![]()
Financing a Business
This fact file reviews the different methods of financing a business and how funds raised are matched to business needs.
1. Introduction
Whether you are starting up or expanding a business you will have a number of financial requirements. Unless you are very lucky there will be a gap between paying your suppliers and receiving payment from your own customers. Customers will delay payment for as long as 3 or 4 months. You may find it more difficult to persuade your suppliers to wait as long for payment and hence you will need working capital. In addition, you may need to buy or lease equipment and premises. These too will need to be financed.
There are five possible sources of money:
(i) Equity. You might provide it, say from your savings, or you might persuade acquaintances or financial institutions to invest in the business.
(ii) Loans. You might persuade a bank or some other lender to provide a loan to the business.
(iii) Creditors. You might borrow from your trade creditors, though this is often difficult until the business has built up a good credit record.
(iv) Grants. A grant may be available from the government, your local authority or a related organisation.
(v) Profits. If you are already in business, you may be able to retain some of the profit within the business. This becomes part of the equity in the business but it is also available to help fund working capital or additional fixed assets.
In general, banks and other lenders aim to match the term of a loan to the expected useful life of an asset, though they play safe with the loan term being shorter.
Business finance is often divided into three categories:
(i) Short term: trade creditors and overdraft.
(ii) Medium term: loans of less than seven years, leasing and hire purchase.
(iii) Long term: loans of more than seven years and equity.
2. Funding Working Capital
Unless there is sufficient equity in the business (whether introduced as capital invested or as retained profit), working capital is generally funded by trade creditors and an overdraft facility. The disadvantage of an overdraft is that it is repayable on demand. You will also have to pay an arrangement fee, but you will only pay interest on the outstanding balance. Whilst the interest rate may be higher than for a term loan the overall cost may be lower. The bank may also seek a personal guarantee and/or a charge over stock. The size of overdraft required clearly depends on the working capital requirement and has to be agreed at least annually with your bank manager.
The current assets less the current liabilities shown on the balance sheet are the businesss working capital. But the balance sheet is only a snapshot of the business. Your cash flow forecast, therefore, gives a more accurate figure. Even this, however, is prone to error. Receipts may be delayed by two or three weeks, pushing up the requirements in the middle of a month, for example, though this will not be reflected in month end figures.
Some businesses, such as retail or mail order, are cash positive. In other words, they receive cash for their goods straight away but do not have to pay their creditors for 30, 60 or 90 days. These businesses can easily fund their working capital solely from trade creditors. For most businesses, customer payments will be made after supplier invoices become due. As a rule of thumb, it makes sense to aim for minimum working capital of a months average sales multiplied by the number of months it takes to collect payment. If you want to be more accurate, then use the following procedure (shown with example):
Determine average number of weeks raw material is in stock 2 Deduct credit period from suppliers in weeks (-4) Add: average number of weeks to produce goods or service 1 Add: average number of weeks finished goods are in stock 1 Add: average time customers take to pay 9 Total 9
If sales for the year are estimated at £208,000 then the maximum working capital required is 9/52 x 208,000 = £36,000. It would be more accurate to use in the cost of sales (direct and fixed) rather than the full selling price, but the above will give a sufficient approximation. If your business is growing, then your overdraft requirement will grow at the same rate.
An alternative method of financing working capital, at least in part, is factoring or invoice discounting. There are a number of factoring agents who will take your invoices and give you a proportion of the total, around 80%, immediately. The balance is paid (less their commission) when the customer pays the factor. Factoring is therefore an expensive way of speeding up cash flow for small businesses, but larger businesses may reduce their administration costs by this method. Generally, factoring agents expect businesses to have sales of at least £30,000 per month. See BIF34 Factoring and Invoice Discounting.
3. Funding Capital Assets
Capital assets are usually defined by their life and divided into medium and long term finance. Equipment and machinery is usually financed over 3 years. Agreements should ideally be over the life of the asset but most banks will exercise caution. In the case of buildings which have a long life, say 60 years plus, long term finance in the form of a mortgage may be available.
Equity, or shareholder capital, is the money introduced into a business by the proprietor(s) and anyone else willing to invest capital in the hope of getting a future return. If it is a company, then the equity is introduced in exchange for shares. If the business does well, the directors declare a dividend each year. If it does very well, it may be floated on the Alternative Investment Market or the Stock Market, in which case the original share holdings will become valuable. See BIF 176 Raising Capital by Selling Shares, BIF 177 Shares and Shareholders, and BIF 62 Seeking Venture Capital. Often though, shareholders capital will be locked into the small business. Advance corporation tax is deductible from dividend payments. Even if dividend payments are not paid, corporation tax is still payable on all profits.
Loan capital, or debt, is money lent to a business. Normally, the period of the loan is determined according to the life of the asset for which it is used. A long term loan for premises and a medium or short term loan for equipment. Interest on loans is tax deductible, whereas dividends are paid out of profit. The purchase of buildings or land can probably be spread over 20 or 25 years with the asset used as security for the loan. It is unusual however for the banks to provide the entire sum required, preferring to limit their loan to 75 per cent of the value of the assets.
Once you have built up a track record with your bank, you should be able to attract medium term loans, say three to seven years, to cover the cost of the plant and equipment. Established companies may be able to raise long term debt as a debenture or convertible loan stock which normally receives a fixed rate of interest and is repayable in full at the end of the term. Debentures sometimes carry options to turn them into shares. Long term debt is usually included with the capital on the balance sheet, whereas short term debt, and especially overdrafts, are treated as current liabilities.
Most banks look for a gearing of about one to one. The gearing is the proportion of debt to total finance; the higher the gearing, the more debt there is relative to equity. Once your business starts to grow, therefore, it will be essential to introduce more money as equity or else retain substantial profits in the business.
It is often possible for businesses to buy equipment on hire purchase, leasing or lease purchasing. Lease companies will not have the same concerns about gearing as the banks. They will, however, be interested in your cash flow and whether you can afford the repayments. The equipment will remain the property of the leasing company; you have the legal right to use the equipment for the period of the lease, assuming of course, that the lease payments are up to date. At the end of the lease, the equipment reverts to the leasing company, although it is often possible to buy the equipment for a small sum.
4. Grants
There are several sources of grant aid which should be investigated when you are starting in business and, particularly, whenever you are buying equipment. At the least, check with the Department of Trade and Industry locally and with your local authority to see if they have any grants available for which you might qualify.
5. Useful Tips
(i) Regularly calculate the total level of funding required for, say, the next year, split into fixed asset and working capital requirements.
(ii) Determine what level of borrowing is needed.
(iii) Think carefully about the term, the cost, the suitability, the timescale and any security required. Remember that cost should not be the sole criterion.
(iv) Keep your lenders informed of your financial position; giving ample warning if you wish to increase your overdraft, for example.
(v) In times of recession, try to keep as much of your debt as possible as fixed medium term loans and keep your overdraft requirement to the minimum. In times of expansion, when finance is more readily available, it may be more cost effective to use an overdraft.
©