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Business Finance

WHY DO BUSINESSES NEED FINANCE TO START UP AND GROW?

  • Business activity cannot take place without finance – or the means of purchasing the materials and assets before the production of a good or service can take place.
  • Finance decisions are some of the most important that managers have to take- inadequate or inappropriate finance can lead to business failure
  • The range and choice of finance sources are extensive and skilled managers will be able to match accurately the needs of their business for particular types of finance with the sources available.
  • Start-up capital- the capital needed by an entrepreneur to set up a business.
  • Working capital- the capital needed to pay for raw materials, day-to-day running costs, and credit offered to customers.
    • In accounting terms working capital = current assets – current liabilities.

EXAMPLES OF SITUATIONS WHERE FINANCE IS REQUIRED

  • Setting up a business will require cash injections from the owner/s to purchase essential capital equipment and, possibly, premises. This is called start-up capital.
  • All businesses need to finance their working capital – the day-to-day finance needed to pay bills and expenses and to build up stocks.
  • When businesses expand, further finance will be needed to increase the capital assets held by the firm – and, often, expansion will involve higher working capital needs.
  • Special situations will often lead to a need for greater finance- for example, a decline in sales, possibly as a result of economic recession, could lead to cash needs to keep the business stable.

CAPITAL EXPENDITURE AND REVENUE EXPENDITURE

  • Capital expenditure- the purchase of assets that are expected to last for more than one year, such as building and machinery.
    • Typically, one-time large purchases of fixed assets that will be used for revenue generation over a longer period of time.
  • Revenue expenditure- spending on all costs and assets other than fixed assets and includes wages and salaries and materials bought for stock.
    • Ongoing operating expenses, which are short-term expenses used to run the daily business operations.

WORKING CAPITAL

  • Finance is needed by every business to pay for everyday expenses, such as the payment of wages and buying of stock.
  • Without sufficient working capital a business will be illiquid – unable to pay its immediate or short-term debts.
    • In this case, the business either raises finance quickly – such as a bank loan – or it may be forced into ‘liquidation’ by its creditors, the firms it owes money to.
  • Sufficient working capital is essential to prevent a business from becoming illiquid and unable to pay its debts.
    • Too high a level of working capital is a disadvantage- the opportunity cost of too much capital tied up in inventories, accounts receivable and idle cash is the return that money could earn elsewhere in the business
  • The working capital requirement for any business will depend upon the length of this ‘working capital cycle’- the longer the time period from buying materials to receiving payment from customers, the greater will be the working capital needs of the business.
  • Liquidity- the ability of a firm to be able to pay its short-term debts.
  • Liquidation- when a firm ceases trading, and its assets are sold for cash to pay suppliers and other creditors.

SOURCES OF FINANCE

  • Businesses are able to raise finance from a wide range of sources. It is useful to classify these into:
    • Internal- money raised from the business’s own assets or from profits left in the business (retained earnings)
    • External- money raised from sources outside the business.

INTERNAL SOURCES OF FINANCE

  • Profits retained in the business
    • If a company is trading profitably, some of these profits will be taken in tax by the government (corporation tax) and some is nearly always paid out to the owners or shareholders (dividends)- if any profit remains, this is kept (retained) in the business and becomes a source of finance for future activities
    • A newly formed business or one trading at a loss will not have access to this source of finance
    • For other companies, retained earnings are a very significant source of funds for expansion
    • Once invested back into the business, these retained earnings will not be paid out to shareholders, so they represent a permanent source of finance
  • Sale of assets
    • Established companies often find that they have assets that are no longer fully employed- these could be sold to raise cash
    • Some businesses will sell assets that they still intend to use, but which they do not need to own- the assets might be sold to a leasing specialist and leased back by the company; this will raise capital – but there will be an additional fixed cost in the leasing and rental payment
  • Reductions in working capital
    • When businesses increase stock levels or sell goods on credit to customers (trade receivables), they use a source of finance
    • When companies reduce these assets – by reducing their working capital – capital is released, which acts as a source of finance for other uses
    • However, there are risks in cutting down on working capital- cutting back on current assets by selling inventories or reducing debts owed to the business may reduce the fi rm’s liquidity to risky levels
  • Evaluation:
    • Internal sources of finance have no direct cost to the business, although if assets are leased back once they are sold, there will be leasing charges
    • Internal finance does not increase the liabilities or debts of the business, and there is no risk of loss of control by the original owners as no shares are sold
    • However, it is not available for all companies- newly formed businesses or unprofitable ones with few ‘spare’ assets can’t make use of their internal sources of finance
    • Solely depending on internal sources of finance for expansion can slow down business growth, as the pace of development will be limited by the annual profits or the value of assets to be sold- rapidly expanding companies are often dependent on external sources for much of their finance

EXTERNAL SOURCES OF FINANCE

  • Short-term sources- these methods are often used to obtain finance for a short period of time, usually a few months up to a year
    • Bank overdrafts
      • A bank overdraft is the most flexible of all sources of finance- this means that the amount raised can vary from day to day, depending on the particular needs of the business
      • The bank allows the business to ‘overdraw’ on its account at the bank by writing cheques or making payments to a greater value than the balance in the account
      • This overdrawn amount should always be agreed in advance and always has a limit beyond which the firm should not go
      • Businesses may need to increase the overdraft for short periods of time if customers do not pay as quickly as expected or if a large delivery of stocks has to be paid for
      • However, this form of finance often carries high interest charges
      • If a bank becomes concerned about the stability of one of its customers, it can ‘call in’ the overdraft and force the firm to pay it back- this in extreme cases, can lead to business failure.
    • Trade credit
      • By delaying the payment of bills for goods or services received, a business is obtaining finance
      • Its suppliers/creditors are providing goods and services without receiving immediate payment from the business- it is comparable to ‘lending money’
      • However, the downside to these periods of credit is that they are not free – discounts for quick payment and supplier confidence are often lost if the business takes too long to pay its suppliers
    • Debt factoring
      • When a business sells goods on credit, it creates trade receivables- the longer the time allowed to pay up, the more finance the business has to find to carry on trading
      • One option, if it is commercially unwise to insist on cash payments, is to sell these claims on trade receivables to a debt factor- in this way immediate cash is obtained, but not for the full amount of the debt
      • The debt-factoring company’s profits are made by discounting the debts and not paying their full value- when full payment is received from the original customer, the debt factor makes a profit
      • Smaller firms who sell goods on hire purchase often sell the debt to credit-loan firms, so that the credit agreement is never with the firm but with the specialist provider
  • Medium-term sources- these methods are often used to obtain fixed assets with a medium lifespan of one to five years
    • Hire purchase and leasing
      • Hire purchase is when an asset is sold to a company that agrees to pay fixed repayments over an agreed time period; that asset then belongs to that company- this avoids making a large initial cash payment to buy the asset
      • Leasing involves a contract with a leasing or finance company to acquire, but not necessarily to purchase, assets over the medium term
      • A periodic payment is made over the life of the agreement, but the business does not have to purchase the asset at the end- this agreement allows the firm to avoid cash purchase of the asset
      • The risk of using unreliable or outdated equipment is reduced as the leasing company will repair and update the asset as part of the agreement
      • Hire purchase or leasing is not a cheap option, but they do improve the short-term cash-flow position of a company compared to outright purchase of an asset for cash
    • Medium-term bank loan
  • Long-term sources of finance- these methods are used to obtain finance for a period of over five years; there are two main choices of debt or equity finance
    • Debt finance can be raised in two main ways:
      • Long- term bank loan
        • These may be offered at either a variable or a fixed interest rate- fixed rates provide more certainty, but they can turn out to be expensive if the loan is agreed at a time of high interest rates
        • Companies borrowing from banks will often have to provide security or collateral for the loan; this means the right to sell an asset is given to the bank if the company cannot repay the debt
        • Businesses with few assets to act as security may find it difficult to obtain loans – or may be asked to pay higher rates of interest
        • In the UK, a small business can apply to the Department of Trade and Industry for the loan to be part of the ‘guaranteed loan scheme’- banks will be more willing to lend if a company has been successful in this application because it gives the bank security of repayment
        • Merchant banks- these are specialist lending institutions that provide advice as well as finance to firms engaging in expansion or merger/takeover plans
      • Debentures/long-term bonds
        • Debenture- bonds issued by companies to raise debt finance, often with a fixed rate of interest
        • A company wishing to raise funds will issue or sell such bonds to interested investors- the company agrees to pay a fixed rate of interest each year for the life of the bond, which can be up to 25 years
        • The buyers may resell to other investors if they do not wish to wait until maturity before getting their original investment back
        • Long-term loans or debentures are usually not secured on a particular asset- when they are secured, the investors have the right if the company ceases trading, to sell that particular asset to gain repayment, then the debentures are known as mortgage debentures
        • Debentures can be a very important source of long-term finance
        • Convertible debentures can (if the borrower requests it) be converted into shares after a certain period of time, and this means that the company issuing them will never have to pay the debenture back
    • Equity finance
      • Equity finance is permanent finance raised by companies through the sale of shares
      • All limited companies issue shares when they are first formed- the capital raised will be used to purchase essential assets
      • Both private and public limited companies are able to sell further shares – up to the limit of their authorised share capital – in order to raise additional permanent finance
      • This capital never has to be repaid unless the company is completely wound up as a result of ceasing to trade
      • Private limited companies can sell further shares to existing shareholders- this has the advantage of not changing the control or ownership of the company – as long as all shareholders buy shares in the same proportion to those already owned
      • Owners of a private limited company can also decide to ‘go public’ and obtain the necessary authority to sell shares to the wider public- this would obviously have the potential to raise much more capital than from just the existing shareholders; however, it comes with the risk of some loss of control to the new shareholders
      • In the UK, this can be done in two ways and these are quite typical for many countries:
        • Obtain a listing on the Alternative Investment Market (AIM), which is that part of the Stock Exchange concerned with smaller companies that want to raise only limited amounts of additional capital. The strict requirements for a full Stock Exchange listing are relaxed.
        • Apply for a full listing on the Stock Exchange by satisfying the criteria of selling at least £50,000 worth of shares and having a satisfactory trading record to give investors some confidence in the security of their investment. This sale of shares can be undertaken in two main ways:
          • Public issue by prospectus- this advertises the company and its share sale to the public and invites them to apply for the new shares
          • Arranging a placing of shares with institutional investors without the expense of a full public issue- rights issue of shares
    • Evaluations: some businesses normally use both debt and equity finance for very large projects
      • Advantages of debt finance:
        • As no shares are sold, the ownership of the company does not change or is not ‘diluted’ by the issue of additional shares
        • Loans will be repaid eventually (apart from convertible debentures), so there is no permanent increase in the liabilities of the business
      • Advantages of equity finance:
        • It never has to be repaid; it is permanent capital
        • Dividends do not have to be paid every year; in contrast, interest on loans must be paid when demanded by the lender
    • Other sources of long-term finance
      • Grants
        • There are many agencies that are prepared, under certain circumstances, to grant funds to businesses- the two major sources in most European countries are the central government and the European Union
        • Usually grants from these two bodies are given to small businesses or those expanding in developing regions of the country
        • Grants are available to small and newly formed businesses as part of most governments’ assistance to small businesses
        • Grants often come with conditions attached, such as location and the number of jobs to be created, but if these conditions are met, grants do not have to be repaid
      • Venture capital
        • Venture capital is risk capital invested in business start-ups or expanding small businesses that have good profit potential but do not find it easy to gain finance from other sources
        • Venture capitalists take great risks and could lose all of their money – but the rewards can be great
        • Venture capitalists generally expect a share of the future profits or a sizeable stake in the business in return for their investment

FINANCE FOR UNICORPORATED BUSINESSES

  • Unincorporated businesses – sole traders and partnerships – cannot raise finance from the sale of shares and are most unlikely to be successful in selling debentures as they are likely to be relatively unknown firms
  • Owners of these businesses will have access to bank overdrafts, loans, and credit from suppliers. They may borrow from family and friends, use the savings and profits made by the owners and, if a sole trader wishes to do this, take on partners to inject further capital
  • Lenders are often reluctant to lend to smaller businesses, which is what sole traders and partnerships tend to be, unless the owners give personal guarantees, supported by their own assets, should the business fail

MICROFINANCE

  • Microfinance involves providing financial services for poor and low-income customers who do not have access to banking services, such as loans and overdrafts offered by traditional commercial banks
  • Example- Muhammad Yunus founded Grameen Bank to make very small loans to poor people with no bank accounts and no chance of obtaining finance through traditional means
  • Many business entrepreneurs in Bangladesh and other Asian countries have received microfinance to help start their business.
  • In some of these countries, more than 75% of successful applicants for microfinance are women. Women have, in some traditional societies, always found it very difficult to obtain loans or banking services from traditional banks
  • There is evidence that entrepreneurship is greater in regions with microfinance schemes in operation – and that average incomes are rising because of more successful businesses
  • However, interest rates can be quite high as the administration costs of many very small loans is considerable
  • Some economists also suggest that if a small business start-up financed by microfinance fails, then the scheme has encouraged very poor people to take on debts that they cannot repay

CROWDFUNDING

  • Crowdfunding is the use of small amounts of capital from a large number of individuals to finance a new business venture
  • Crowd funding websites allow an individual to promote their new business idea to many people who may be willing to each invest a small sum- for example, around $10
  • There are many established websites such as Kickstarter and Crowdcube that allow entrepreneurs to publicise their new ideas
  • Through these websites, the entrepreneur will explain what the business is about, what its objectives are and why finance is needed
  • Investors can commit small sums of money to the new venture until the ‘target sum’ is reached
  • The publicity generated can also be an effective form of promotion for the new business and its product
  • If business ventures turn out to be successful, the crowd funding investors will receive either their initial capital back plus interest – this is sometimes known as peer-to-peer lending, or an equity stake in the business and a share in profits
  • However, entrepreneurs using crowdfunding must keep accurate records of thousands of investors to either pay back interest and capital or a share of the profits; and another risk is that exposing a new project idea on the Internet means that it could be copied by others before the entrepreneur has had a chance to start the business up

FACTORS INFLUENCING THE CHOICE OF SOURCES OF FINANCE

  • Cost
    • Obtaining finance is never free – even internal finance may have an opportunity cost.
    • Loans may become very expensive during a period of rising interest rates
    • A Stock Exchange flotation can cost millions of dollars in fees and promotion of the share sale
  • Flexibility
    • When a firm has a variable need for finance – for example, it has a seasonal pattern of sales and cash receipts – a flexible form of finance is better than a long-term and inflexible source
  • Legal structure and need to retain control
    • Share issues can only be used by limited companies – and only public limited companies can sell shares directly to the public. Doing this runs the risk of the current owners losing some control – except if a rights issue is used
    • If the owners want to retain control of the business at all costs, then a sale of shares might be unwise.
  • What the finance is required for
    • It is very risky to borrow long-term finance to pay for short-term needs- businesses should match the sources of finance to the need for it
    • Permanent capital may be needed for long-term business expansion
    • Short-term finance would be advisable to finance a short-term need such as to increase stocks or pay creditors
  • Amount required
    • Share issues and sales of debentures, because of the administration and other costs would generally be used only for large capital sums
    • Small bank loans or reducing trade receivables’ payment period could be used to raise small sums
  • Level of existing debt
    • The higher the existing debts of a business (compared with its size), the greater the risk of lending more- banks and other lenders will become more cautious about lending more finance