Companies and Capitalenriqueva febrero 16, 2014 0 COMMENTS
Companies and Capital, these two concepts have been linked since the beginning of the financial system. Shakespeare in the Play, The Merchant of Venice, gave us an amazing example of this link and how the capital providers system works but, is this system is still prevalent in the early XXI century. Did the Companies primarily objective to reward shareholders must continue? This essay will try to convince that the primarily objective of a company despite the changes of how the global business are made, must continue rewarding primarily it shareholders in accordance with the mission and objectives of the company.
It is prudent to start by defining the concepts of Company and capital. According to the Oxford Dictionary a Company is “The person or group of people whose society one is currently sharing” or a “A commercial business” (Oxford, 2014) and Capital is defined as the “Wealth in the form of money or other assets owned by a person or organization or available for a purpose such as starting a company or investing” (Oxford, 2-2014). Therefore, it can be concluded that a company is a commercial business composed by a group of people in a shared Society that require capital in order to start operations and for its daily operations but; how this relationship works? Shakespeare gave us a nice example.
In the play the Merchant of Venice by W. Shakespeare; Bessanio want to conquer the love of Portia but he needs capital for its enterprise. He tries to convince his friend, the Merchant Antonio to invest in its enterprise. Antonio is willing but, all his capital has been invested in different Merchant companies. He offers his name to be used with the trade creditors but Bessanio thinks that credit will be no enough. Antonio goes with Shylock a Goldsmith to raise the capital for the enterprise of Bessanio. When Antonio ask for 3000 thousand ducats to Shylock, Shylock analyze the risk of the loan and conclude that there is a risk of default by Antonio, in order to assure he will get his money back. Shylock creates a particular debt indenture with Antonio, if Antonio defaults; shylock will receive from Antonio one pound of the flesh of Antonio. Antonio accepts the covenants of Shylock and the bond is issued. Latter on Bessanio triumphs in his enterprise and every Antonio merchant enterprise failed, so he defaults in his bond with Shylock. Shylock claims its bond covenant. Bessanio came to rescue Antonio and try to restructure the bond. Shylock refuse the proposal of Bessanio, and continue with its malicious plan. At the end Shylock end up trapped in its own ploy. He is punished; Antonio is saved from death and financially, thanks to its Private Equity Investment in Bassano’s enterprise. The way the capital providers operate in the actual world is more complex but the essence is the same as it was in Shakespeare´s time.
In the actual Europe “equity investors, debt providers and trade creditors are the primary capital providers in the European Union” (Cascino, 2013). Nevertheless these capital providers are more complex in its objectives and structures and use more complex sources of information if we compare them to the early modern age capital providers. For example today, Equity Investors can be divided in professional equity investor, retail investors and inside equity investors “family ownership” (Cascino, 2013). Professional equity investors can be divided in institutional investors, hedge funds, private equity funds, investment trusts and all will rank distinctly information for its investment decisions. “For example, pension funds have longer investment horizons than investment trust, which might cause different emphasis on strategic information rather than on short term results” (Cascino, 2013). Even with different objective and investment horizons in general “Professional equity investors rely heavily on financial statement information, particularly the income statement, in their decision making” (Cascino, 2013) and the use of “Direct management contact is a vital information source, even though price-sensitive information is not disclosed as part of this contact. (Cascino, 2013)
The retail investors have different objectives than the professional equity investors and have different sources of information. “Retail investors use four main information sources for their investment decision, namely: public media; advice by financial institutions; friends or family; and financial statements” (Cascino, 2013). Since the retail investors have no the same easiness to the company management, they must rely on public information that is why they are cautious in the quality of information, evidence shows, “that retail investors prefer audited to no audited information” (Hodge, 2003). Retail investors don’t use the information properly, but they provide liquidity to the market.
The inside equity investors “are typically defined as equity investors with an active involvement in the firm’s managerial decisions process” (Cascino, 2013). When inside equity investors are present in a company is due the presence of a family owned company. The main benefit of having inside equity investors is that “firms face lower risk wealth expropriation from the management” (Cascino, 2013). In somehow, inside investor behave the same way as institutional investors the both have same objectives that makes him to think in long horizon instead of short horizon; “Being part of the management and at the same time being owner of the company produce accounting information that is reliable, high quality information.” (Cascino, 2013).
The debt providers the Shylocks of our time are the ones who provide the most amount capital to the EU companies. “The average European country has a debt market twice the size of its equity market” (Cascino, 2013). The debt market remains the same in principle as it was in Shakespeare´s time, every bond have an interest rate, a maturity date, collaterals, covenants and the loan of the size. The debt market consists of two categories, the bank loans and the bond market, the two are important for company, although the bond market is only used by the big companies. Gilman (1925) says that among the first external users were the banks, which saw in the books of a company a way to verify the quality of the debtor. Since then, the debt providers have evolved, in the actual world, the debt providers rely on financial statements, credit agencies and in general are the most sophisticated financial data analysts.
The last one of the capital providers are the Trade creditors. The trade creditors are a key factor for the operations of a company. In Europe “most countries experience actual credit terms between 35 and 65 days (Intrum Justitia, 2011). What it is interesting is that the financial statements play a small role in credit decisions. Non financial factors, as professional relationships of the managements with the creditors, play a significant factor in the trade credit (Peterson & Raja, 1994) and also is important to notice that “Credit bureaus are used extensively by providers of trade credit and these bureaus rely on financial statement data, as well as non-financial information (Cascino, 2013).
The role of the capital providers in the business world is changing due the change of how businesses are made. In the UK the companies are becoming more financial orientated than core business orientated, there is a tendency of the management to focus more in earnings than in future development. Also companies are not investing at this moment, despite they have huge amount of cash and are relying less in equity. “Equity markets have not been an important source of capital for new investments in British business for many years. Large UK companies are self-financing” (Kay, 2011). “New equity issuance has therefore been negative over the last decade” (Kay, 2011). Why is this happening?
There is no conclusive explanation for this phenomenon but, there are many factors that can explain this incident. The overregulation of public equity markets have open the opportunity to private equity; the low interest rates of the last years have reduced the cost of debt making it lower than the cost of capital and also the increasing usage of off-balance sheets by companies. This phenomenon associated with a new type of equity investors, like asset managers, and the cultural tendency toward short term thinking have changed the equity capital sector.
Despite these changes in the last 50 years, the shareholders interest must remain as the primarily objective of a company. Kay (2011) argues that since the shareholders suffer of short-termism the management should think first in the company before the shareholders. This argument if is implemented will give legal basis to the senior management to capture the control of the company, relegating the interests of the stockholder to second place. The shareholders are the ones who invest capital, are the one who believe in the company, are the ones who have the risk of losing everything, like the Merchant Antonio, that is why the shareholders interest must remain as the primarily objective of a company. The shareholder must look that the company fulfill its obligations with the debt providers and trade creditors in the agreed terms. This quest can be made only by selecting good senior management. A good management will fulfill the obligations of the company and in the same time will seek to harmonize the interest of the company without jeopardizing the sustainability of the company in the long run.
It is true that the senior management have an increasing pressure for short term results. Nevertheless, all this pressure will depend on the type providers of equity that are present in a company. That is why is extremely important in the company investment analysis to see who will be the companions of the enterprise, and from there to decide if you want to share a society with them or not. At the end a company should look investors who believe in what the company is doing, like Bessanio look for Antonio, investors should looks for more Bassano’s and companies should fulfill its obligations with the Shylock’s of today in order to avoid problems.
- Cascino, S., Clatworthy, M., Osma, B.G., Gassen, J., Imam, S. and T. Jeanjean (2013) The use of information by capital providers: academic literature review. ICAS/EFRAG, Edinburgh / Brussels.
- Gilman, S. 1925, ANALYZING FINANCIAL STATEMENTS, first edition, THE RONALD PRESS COMPANY, New York, pp 3-10.
- Intrum Justitia, (2011), European Payment Index 2011 Intrum Justitia.
- Kay, J. (2012) The Kay Review of UK Equity Markets and long term decision making, Department for Business, Information and Skills, UK Government, London.
- Oxford University Press 2014,Available: http://www.oxforddictionaries.com/definition/english/capital?q=capital [2014, 06/17].
- Oxford University Press 2014, 2, Available: http://www.oxforddictionaries.com/definition/english/company?q=company.
- Petersen, M. A., and Rajan, R.G. (1994), ‘The bene!ts of !rm–creditor relationships: Evidence from small business data’, Journal of Finance, (49), 3–37.
- Whittington, G. 2008, “Harmonisation or discord? The critical role of the IASB conceptual framework review”, Journal of Accounting and Public Policy, vol. 27, no. 6, pp. 498