2.1 RAISING FINANCE

FINANCE 

WHAT IS FINANCE?

FINANCE = MONEY

SOURCES OF FINANCE = WHERE we get finance from

WHY DO BUSINESSES NEED FINANCE?

• For starting up a business
• Everyday bill payments

• Expansion
• Internal Growth

• Replacement of Machinery/Equipment
• Take over bid

WHY DO BUSINESSES NEED FINANCE?

STARTING UP - Buildings, machinery, raw materials and office equipment

WORKING CAPITAL - Short term finance required for the day-to-day running of a business

UNFORSEEN EVENTS - Sudden decline in sales, large customer fails to pay on time or pay expenses quickly

THE PURPOSE OF FINANCE

• “Different sources of finance have different implications for a business, so it is important that the most appropriate method of finance is chosen for the purpose that the business has in mind”

SOURCES OF FINANCE can either be

• INTERNAL
• EXTERNAL

INTERNAL SOURCES OF FINANCE - This means finance which is raised internally, it does not increase the debts of the business

EXAMPLES

• Retained profit
• Personal savings
• Sale of unwanted assets
• Sale and leaseback

EXTERNAL SOURCESOF FINANCE - This means finance provided by people or institutions outside the business, creating a debt that will require repayment

EXAMPLES

• Loans
• Overdrafts
• Shares
• Debentures

TIME PERIODS FOR FINANCE

FINANCE IS GENERALLY CONSIDERED TO BE EITHER:

SHORT TERM - up to 3 years

MEDIUM TERM - 3 - 10

LONG TERM - Over 10 years

SHORT-TERM FINANCE is needed for the day-to-day running of a business and is usually for a period of up to 3 years

In order to understand short-term finance it is necessary to understand the concept of CASH FLOW

CASH FLOW

A business needs sufficient inflows of cash to finance its day-to-day outgoings

INFLOWS refers to money recieved by the business

EXAMPLES

• Sales Revenue
• Capital
• Loans
• Grants

OUTFLOWS refers to money paid out by the business

EXAMPLES

• Purchases
• Rent & Rates
• Wages & Salaries

WHY IS CASH FLOW IMPORTANT?

Think of a business as a bath without a plug..

• There should be cash available - so the bath is never empty

• If the bath is ever empty the business is in TROUBLE - it has a CASH FLOW PROBLEM

• If this is not the case the business needs short-term finance to overcome this problem

SOURCES OF FINANCE

• Sources of finance are the options available to a business when seeking to raise funds to support future business actions

• For a start-up business this might be raising sufficient capital to establish the business

• For an established business this might be to fund growth or implement a new strategy e.g. relocation

• Sources of finance can be:

OWNER'S CAPITAL: PERSONAL SAVINGS

• When an entrepreneur invests their own money in a business e.g. from personal savings

• Owner’s capital is how much the owner has invested in the business

• Owner’s capital shows the proportion of the business’ assets that are owned by the business owner rather than creditors

• Assets are items owned by the business e.g. stock is a current asset that will stay in the business for less than a year and vehicles are long term assets

• Creditors are people who the business owes money to e.g. the bank

OWNER'S CAPITAL: PERSONAL SAVINGS

• The benefits are:

• However:

RETAINED PROFIT

• Profit kept within a business from profit for the year to help finance future activities

ADVANTAGES

• Avoids interest repayments

• Does not dilute the business ownership

DISADVANTAGES

• Only an option if sufficient retained profit exists within the business

• May cause shareholder dissatisfaction if this is at the expense of dividend payments

• Reduces the security blanket of keeping retained profits for unforeseen situations or to take advantage of new opportunities

SALE OF ASSETS

• Assets are items of value owned by a business

• Current assets are items owned that will change in value in the short run (within one year)

• Stock for example is being bought and sold on a regular basis

• Sale of assets refers more to the sale of a long term or fixed assets

• Fixed assets will stay in the business for more than a year e.g. machinery and vehicles

• These assets can be sold in order to get an immediate injection of cash in to a business and thereby provide finance

SALES OF ASSETS

• The benefits are:

• However:

EXTERNAL FINANCE                                                                                                External finance is capital raised from outside of the business

A SOURCE OF FINANCE IS WHERE THE FINANCE IS COMING FROM i.e. the provider

• Family and friends
• Banks
• Peer-to-peer funding
• Business angels
• Crowd funding
• Other businesses

A METHOD OF FINANCE IS HOW THE FINANCE IS PROVIDED

• Loans
• Share capital
• Venture capital
• Overdrafts
• Leasing
• Trade credit
• Grants

SOURCES OF FINANCE

• Family and friends

• Investment from people known to the entrepreneur

• Amount may be limited

• Repayment terms and conditions may be flexible

• May place pressure on relationships

• Banks

• Financial institutions that are licenced to take deposits, pay interest, make loans and act as an intermediary in financial transactions, as well as provide other financial services to their customers

• Banks will have departments and employees who specialise in business banking including offering advice on topics such as methods of finance and business planning

SOURCES OF FINANCE

• Peer-to-peer funding (P2P)

• Borrowers are given a credit rating

• Normally an unsecured personal loan although on some occasions collateral may be offered

• Cuts out the use of traditional intermediaries e.g. banks

• Lending is done online

• Lenders decide who they want to lend to then compete to win the lending opportunity in a reverse auction i.e. the lender willing to offer the lowest interest rate wins

• The lenders motive is profit

SOURCES OF FINANCE

• Business angels

• Can be seen as high risk as the business is not established but angels will assess the potential for reward

• The entrepreneur will need to demonstrate a good understanding of their business model and present a detailed business plan in order to secure the investment

• Business angels may also offer support and expertise

• Some business angels form groups to share research and make joint investments

SOURCES OF FINANCE

• Crowdfunding

• The business uses the internet to explain how much money is required, how it will be used and the exit strategy stating predicted return on the investment

• The investor is only tied into their promised contribution if the total amount is raised

SOURCES OF FINANCE

• Other business

• This may be with a view to higher potential returns than the business is receiving with cash sat in the bank

• This is particularly true at present with low interest rates

• Alternatively this may be to support another business

• Set up a subsidiary business

• Support a supplier

• Support a customer

METHODS OF FINANCE

• Loan

• A set amount of money provided for a specific purpose, to be repaid with interest, over a set period of time

• May be secured against an asset and if there is a default on repayments the asset can be taken

• Financial institutions can vary interest rates depending upon the amount of risk placed on the loan

• An external source of finance generally considered to be more suitable for longer-term projects

• However this will depend upon the size of the loan and the repayment period

LOANS

ADVANTAGES

• Quick and easy to secure

• Fixed interest rates allow firms to budget

• Improved cash flow

• The borrower retains ownership of the company

DISADVANTAGES

• Interest must be paid regardless of financial performance

• A firm that is highly geared i.e. has a high proportion of capital raised through debt, may be seen as high risk

• Often more expensive than other forms of finance

METHODS OF FINANCE - SHARE CAPITAL

• Finance raised from the sale of shares

• This is a form of equity capital i.e. the shareholder becomes a part owner of the business

• Shareholders will be rewarded for their investment by the payment of dividends but may also benefit from an increase in share price increasing the value of their shares

• Only an option for incorporated businesses i.e. Ltds and Plcs

• Issuing shares is a complex and costly process so only really an option for raising large amounts of finance to fund long term projects

SHARE CAPITAL

ADVANTAGES

• Only need to pay dividends if a profits is being made and the amount of dividend is not fixed

• Possible to raise large amounts of finance

• No intrest repayments

DISADVANTAGES

• Loss of ownerships as shareholders are part owners

• Potential risk of loss of control for a Plc with a threat of hostile takeovers

• Complex and costly process of issuing shares, especially for Plc

METHODS OF FINANCE - VENTURE CAPITAL

• Investment from an established business into another business in return for a percentage equity in the business

• Also known as private equity finance

• Venture capitalists will normally look for a high rate of return in a specific time period

• The business or entrepreneur may also benefit from expertise and mentoring from the venture capitalist

• Often associated with high risk start-ups

VENTURE CAPITAL

ADVANTAGES

• Potential for large sums of money for investment
• Expertise to help the business

• Makes it easier to attract other sources of finance
• Provides the required capital for expansion

DISADVANTAGES

• A long and complex process
• Expert financial projections are likely to be required

• Initially expensive for the firm e.g. legal and accounting fees

• Partial loss of ownership
• Risk of conflict or percieved interference

METHODS OF FINANACE - OVERDRAFTS

• An overdraft is the facility to overspend on a current account up to an agreed sum

• The business in effect can withdraw money from the account that is not there meaning they go overdrawn or in the red

• Interest is charged on the overdrawn amount

• This is a good short-term source of finance

• An external source of finance provided by banks and building societies

ADVANTAGES

• Only borrowed when required allowing flexibility
• Quick and easy to arrange

DISADVANTAGES

• The bank can call it in at any time
• Only available from a current bank account

METHODS OF FINANCE - LEASING

• Leasing allows a business to benefit from the use of an asset without owning it or buying it outright

• The business pays a set amount in instalments to lease the asset for a pre determined period of time

• The asset remains the property of the leasing company and at the end of the time period the asset is returned to the lease company and the business stops making the payments

• Avoids the need to finance the asset but may be more costly in the long run

• However the lease company is responsible for any repairs and maintenance

• At the end of the lease period the business may start a new lease agreement for the latest model e.g. new spec photocopier!

METHODS OF FINANCE - GRANTS

• Grants are fixed amounts of capital provided to business by the government or other organisations to fund specific projects

• Often conditions are attached to the grants for example:

LIMITED AND UNLIMITED LIABILITY

• Limited liability

• An investor’s liability/financial commitment is limited to the total amount invested or promised in share capital

• An investor’s personal belongings beyond this venture are protected

• Unlimited liability

• The owners of a business are responsible for the total amount of debt of the business

• The owner may lose their personal belongings, e.g. home and cars, if the value of these is needed to cover the debts of the business

LIMITED AND UNLIMITED LIABILITY

• Unlimited liability is seen as high risk

• Sole trader
• a person who is the exclusive owner of a business, entitled to keep all profits after tax has been paid but liable for all losses.
• Partnership
• A legal form of business operation between two or more individuals who share management and profits. 
• Private limited company
• A type of company that offers limited liability, or legal protection for its shareholders but that places certain restrictions on its ownership. ... shareholders cannot offer their shares to the general public over a stock exchange
• Public limited company
• A company whose securities are traded on a stock exchange and can be bought and sold by anyone. ... Also called publicly held company. 

CREATING AND SETTING UP A BUSINESS

• A business plan is an important part of setting up a business

• A business plan will be used both internally by the entrepreneur and externally by banks, external investors or those willing to provide grants

• The contents of a business plan include:

CREATING AND SETTING UP A BUSINESS

What is the purpose of a business plan?

• To secure external funding

• banks, potential partners, venture capitalists, business angels

• To ensure that the firm develops a healthy financial structure

• To help identify problem areas that the business might face

• As a focus to set targets and check on the firms development

• To provide realistic expectations of what can be achieved

• specific, measurable, achievable, realistic and time-based (SMART)

RELEVANCE OF A BUSINESS PLAN IN OBTAINING FINANCE

• When raising finance a business plan acts as a sales document or brochure for the business telling potential investors how and why the business will succeed, which is also how and why it will be able to repay loans or reward equity investors e.g. pay dividends

• The business plan will:
  • Show that the entrepreneur is well organised and has logically worked through all the issues related to the start-up
  • Give clear objectives that the entrepreneur will work towards
  • Evidence the research to support sales and financial forecasts

• Provide detailed financial forecasts including:

• Cash - flow forecasts

• Budgets

• Forecast financial documents

CASH FLOWS INTO A BUSINESS

• Cash sales
• Payment from debtors
• Owners' capital invested 
• Sale of assets
• Bank loan

CASH FLOWS OUT OF A BUSINESS

• Purchasing stock
• Paying wages
• Paying debts - bank loans, creditors
• Purchasing assets

Cash-flow is interested in the balance between these cash inflows and cash outflows in terms if their relative size and timings

THE NATURE OF CASH FLOW

• Cash flow is important to a business as it needs to ensure a positive cash balance in order to be able to meet day to day expenses

• A cash flow forecast is a forward looking statement that tries to predict cash inflows and outflows in the future

• Cash flow forecasts are an important part of a business plan

• A cash flow statement is a backward looking statement that shows what happened to cash inflows and outflows

• Cash flow statements are normally presented as a part of a business’ accounts

• A potentially profitable business may fail because it has cash flow problems

• Net cash flow
  • The net result of cash inflows and cash outflows each month

• Net cash flow = cash inflows – cash outflows

• Opening balance
  • How much the business has at the start of each month

• For a new business in month 1 this will be 0

• The closing balance for one month becomes the opening balance for the next

• Closing balance
  • How much the business has at the end of each month

FACTORS AFFECTING CASH-FLOW

• Transaction types
  • Sales
    • cash v. credit

• Timings of cash flows
  • Seasonal sales
    • e.g. strawberry farm

• Nature of business
  • Start-up capital and costs
  • Time taken from input to output
  • Stock holdings

TIMINGS OF CASH INFLOWS AND OUTFLOWS

• Cash inflows

• If cash inflows are slow this may cause cash flow problems

• A firm may try to speed up cash inflows

• This may include offering a discount for early payment or penalties for late payments

• Businesses may need to chase customers for payment i.e. credit control

• When a business is owed money from customers these are referred to as receivables

• The business is still to receive the payment

CASH FLOW PROBLEMS

• Businesses need to have sufficient cash to meet day to day finances

• Insufficient liquid cash funds may mean an inability to meet short term debts

• Limited cash may result in missed opportunities

• A key consideration should be whether the cash flow problem is short term or long term

• A firm may be able to survive short term cash flow problems

• Long term cash flow problems may be insurmountable

CAUSES OF CASH FLOW PROBLEMS

• Credit sales
  • Long payment terms
  • Poor credit control

• Overtrading
  • Additional overhead and day to day expenses
  • Increased capital expenditure

• Internal management
  • Stock control
  • Relationship with suppliers
  • Poor or inaccurate planning

• Seasonality
  • Unexpected events

IMPROVING CASH FLOW

• Increasing the volume of the inflow of cash
• Speeding up the timing of the inflow of cash

• Inflows

• Reducing the volume of the outflow of cash
• Slowing down the timing of the outflow of cash

• Outflows

THE USE OF CASH-FLOW FORECASTS

• To identify the timing and significance of any potential shortfalls

• To identify possible corrective action

• To help secure finance from potential investors or the bank

• To give confidence about short term survival

• To provide a guide against which to measure actual cash flow

THE LIMITATIONS OF CASH-FLOW FORECASTS

• Based on predicted future inflows and outflows therefore may be inaccurate

• Informed by market research but this may be small scale, biased or flawed

• Affected by the external environment which is outside of the entrepreneur’s control e.g. interest rates change, a supplier goes out of business, a new competitor opens

• Demand may be over (or under) estimated