Structural or pure financial strategies
This chapter picks up on issues raised in earlier chapters, particularly regarding balance sheet structure, whether assets are on or off balance sheet and the level of gearing or leverage.
Operational strategy may be the best it can be - but funding strategy may mean the difference between success and failure. However, an inappropriate funding structure may be the cause of failure.
Volumes could be written on sources of funds, the cost of capital and descriptions of all the financial instruments and structures that do or might exist. This chapter covers the concepts, drivers and arithmetic of types of what are purely financial strategies. Some are what many would call creative accounting and effectively banned or discouraged by the recent improvements to FASB and IASB accounting standards. Leasing is creative, or maybe deceptive is the better word, in that if full details of the leasing agreements are not disclosed, borrowings and resultant gearing appear much lower than is the reality. Group structures are a very logical way of organizing a business's affairs effectively but can also be structured with other motives in mind, for example tax minimization.
Content, order and logic of this chapter
Within this chapter we will cover the following topics:
- Basic definitions
- Gearing or leverage and the 'magic' of gearing
- Leasing and off-balance sheet finance
- Group structures
- Special purpose vehicles or entities - off-balance sheet activities
- Foreign currency issues
- Hedging strategies.
Order and logic
Equity, loan capital, cost of capital and so on are all terms we need to understand, as they are key to structure and the arithmetic of pure financial strategies or financial engineering. The concepts and arithmetic of financial engineering are not deep; the difficulties are in getting the deals together to the satisfaction of all players. We therefore look at basic models, what they may achieve and the limitations both practically and legally. The most common type of financial structuring used today is that of gearing, the arithmetic on which private equity's amazing returns are based. Leasing can be an operationally, cash flow and taxation-wise sensible strategy, but leasing may also be deceptive. Groups with subsidiaries may be effective from a taxations perspective and also in hiding gearing. SPVs are needed and used for many commercial arrangements; they may also assist in hiding assets/ capital employed and gearing. Foreign currency dealings and hedging currencies or commodities may offer insurance and take risk out of operating activities but, conversely, if used to gamble they greatly increase risk.
If you understand the drivers or motives and what are the generally simple principles behind financial strategies, or financial engineering to use that other term, you will be better able to understand and contribute to debate on any proposals. Accounting standard setters, from the perspective of having open and fair accounting rather than any particular ethical slant, are moving to eliminate some of the accounting and much of the deception on which financial engineering depends. However, many schemes are still 'legal' and as long as we humans have to have laws, there will be folk who wish to circumvent and game them to their if not society's advantage.