Sources of Finance to a New Business Finance Essay

Whether you are thinking of starting up your own business or if an existing business is thinking of expanding, it is likely that money will be needed. The money needed to start a business is called business finance. Where do businesses get the finance to start a business or to finance expansion?

This resource will look at some of the possibilities. When you are working through the resource, remember that some sources of finance will be appropriate for some businesses but not for others.

When looking at this area, there are a number of things you need to think about. First of all, you need to consider why the business needs to raise finance. Finance can be needed for a variety of different reasons, which will have an effect on what the most appropriate sources of finance will be.

The type of finance needed to deal with these problems is going to be different - it is unlikely, for example, that Liverpool FC would use a bank overdraft or a credit card as a source of finance to pay for their new stadium!

We tend to break up the sources of finance into two parts - short term finance and long term finance. You might also see reference to medium term finance. There might be some types of finance that do not sit neatly into either short term or long term so medium term might apply!

Short term finance

Hopefully you managed to get the right sources of short term finance in the drag and drop activity. Let us have a look in a bit more detail at each of the main types of short term finance.

Bank Overdraft

Most businesses have an account with a bank. The bank deals with all the deposits (money put into the account) and withdrawals (money taken out). Most banks know that businesses do not always receive money from sales straight away. If you run a sandwich bar in a local trading estate then you might get money straight away when you sell your sandwiches. If you are a business selling electrical equipment to an electrical retailer then you may not get paid straight away when you deliver your goods.

When differences occur in the money a business receives from sales (its revenue or turnover) and the money it has to pay out on labour, machinery, equipment, distribution and so on (its costs) the firm can face difficulties. The money flowing into a business from sales and the amount it spends on costs that go out of the business is called its cash flow.

Cash inflows to a business

 

 

 

Cash outflows from a business

(Revenue from sales, loans, interest, sales of assets etc

 

 

 

(Payment for raw materials, stock, labour, insurance, rent, rates etc.)

A business might need to pay a bill on the 28th November for £1,500 but not have enough money in its account to pay the bill. It might know that it is due to receive £3,500 from a customer on the 10th December but in the meantime it has a cash flow problem. This is when it is appropriate to arrange an overdraft with a bank. An overdraft is an agreement with a bank to allow the business to spend money it does not have - it is a form of a loan therefore. In our example, the business might arrange for an overdraft facility of £5,000 with its bank. It can now pay the bill for £1,500 and not worry about the cheque 'bouncing'.

A cheque is said to 'bounce' when the bank refuses to honour the payment. It might be returned to the business and if this happens a charge is made to the business. Not only do bounced cheques cost the business money in bank charges but the relationships with its suppliers can be damaged. Some suppliers might think twice before supplying the business with any more stock in such circumstances!

Arranging an overdraft avoids this problem. The business will get charged interest on the amount they have loaned. In our example, the overdraft facility is £5,000. If the business only uses £1,500 of that limit, they only pay interest on the £1,500, not the whole £5,000. This is a key difference between an overdraft and a loan.

Overdraft facilities do have their disadvantages. The interest rate on an overdraft can be quite high, especially for small firms where the risk to the bank that they might not get their money back is greater. In addition, the business is not allowed to exceed their overdraft limit. If they do the bank might refuse to pay cheques to creditors (people who are owed money) and may hit the business with a hefty charge for exceeding the limit. Overdraft facilities can be re-negotiated but if this is tried too many times, it may be a signal to the bank that a business has not got control over its finances.

Trade Credit

This is a period of time given to a business to pay for goods that they have received. It is often 28 days but some businesses might not pay for 6 months and on some occasions even a year after they have received goods.

Hill Farm Furniture is a small business based between Nottingham and Lincoln. The business makes high quality kitchen furniture. The vast majority of the work done by the business is strictly to order and made to suit the specific requirements of the customer. Hill Farm use wood - lots of it! When they receive a delivery from their supplier they do not pay straight away. They will receive a 28 day period before having to settle the bill.

For a small business like Hill Farm Furniture, trade credit might be a useful source of short term finance to help them manage their cash flow more effectively. Source: Hill Farm Furniture.

For many small firms, this effectively means they are getting some funds for free. Assume that the bill for a delivery of wood comes to £8,000 for Hill Farm. If they have 28 days before they have to pay they have effectively received a loan of £8,000 from their supplier for 28 days - interest free. This gives the business the time to be able to manage their finances and balance their cash flows more effectively.

If a business did not pay the debt after the 28 days has past then there might be a penalty to pay. The supplier might charge a fee or start charging interest or even take the business to court to get its money back. Non payment of debts like this can cause businesses - especially small businesses - real problems. If they are not receiving money for the goods they have supplied they cannot pay their own debts!

Task

Businesses supplying the motor parts retailer Halfords were very angry at a decision made by the company in December 2005. Halfords announced that they were going to change the trade credit terms with their suppliers from 90 days to 120 days.

Consider the advantages and disadvantages to a small firm supplying Halfords of this decision.

Credit Card

A credit card works very much like trade credit. If you buy something using a credit card, you will receive a statement once a month with the details of the amount spent during the last month. You then have a certain period of time to either pay the full amount or a minimum amount.

Example:

James runs a sandwich bar. He gets a lot of his supplies from a cash and carry - bread, cheese, margarine, ham, tuna and so on. He pays for his weekly supplies by credit card. On the 16th of each month he receives his statement. This month it is for £645. He is told that he must pay a minimum sum of £50 or the full amount by the 5th of next month. If he pays the full amount he effectively gets over a month's interest free loan. If he chooses to pay off only part of the full amount he will have to pay interest on the amount still owed. That can be expensive!

Many businesses have a company credit card. It can be a useful way of managing expenses and if paid off in full can be a useful and cheap source of short term finance.

Lease

Most businesses have to buy equipment and machinery of some sort. Many firms have a fleet of company cars which certain staff use or vehicles that they use for distribution. There are a number of ways of buying these things. The business might go to the bank for a loan, arrange some sort of finance deal with the supplier, use cash they have in the business or arrange a lease option.

Some machinery or equipment might not be a cost effective proposition to be bought outright. In these cases, leasing may be a more sensible option. Copyright: Adrian Adrian, from stock.xchng.

A lease effectively means that the business is paying for the use of a product but do not own it. It is also called 'hiring'. A lease agreement on a van, for example, might mean that the firm pays out £350 per month for a three year lease. At the end of the three years the vehicle returns to the owner.

Lease agreements can be of benefit to the firm for the following reasons:

It can be cheaper to arrange a lease rather than having to buy equipment outright

Leases can be very flexible - equipment might only be needed for a short time or for a particular project and so does not warrant being bought outright.

The company that owns the equipment, machinery or vehicles is responsible for the maintenance and this can help reduce costs for the business.

The payments made are generally fixed and will not therefore change as interest rates change. This helps business plan more effectively.

Bank Loans

Bank loans are very flexible. They can vary in the length of time that the loan has to be repaid. Loans arranged with a bank that are less than one year are regarded as short term finance. As with any other form of loan there are interest payments to be made and this can be expensive and also can vary.

Task

Tyrell worked in a Pizza Hut store for five years before deciding to set up his own pizza delivery store. The business has been going for two years and has been quite successful. The quality of the service and the pizzas themselves has led to an increased demand for his products.

The pizza business is booming but how should Tyrell finance his plans for expanding his distribution network? Copyright: Jacque Stengel, from stock.xchng.

Tyrell now feels he needs to increase the number of vehicles he has that deliver the pizzas. He did buy two Smart cars initially to make deliveries from a local dealer. He is now contemplating buying two more. He is thinking about the most appropriate way of financing the acquisition of the two cars.

Prepare a 200 word report advising Tyrell of his options and what source of finance you would recommend and why.

Long Term Sources of Finance

Long term sources of finance are those that are needed over a longer period of time - generally over a year. The reasons for needing long term finance are generally different to those relating to short term finance.

Long term finance may be needed to fund expansion projects - maybe a firm is considering setting up new offices in a European capital, maybe they want to buy new premises in another part of the UK, maybe they have a new product that they want to develop and maybe they want to buy another company. The methods of financing these types of projects will generally be quite complex and can involve billions of pounds.

Large-scale development of plant and equipment may cost millions of pounds. Long term finance is needed for this type of development. Copyright: Alfonso Lima, from stock.xchng.

It is important to remember that in most cases, a firm will not use just one source of finance but a number of sources. There might be a dominant source of funds but when you are raising hundreds of millions of pounds it is unlikely to come from just one source.

Shares

A share is a part ownership of a company. Shares relate to companies set up as private limited companies or public limited companies (plcs). There are many small firms who decide to set themselves up as private limited companies; there are advantages and disadvantages of doing so. It is possible, therefore, that a small business might start up and have just two shareholders in the business.

If the business wants to expand, they can issue more shares but there are limitations on who they can sell shares to - any share issue has to have the full backing of the existing shareholders. PLCs are different. They sell shares to the general public. This means that anyone could buy the shares in the business.

Merrill Lynch: a merchant bank that engages in large-scale deals to acquire sources of finance.

Some firms might have started out as a private limited company and have expanded over time. There might come a time when they cannot issue any more shares to friends or family and need more funds to continue expanding. They might then decide to become a public limited company. This is called 'floating the business'. It means that the business will have to go through a number of administrative and legal procedures to allow it to be able to offer shares to the general public.

It might be that a business wants to raise £300 million to finance its expansion plans. It might issue 300 million £1 shares in the company. The offering of these shares has to be accompanied by a prospectus which lays out details of the business - what it is involved in, how it is structured, how it will be managed and so on. This is so that prospective investors, people or institutions who might want to buy the shares, can get information about the company before committing to buying shares.

Often a business will employ the services of a merchant bank to help with a share issue. These institutions specialise in arranging large financial deals of this sort. Examples of such institutions are Morgan Stanley, Merrill Lynch, Rothschilds and Goldman Sachs. These institutions may agree to underwrite the share issue. What this means is that if all the shares are not sold, the institution will still provide all the money to the firm issuing the shares.

Once the shares are sold, share owners can buy and sell their shares through the stock exchange. Such buying and selling does not affect the business concerned directly and is one of the main advantages of the stock exchange. You can get more details of how the stock exchange works through our resource on the London Stock Exchange.

There may be times in the development of a plc when it needs to raise more funds. In this case it can issue more shares. Many firms will do this through what is called a 'rights issue'. This occurs where new shares are issued but existing shareholders get the right to purchase new additional shares at a reduced price. If the business is doing well and the new finance is needed for expansion, this can be an attractive proposition for existing shareholders. For the business it is a relatively quick and cheap way of raising new funds.

Task

Follow this link to Morgan Stanley's United Kingdom Transactions. (https://www.morganstanley.com/about/offices/uk-transactions.html)

Select three of the transactions from the list. Try and work out who was trying to raise finance, how much they wanted to raise and then think about what they might have wanted to raise this money for. For example, one of the entries for March read:

March - Transport for London - £200 million Euro market public issue, 25-year fixed-rate note.

In this case, the business trying to raise money was Transport for London. They wanted to raise £200 million and did so through borrowing money over a 25 year period. The people lending the money would have received a fixed rate of interest for the period that they choose to hold the loan. (These notes can be bought and sold as well!). Why did Transport for London want to raise the money? Well, that is for you to think about.

Venture Capital

Venture capital is becoming an increasingly important source of finance for growing companies. Venture capitalists are groups of (generally very wealthy) individuals or companies specifically set up to invest in developing companies. Venture capitalists are on the look out for companies with potential. They are prepared to offer capital (money) to help the business grow. In return the venture capitalist gets some say in the running of the company as well as a share in the profits made.

Venture capitalists are often prepared to take on projects that might be seen as high risk which some banks might not want to get involved in. The advantages of this might be outweighed by the possibility of the business losing some of its independence in decision making.

Examples of venture capitalists (who are also called private equity firms) are Advantage Capital Limited, Braveheart Ventures, Permira and Hermes Private Equity.

Task

Go to the BVCA Web site. (https://www.bvca.co.uk/index.html)

The site contains a list of members - all firms providing capital for businesses! It also contains some case studies of how private equity firms have helped entrepreneurs. To find this, go to 'Entrepreneurs', 'Entrepreneurs - case studies' and open the pdf file. You can get some interesting information on the work of venture capitalists here.

Now go to Permira's page on the Gala Coral Group (https://www.permira.com/permira/en/dealdetail.jsp?id=50530) and read the information.

How much money did Permira invest in Coral?

In October 2005, Gala bought Coral Eurobet. How much did they pay to buy this company?

What do Permira plan to do to help the business grow in the future?

Why do you think that Permira believes the investment in the Gala group is a good one?

Government Grant

The Eden Project near St Austell in Cornwall. The cost of the project was £133.6 million. Some of the funding came from the National Lottery and some came from the EU. Copyright: Simon Nicholson, from stock.xchng.

Some firms might be eligible to get funds from the government. This could be the local authority, the national government or the European Union. These grants are often linked to incentives to firms to set up in areas that are in need of economic development. In Cornwall, for example, there have been a number of initiatives to encourage new businesses to locate there.

Cornwall has the lowest gross domestic product (GDP) per head of the population in the UK. The average wage in Cornwall is 28% below the UK average. As a result, the area attracts funding from the EU and the government. Firms looking to set up in Cornwall might be able to apply for some help in starting or moving a business to the area. One of the disadvantages of this type of funding is that it involves large amounts of paperwork and administration. This can add to costs and in some cases might not make the project worthwhile.

One famous example of how a business project can be developed using European Union funding was the Eden Project. The EU was not the only source of finance to help set up the project but was an important partner in helping to realise this important tourist destination for a deprived part of Cornwall.

Bank Loans

As with short term finance, banks are an important source of longer term finance. Banks may lend sums over long periods of time - possibly up to 25 years or even more in some cases. The loans have a rate of interest attached to them. This can vary according to the way in which the Bank of England sets interest rates. For businesses, using bank loans might be relatively easy but the cost of servicing the loan (paying the money and interest back) can be high. If interest rates rise then it can add to a businesses costs and this has to be taken into account in the planning stage before the loan is taken out.

Mortgage

A mortgage is a loan specifically for the purchase of property. Some businesses might buy property through a mortgage. In many cases, mortgages are used as a security for a loan. This tends to occur with smaller businesses. A sole trader, for example, running a florists shop might want to move to larger premises. They find a new shop with a price of £200,000. To raise this sort of money, the bank will want some sort of security - a guarantee that if the borrower cannot pay the money back the bank will be able to get their money back somehow.

The borrower can use their own property as security for the loan - it is often called taking out a second mortgage. If the business does not work out and the borrower could not pay the bank the loan then the bank has the right to take the home of the borrower and sell it to recover their money. Using a mortgage in this way is a very popular way of raising finance for small businesses but as you can see carries with it a big risk.

There may be a need to move to larger premises but the risks could be great if using your home as security for a loan. Copyright: Sue Anne Joe, from stock.xchng.

Owner's Capital

Some people are in a fortunate position of having some money which they can use to help set up their business. The money may be the result of savings, money left to them by a relative in a will or money received as the result of a redundancy payment. This has the advantage that it does not carry with it any interest. It might not, however, be a large enough sum to finance the business fully but will be one of the contributions to the overall finance of the business.

Retained Profit

This is a source of finance that would only be available to a business that was already in existence. Profits from a business can be used by the owners for their own personal use (shareholders in plcs receive a share of the company profits in the form of a dividend - usually expressed as Xp per share) or can be used to put back into the business. This is often called 'ploughing back the profits'.

The owners of a business will have to decide what the best option for their particular business is. In the early stages of business growth, it may be necessary to put back a lot of the profits into the business. This finance can be used to buy new equipment and machinery as well as more stock or raw materials and hopefully make the business more efficient and profitable in the future.

Selling Assets

As firms grow they build up assets. These assets could be in the form of property, machinery, equipment, other companies or even logos. In some cases it may be appropriate for a business to sell off some of these assets to finance other projects.

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