3.5.3 Making financial decisions: sources of finance

Starting up: new businesses need money to invest in LT assets eg buildings + equipment. Also need cash to purchase materials, pay wages + pay bills eg water + electricity. Inexperienced entrepreneurs underestimate capital needed for day-to-day running of business. Generally, for every £1,000 needed to establish business, £1,000 needed for day-to-day needs.

Growing: once established, income from sales. If greater than operating costs -> profits. Should be kept in business + used to help finance growth. Later, owners can draw money out, but as much as poss should be left in at this stage. May not be enough to allow growth as fast as would like to. May need to find additional finance - probably from external sources eg bank loans.

Other situations - eg cash flow problem. Major customer may refuse to pay for goods -> gap in cash indlows. Larger order, requiring purchase of additional raw materials. Need to find additional funding.

Comes from w/in business + resources. Most important - profit. Will start accumulating in company bank acc, typically be spent eg on buying new machinery, launching advertising campaign in new country etc. Soothes difficult cash situation. Best + most common way to finance investment into firm's future. Research - over 60% business investment from reinvested profit.

Company's working capital - cash spent on building inventory + in credit provided to customers. If investment can be cut, cash generated. Lot of potential finance generated from w/in business.

Loan capital: most usualy way through borrowing from bank. May be in form of bank loan or overdraft. Usually for set period of time. May be ST (1 or 2 years); medium term (3-5 years), or LT (5+ years). Can be repaid in instalments or at end of loan period. Bank charges interest on loan - can be fixed or variable. Bank will demand collateral to provide security in case loan can't be repaid. Overdraft ST. Facility allows business to be 'overdrawn' - account allowed to 'go into red'. Length of time runs for negotiated. Interest charges higher than loans, but only apply to actual debts instead of facility itself. For firms using overdraft as way of smoothing ST cash variations, interest payments can be small.

Share capital: Alternative to debt, if busines ltd, may look for additional share capital - should come from private investors or venture capital funds. Venture capital providers interested in investing in business w/ dynamic growth prospects. Willing to take risk on business may fail or do well. Believe if make 10 investments, 5 can flop, 4 do 'ok', as long as one is really successful.

Retained (reinvested) profit:
 + doesn't have associated cost
 + doesn't have to be repaid, no interest charges (unlike loans).
 - May be too little profit to allow business to grow to full capability.

Cash squeezed out of day-to-day finances: eg by cutting stocks, delaying payments to suppliers + chasing up customers.
 + reduces amount needs to be borrowed.
 - very ST solution
 - if cash taken from day-to-day capital for purpose eg buying LT assets, firm may find itself short of cash flow.

Debt factoring: a way of squeezing capital from day-to-day finances. Compnay that sells goods on credit can arrange that its bank take over invoicing, giving seller 80% value of sale immediately, then collecting payment from customer. Having taken own commision, bank then hands over remaining sum to seller. Seller has most of cash immediately to help business, doesn't have to chase payment from customer. Receives 96% value of sale - bank does legwork, but keeps around 4% profit for themselves.

Bank overdrafts: most common form of borrowing for small businesses. Allows firm to overdraw up to agreed level.
 + firm only has to borrow when + as much as it needs
 - expensive, bank can insist on being repaid w/in 24 hours
Trade credit: simplest form. Business obtains goods/services from another business, but doesn't pay immediately. Average credit period - 2 months.
 + good way if boosting day-to-day finance
 - other businesses may be reluctant to trade if do not get paid in good time
Bank loan: usually for period of 2-5 years - medium term finance.
 + good form of finance for new, growing business as no need to repay until contract says so - usually at end of period.
Venture capital: way of getting outside investment if unable to raise finance through stock markets or loans. Venture capitalists invest in smaller, riskier companies - to compensate for risk, usually require substantial part of ownership of company + want to contribute to running. Dilutes owner's control, brings new exp + knowledge. Modern version is 'crowdfunding' - a way of getting small investors to put money into new business. Works via internet + most effectively when sponsors use social media to promote. 

Businesses need sufficient acces to finance to meet current + future needs. Major issue for new firms + for those rapidly expanding. When expands w/o sufficient finance - 'overtrading'. Key to match finance to use. 

ST finance usually considered to be for <1 year, MT 1-5 years, LT 5+ years. ST finance shouldn't be used to finance LT projects eg overdrafts - puts continual pressure on cash position. Overdraft should only be used to cope w/ ups + downs in cash flow. Growth is LT activity appropriate LT finance should be used to fund it.

Another key aspect of appropriate finance - businesses should find right balance b/ween 'equity' + debt. Equity - share capital, which is safe + stable, as shareholders don't need to be paid a dividend if times tough. Debt-based finance eg overdraft/loan more risky. Even when business poor, bank expects to be paid interest on load, plus - w/ overdraft - bank may demand overdraft repaid immediately.