally-binding elements.

1. Offer: a willingness to work on a specific set of terms, that, once agreed, binds the two parties.

2. Acceptance: unconditional agreement to the terms of the contract, whether spoken or in writing.

3. Consideration: the price paid by one party for the other’s promise.

4. Intention to create legal relations: commercial arrangements, unlike social ones, are presumed to be binding.

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Performance

Performance changes, depending on the circumstances. If a contract is only partially completed, the ‘performing’ party carrying it out may only be partially compensated.

Uncertainty, incompleteness and severance

If a contract is incomplete or unclear, the contract won’t hold up in law. However, a court will try to give effect to commercial contracts where possible through a reasonable construction of the contract, including implying a suitable price where necessary.

Terms of contract

A contractual term is ‘any provision forming part of a contract’. Each term leads to a contractual obligation and breaching it could cause litigation. Not all terms are stated expressly and some carry less legal weight if they’re not central to the contract’s objectives.

Classifying terms

There are different classifications of contractual terms, depending on the context or jurisdiction. Under English law, there’s a distinction between important conditions and warranties; a condition is a generic term, while a warranty is a promise. So if one party breaches a condition the other can get out of the contract, while warranties allow for amendments and damages but not complete discharge from the contract.

Representations and warranties

Facts in a contract are either warranties or representations. Warranties are factual promises that are enforced through a contract, while representations are usually pre-contractual statements and can affect the buyer’s decision if they’re too open to interpretation. A court may need to decide whether or not a representation is part of a contract.

Implied terms

Even though they’re not expressly stated, implied terms can still form part of a contract. For example, if someone is selling a piece of equipment, it’s unlikely they’d state that they actually owned it – it would

simply be assumed that no one would attempt to sell something for which they didn’t hold title. Express terms are those stated during negotiation or written into the contract.

Representation• Any statement

made by one of two contracting parties

Warranty Non-Key Terms• An important representation,

breach of which may result in damages but not rescission of contract

Condition Key Term• A representation which is a

key term, breach of which will result in rescission of contract and damages

CLASSIFICATION OF TERMSRepresentation, Warranties & Conditions


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Setting aside a contract

Setting aside, or unmaking, a contract can happen in one of four ways:

1. Void: this implies the contract never existed in the first place.

2. Voidable: either party can quit the contract.

3. Unenforceable: neither party can go to court to sort out the contract.

4. Ineffective: a court cancels the contract because a public body hasn’t followed public procurement law.

A contract might be set aside for a few reasons

• Misrepresentation: when one party makes a false statement that leads the other party into the contract. A court will decide if this was done on purpose or not. As far as leasing is concerned, the more specialist and senior the document signatory (e.g. Finance or Purchasing Manager) the more difficult it will be for the customer to argue that they misunderstood the nature of the contract being offered. The opposite also applies, so a greater degree of care is needed when leasing companies and equip-ment suppliers are dealing with small businesses, charities and non-commercial organisations.

• Mistake: this could be a common mistake, where both parties believe something false to be true; a mutual mistake, where both parties think they’re contracting to something different; or a unilateral mistake, where only one party is mistaken.

• Duress: where one party has been threatened or forced into signing the contract.

• Capacity: the contract is either void or voidable if one party is incapable of carrying out their part of the contract or an individual signed a contract beyond his or her delegated authority (ultra vires).

• Illegality: the contract is based on something illegal.

What happens when a contract is breached?

If one party doesn’t act as they’ve said they will in the contract, they’re in breach of it. Normally this leads to financial damages paid by them to the other.

This could be compensation, which attempts to pay an accurate amount for the losses caused by the contract breach, or penalty clauses, which estimate it instead.

Compensation could be in the form of ‘expectation’ damages, where the party that’s suffered as a result of the contract breach receives what they were likely to get if the contract had been fulfilled. Or they could be reliance damages, where it’s not possible to estimate the expectation damages.

Damages can be general, where they naturally flow from the breach of contract, or consequential, where they happen further down the line as a result of the breach.


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LEASING AND CONTRACT LAWFor a contract to be enforceable, there has to be an offer by one party with an acceptance by another, in return for a consideration.

In leasing arrangements, the offer is made by a supplier to a customer to acquire a piece of equipment in return for an agreed monthly or quarterly rental payment. The offer is accepted when an authorised customer representative signs a leasing agreement. For the contract to be completed (the consideration), all equipment must be fully installed and the customer must make rental payments of the amount and frequency stated in the leasing agreement.

Any misrepresentation at, or before, the point of sale could make an agreement unenforceable, but as long as the supplier has fulfilled all the parts of the contract they’re responsible for, the contract can’t be broken by buyer’s remorse (e.g. a customer realising they could have got similar equipment at a cheaper price).

SUPPLIER MISREPRESENTATIONSupplier misrepresentation is the biggest avoidable breakdown in leasing contracts. The most common reason is that the equipment isn’t capable of performing the tasks promised, which can be difficult to prove. More clear-cut is where the equipment supplied doesn’t mirror that shown on the document, such as a different model, second-hand equipment described as new, or incomplete delivery of all relevant components, in which case the leasing agreement will normally be unenforceable.

THE DATA PROTECTION ACT 1998/2003The Data Protection Act applies to individuals and allows third parties to collect and store personal information, subject to certain conditions. Firstly the person whose data is stored must have consented to it, and it’s needed for one or more of the following:

• carrying out, or starting, a contract• under a legal obligation (other than the one

stated in the contract)• protecting the vital interests of the data subject• carrying out any public functions• pursuing the legitimate interests of the data

controller or third parties (unless it could unjustifiably prejudice the interests of the data subject).

THE BRIBERY ACT 2010The Bribery Act covers any function of a public nature, any activity connected with a business, or for a person’s enjoyment, or any activity performed by, or on behalf of, a group of people, whether corporate or not.

• Section 1 occurs when a person offers, gives or promises to give a ‘financial or other advantage’ to another individual in exchange for improperly performing a ‘relevant function or activity’.

• Section 2 covers the offence of being bribed, which is defined as requesting, accepting or agreeing to accept such an advantage, in exchange for improperly performing such a function or activity.

Penalties for bribery include up to 10 years’ imprisonment and an unlimited fine.


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THE FINANCIAL CONDUCT AUTHORITY (FCA)Since the banking crisis of 2007/2008 the finance industry has been subject to more regulation than ever, with changes in policies and procedures often taking place with immediate effect, giving little or no time to provide advance notice to business introducers.

The Financial Conduct Authority (FCA) was formed in 2012 to address concerns over poor practice in the finance industry and is responsible for ensuring compliance with the Consumer Credit Act (CCA).

The FCA aims to prove they’ve taken all possible action to ‘clean up’ the finance industry, and banks and associated businesses have had to act very quickly to their guidance. The FCA’s strategic objective is to ensure that the relevant markets function well.

Under its operational objectives the FCA aims to:• protect consumers• protect and enhance the integrity of the UK

financial system• promote effective competition.

In the leasing industry, the FCA has three main areas of responsibility – licensing and the authorisation of consumer credit business, treating customers fairly and anti-money laundering policies.

Licensing and authorising the consumer credit business

Consumer credit means offering credit, loans or debt services, as either a primary or secondary function, to any individual or unincorporated business.

Any firm which offers consumer credit must be authorised and regulated by the FCA.

Individual agreements for unincorporated businesses will be unregulated if payments due under a hire agreement are below £25,000 (including VAT and fees), or credit extended on a credit agreement is below £25,000.

Licensing and the authorisation of consumer credit business

Any firm holding a CCA license before the FCA took over managing the Consumer Credit Act (CCA) from the Office of Fair Trading (OFT) on 1 April 2014 had to obtain interim permission from the FCA before applying for full permission to continue offering consumer credit.


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How this affects equipment suppliers’ who introduce business to finance companies

The changes to the regulations have had an important impact on funders and equipment suppliers’, because the FCA’s definition of credit brokering is wider than the definition used under the OFT.

The FCA recognises that the credit activities of equipment suppliers’ aren’t core to their business and allows such firms to apply for limited permission – a lighter touch regime. Under the FCA Consumer Credit Sourcebook (CONC) 2.3.4R, a funder must take reasonable steps to satisfy itself that any credit broker or supplier with whom it deals is duly authorised by the FCA. All equipment suppliers’ must apply for full authorisation and appropriate permissions.

The regulations mean equipment suppliers’ have to hold certain licence categories to carry out activities:

LICENCE CATEGORY WHEN IT’S NEEDED

Credit brokerage (previously Category C licence) To submit a deal unless the end user customer is a Limited Company, Public Limited Company, Limited Liability Partnership (LLP) or other incorporated entity

Debt adjusting (previously Category D licence) If the deal includes the settlement of an existing deal

Debt counselling (previously Category E licence) If the dealer gives advice to the end user customer about the liquidation of an existing debt i.e. advice on paying off the debt under an existing deal.


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Treating Customers Fairly (TCF)

The FCA has laid out a series of measures for businesses offering consumer finance to make sure credit is offered to customers fairly. Not complying can result in one or more of the following FCA actions:

• private warning for a company or individual• publicly naming a company or individual• imposing a ‘voluntary’ requirement

• impose a fine and publically naming a company or individual

• in very serious cases, suspension or withdrawal of a company’s authorisation to do business.

To treat customers fairly, the FCA lays out a principled-based approach with these key requirements:

FCA PRINCIPLE THE FIRM’S OBLIGATIONS

Integrity Conduct business with integrity

Skill, care and diligence Conduct its business with due skill, care and diligence

Management and control Take reasonable care to organise and control its affairs responsibly and effectively, with adequate risk management systems

Financial prudence Maintain adequate financial resources

Market conduct Observe proper standards of market conduct

Customers’ interests Pay due regard to the interests of its customers and treat them fairly

Communications with clients Pay due regard to the information needs of its clients, and communicate information to them in a way which is clear, fair and not misleading

Conflicts of interest Manage conflicts of interest fairly, both between itself and its customers and between a customer and another client

Customers: relationships of trustTake reasonable care to ensure the suitability of its advice and discretionary decisions for any customer who is entitled to rely upon its judgement

Clients’ assets Arrange adequate protection for clients’ assets when it is responsible for them

Relations with regulatorsDeal with its regulators in an open and co-operative way, and must disclose to the appropriate regulator appropriately anything relating to the firm of which that regulator would reasonably expect notice.


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CULTURAL GOVERNANCETo make sure finance companies comply with these principles, the FCA has identified six outcomes to measure how well they’re adapting to the new regulatory environment. An overriding requirement is that the culture in such organisations puts customer care at the heart of all operational activities, as follows:

CULTURAL GOVERNANCE OutcomeCustomers can be confident that they’re dealing with firms where the fair treatment of customers is central to the corporate culture.

LEADERSHIP

A D D R E S S I N G T H E C U L T U R A L D R I V E R S W I L L D R I V E S U C C E S S I N O T H E R O U T C O M E S

MarketingProducts and

services marketed and sold are

designed to meet the needs of

identified customer types and targeted

accordingly.

InformationCustomers are

provided with clear information and

kept appropriately informed before, during and after

point of sale.

SuitabilityWhere consumers receive advice, it’s suitable and takes account of their circumstances.

ProductsCustomers are provided

with products and services that perform

as firms have led them to expect, and are of

an acceptable standard.

Post-SalesCustomers don’t

face unreasonable post-sale barriers imposed by firms

to change product or make a complaint.

STRATEGY CONTROLS REWARDDECISION MAKING

RECRUITMENT, TRAINING &

COMPETENCE


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ANTI-MONEY LAUNDERING POLICIES‘Know Your Customer’ (KYC) is the financial industry term for anti-money laundering. Money laundering is where criminals disguise the original ownership and control of the proceeds of criminal conduct by making it look like they came from a legitimate source.

The basic money laundering process has three steps:

1. ‘Placement’ of the dirty money into a legitimate financial institution, usually as a bank deposit. This is the riskiest stage for criminals, because banks are required to report high-value transactions.

2. ‘Layering’ the money by sending it through various financial transactions to change its form and make it difficult to follow. This could be bank-to-bank transfers, making deposits and withdrawals to vary the amount of money in the accounts, changing currency and buying high-value items like boats, houses or football clubs to change the form of the money. The idea is to make the original dirty money as hard to trace as possible.

3. At the ‘integration’ stage, the money re-enters the mainstream economy in legitimate-looking form by appearing to come from a legal transaction, such as investing in a business. It’s very difficult to catch a launderer during the integration stage if there’s no documentation during the previous stages.

Finance companies and banks have a very important part to play in combatting money laundering at all stages of the process through KYC policies.

There are four key elements to an effective KYC solution:

1. CUSTOMER ACCEPTANCE POLICYREQUIREMENTSMust be clear, with explicit criteria. The lender must perform due diligence with background checks to ensure the customer or entity is using their real name and not involved in illegal activities.

3. TRANSACTION MONITORINGREQUIREMENTSContinuous monitoring of a customer base and its normal behaviour to reduce risk. High-risk accounts, classified based on country of origin, fund sources, etc. or ac-tivities, such as complex or unusually large transactions and those with no visible lawful purposes, should undergo extra scrutiny. Banks and finance companies can set thresholds for transaction amounts that warrant enhanced due diligence.

2. CUSTOMER IDENTIFICATION PROCEDURESREQUIREMENTSMust be clearly outlined and performed at every stage of the financial relationship; establishing an account, carrying out a transaction, resolving doubts about the authenticity of previously obtained identification, etc. Identify and verify all customers’ identities and purposes (using reliable, independent data, information, and/or source documents) to the lender’s satisfaction.

4. RISK MANAGEMENTREQUIREMENTSAll banks and other financial institutions should establish internal audit and compliance functions, including establishing a company-wide training programme on policies and procedures. Responsibility for these functions should be explicitly outlined and allocated within the bank, taking into account segregation of duties, and manage-ment oversight is essential. Accounts should be subject to risk categorisation, and banks may create risk profiles with accompanying procedures for each category.


09 GLOSSARY OF LEASING TERMS

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MODULE 9 Glossary of leasing terms

TERM DEFINITION

Acceptance certificate A critical item of lease documentation which shows the lessee has accepted the equipment and the lease can start.

Acceptance ratio A term used in vendor leasing to signify the ratio of the number of potential leases received by the lessor from the vendor to the number of deals passing credit approval.

Advance payments One or more payments needed to be paid to the lessor at the start of the lease. Also used in the context of lease payments that are due at the beginning of each payment period e.g. monthly payments payable ‘monthly in advance’. The alternative to payments in advance is ‘payments in arrears’, i.e. at the end of each payment period.

Annual percentage rate (APR) The annual rate charged for borrowing (or made by investing), expressed as a single percentage that represents the actual yearly cost of funds over the term of a loan. This includes any fees or additional costs associated with the transaction.

Annual service fee A fee charged on the anniversary of the lease start date by the finance company for lease administration.

Balancing allowance Tax terminology for the adjustment made to the asset pool balance for a loss when disposing of a single de-pooled asset. In the case of a pool of many assets, a balancing allowance may only be given when the whole trade ceases.

Balancing charge Tax terminology for the adjustment made to the asset pool balance for a gain when disposing of a single de-pooled asset. In the case of a pool of many assets then a balancing charge occurs if the disposal gains during an accounting period are higher than the balance of unrelieved expenditure remaining in the pool.

Balloon rental A large rental payment payable by the lessee upon expiry of a leasing agreement.

Bargain purchase option A lease provision which allows the lessee to buy the equipment at the end of the lease term for a price sufficiently lower than its expected fair market value, so that taking the option is reasonably assured. This option invariably means the lease is classified as hire purchase.

Big ticket lease A lease transaction for a very large amount; £20m would be a typical minimum.

Co-terminous Used when equipment has been added to a lease and the additional rentals have been calculated so they end at the same time as the existing contract period.

Cost of Funds The interest rate at which the funder can borrow.

Cross-border lease A lease where the lessor is in one country, while the lessee is in another.

Deminimis Leasing UK Treasury definition of finance leasing transactions in the Local Authority leasing market which qualify as operating leases where maximum rental exposure to a single lessor is less than £10,000.

Depreciation basis The original cost of an asset plus other capitalised acquisition costs, such as installation charges and sales tax. Basis reflects the amount on which depreciation charges are computed.

Discount rate The interest rate applied to all the remaining rentals due after the termination date of a lease to work out a termination sum.

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Discounted lease A lease in which the payments are assigned to a funding source in exchange for up-front cash to the lessor.

Drawdown The moment when the lessor draws money from their account to pay the supplier for the equipment to be leased. The lessor will not normally pay for equipment unless the lessee has signed an Acceptance Certificate.

Document fee A fee collected at the start of a leasing agreement by a finance company, to cover set-up costs.

Early termination If the lessee wants to exit from a lease before the end of its primary (i.e. non-cancellable) term, the lessor may agree a termination sum based on the remaining unpaid rentals.

Economic life of an asset The estimated period for which the asset is expected to be economically usable, with normal repairs and maintenance.

End-of-term options Options in the lease agreement governing the treatment of leased assets at the end of the lease term. Common end-of-term options include sale of the equipment, renewing the lease, or returning the equipment to the lessor.

Equipment schedule A document referenced in the lease agreement that describes in detail the assets being leased.

Extension rental The rental for which the lessee may continue to use the equipment for a further specified period once the primary term of the lease has expired

Fair market value The value of an asset if it were to be sold in an arms-length transaction between a willing buyer and a willing seller.

Finance lease A lease that meets certain criteria established by the accounting rule-making body (SSAP21 and FRS5 in the UK). Such a lease has the characteristics of a purchase, and is required to be shown as an asset and a related obligation on the balance sheet of the lessee.

Finance and Leasing The Association’s members make up 80% of the UK leasing market. Association (FLA)

FFRS5 Reporting the substance of transactions, it covers substance over form issues when reporting (Financial Reporting Standard 5) transactions in financial accounts.

Full pay-out lease A lease where the lessor recovers, through the lease payments, all costs incurred in the lease plus an acceptable rate of return, without any reliance upon the leased equipment’s future residual value.

Full-service lease A lease that includes additional services such as maintenance and insurance, paid for by the lessor, the (Bundled lease) cost of which is built into the lease payments. Sometimes termed a ‘bundled’ lease.

Funding source Any entity providing the funds to acquire equipment for lease transactions.

GAAP (Generally accepted Applies formally to US accounting standards, but is increasingly used less formally to refer to a accounting principles) country’s accounting standards e.g. UK GAAP.

Group relief The tax mechanism in the UK by which unrelieved tax benefits can be surrendered to the company’s immediate or ultimate holding company.

Guaranteed residual value A guarantee from a party other than the lessor that the leased equipment will be worth a pre-deter-mined amount at the end of the lease.

Hire purchase This type of transaction, sometimes referred to as lease purchase or money-over-money lease, is a conditional sales contract in the guise of a lease, in which the lessee is, or will become, the owner of the leased equipment by the end of the lease term, so is entitled to the tax benefits of ownership.

Similar to a finance lease in structure except that the lessee has a bargain purchase option at the end of the primary term (typically £1), in which the lessee is treated as the owner of the asset for tax purposes (and is entitled to the tax benefits of ownership, such as capital allowances). The lessee does not become the legal owner of the asset until all terms and conditions of the agreement have been satisfied.

Initial direct costs Costs incurred by the lessor that are directly associated with negotiating and executing the lease. These costs can include, but are not limited to, commissions, legal fees and cost of preparing non-standard documentation.

Interim rental (Stub rental) A rent charged for using equipment which has been delivered and is ready to use, but the lease hasn’t yet started. In the case of a full pay-out lease the lessor has little justification for charging interim rental unless they have already paid for the equipment and are incurring interest charges.

Internal rate of return (IRR) The precise interest rate that discounts a given rental stream to exactly the cost of investment.

Lease administration The invoicing, rental collection, monitoring and reporting work connected with a lease, done by the lessor.

Lease agreement The contractual terms governing the lease.

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Lease broker/packager A party that provides one or more services in the lease transaction, but that doesn’t retain the lease transaction for its own portfolio. Such services include finding the lessee, working with the equipment manufacturer, securing debt financing for the lessor to use in purchasing the equipment and locating the ultimate lessor in the lease transaction. The lease broker also can be referred to as a packager.

Lease origination The process of finding potential lease transactions.

Lease payments (Lease rentals) The periodic amounts paid by the lessee to the lessor.

Lease rate The monthly, quarterly or annual cost of renting £1,000 worth of equipment for a certain term.

Lease rate factor A percentage figure that, when multiplied by the original equipment cost, gives the periodic lease payment.

Lease restructuring Taking an existing lease and changing it in some material way such as altering its equipment content, contract period, rental level or other major terms.

Lease term or period The fixed duration of the lease in its main or primary period of lease.

Lessee The user of the equipment being leased.

Lessor The owner of equipment, or a party who has rights to leasing to a lessee or user.

Manufacturer’s buyback A guarantee from the equipment manufacturer to the lessor to buy back the equipment at a pre-agreed price at a set point in future.

Market price of equipment The price for which equipment in its present condition could be sold in an arm’s length sale on the open market between a willing buyer and a willing seller.

Market rental The rental at which equipment in its present condition could be rented out in an arm’s length transaction on the open market from a willing lessor to a willing lessee.

Master lease agreement A lease agreement that contains all the main or boiler plate provisions governing leasing between two parties. It doesn’t refer to specific assets or financial terms, which are captured in separate lease contracts still subject to the terms in the master lease agreement.

Middle ticket lease A lease transaction typically in the range £100,000 to £20m.

Money-over-money lease A non-tax lease e.g. hire purchase, where the lease rentals can be calculated on a straightforward margin over cost of funds basis.

Non-recourse A type of borrowing in which the lessor-borrower is not at-risk for the borrowed funds. The lender expects repayment from the lessee and/or the value of the leased equipment, so the lender’s credit decision is based upon the creditworthiness of the lessee, as well as the expected value of the leased equipment.

Non-tax lease A generic term used to describe structures like Hire Purchase where the lessor has no entitlement to Capital Allowances.

Off-balance sheet financing Any form of financing, such as an operating lease, that, for financial reporting purposes, doesn’t have to be reported on a firm’s balance sheet.

Operating lease An agreement that also meets certain criteria established by the accounting rule-making body (SSAP21 and FRS5 in the UK). Such a lease need not be shown on the balance sheet of the lessee. Usually the lessor has taken a significant residual position in the lease pricing, so must salvage the equipment for a certain value at the end of the lease term to earn its rate of return.

Payment profile Often used to describe the number and frequency of rental payments involved in a leasing agreement e.g. a five year agreement involving 20 quarterly payments is commonly referred to as ‘1+19’ where ‘1’ represents a single initial quarterly payment.

Portfolio A collection of leases.

Purchase option An option in the lease agreement that allows the lessee to purchase the asset at the end of the lease term for a fixed amount or at the future fair market value of the leased equipment.

Put option price The price the supplier of equipment might be offered by the finance company to re-purchase the equipment upon termination of the agreement.

Refundable security deposit An amount paid by the lessee to the lessor at the beginning of the lease that is refunded at the end of the lease, provided the lessee has fulfilled all its obligations to the lessor.

Renewal option An option in the lease agreement that allows the lessee to extend the lease term for an additional period beyond the expiration of the initial lease term, in exchange for lease renewal payments. Also referred to as a lease extension, or secondary period.

Rent holiday A period of use of leased equipment during which the lessee pays no rent.


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Residual value The amount the lessor expects to receive from the sale of leased equipment when it is returned at the end of the lease period. Any shortfall is for the risk of the lessor.

Residual value guarantee See ‘Guaranteed residual value’.

Sale and leaseback Where the party selling the equipment to the lessor is also entering into a subsequent lease to gain the continued usage of the same equipment. It’s a common way for companies to raise cash.

Small ticket lease A lease transaction in the range £1,000 to £100,000.

Spread The percentage added by the lessor to its cost of funds to arrive at the all-in interest rate used to calculate the lease rentals.

SSAP21 (Statement of Along with its various amendments and interpretations, combined with FRS5, it specifies the proper Accounting Practice No.21) classification, accounting and reporting of leases by lessors and lessees.

Step payments Lease rentals that increase (or decrease) regularly.

Stipulated loss value The value owing to the lessor at a point in time during the lease. Typically values will be given for regular intervals during the lease, referred to as a stipulated loss value table.

Sub-lease Where the lessee takes equipment on lease and leases the equipment on to a further party.

Synthetic lease Most commonly found in the US, a lease that has been intensively structured to meet two normally mutually exclusive criteria e.g. an operating lease that is off-balance-sheet for the lessor as well as the lessee, or is full pay-out and off-balance-sheet for the lessee.

Tax lease A generic term for a lease in which the lessor takes on the risk of ownership and, as the owner, is entitled to capital allowances.

Tax variation clause A type of indemnification where the lessee commits to reimburse the lessor for any financial loss incurred through the loss of, or inability to claim, any or all of the anticipated tax benefits assumed in the original lease calculation.

Technology refresh lease A form of lease offered widely on high-tech equipment that has built-in options for upgrades and replacements.

Termination sum The sum required by the lessor to end a lease before the end of its primary term.

Total volume rental pan (TVRP) An agreement designed by BNP Paribas Leasing Solutions for the print market that allows lessees to be charged on the basis of useage rather than time.

Universal document A document which doesn’t show the name of the lessor and which can be submitted by a supplier to one or more finance companies (regulated business only).

Upgrade The replacement of part, or all, of the equipment which was subject to a leasing agreement. It involves the part or full settlement of the existing agreement and a new agreement for the new equipment supplied. The resultant lease agreement might include sums required to settle the original agreement.

Vanilla lease The simplest and most straightforward form of lease.

Yield The rate of return to the lessor in a lease.


Technology Solutions Division

St. James Court St. James Parade Bristol BS1 3LH

T: 0117 302 7640

Head Office and Equipment & Logistics Solutions Division

BNP Paribas Leasing Solutions Northern Cross, Basing View Basingstoke, Hampshire RG21 4HL

T: 0345 226 7367

bnp finance unlocked brochure dec 2015

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