Section E of Financial Management syllabus deals with business finance: What types of finance? What sources? What mix?
The article will first consider a business’s formation and initial growth, then a company that is well-established and mature, and will look at the financing choices and decisions that could face it at various stages.
Formation and initial growth
Many businesses begin with finance contributed by their owners and owners’ families. If they start as unincorporated businesses, the distinction between owners’ capital and owners’ loans is almost irrelevant. If it starts as an incorporated business, or turns into one, then there are important differences between share capital and loans. Share capital is more or less permanent and can give suppliers and lenders some confidence that the owners are being serious and are willing to risk significant resources. If the owners’ friends and families do not themselves want to invest (perhaps they have no money to invest) then the owners will have to look for outside sources of capital. The main sources are:
- bank loans and overdrafts
- leasing/hire purchase
- trade credit
- government grants, loans and guarantees
- venture capitalists and business angels
- invoice discounting and factoring
- retained profits.
Bank loans and overdrafts
In the current economic climate, start-up businesses are likely to find it difficult to raise a bank loan, particularly if the business and its owners have no track record at all. Banks will certainly require:
- A business plan, including cash flow forecasts.
- Personal guarantees and charges on personal assets.
The personal guarantees and charges on personal assets get round the company’s limited liability which would otherwise mean that if the company failed, the bank might be left with nothing. This way the bank can ask the guarantors to pay back the loans personally, or the bank can seize the charged assets that were used for security.
Note that overdrafts are repayable on demand and many banks have a reputation of pre-emptively withdrawing overdraft facilities, not when a business is in trouble, but when the bank fears more difficult times ahead.
On a more positive note, where it is known that the need for finance is temporary, an overdraft might be very suitable because it can be repaid by the borrower at any time.
Leasing and hire purchase
In financial terms, leasing is very like a bank loan. Instead of receiving cash from the loan, spending it on buying an asset and then repaying the loan, the leasing company buys the asset, makes it available to the lessee and charges the lessee a monthly amount. Leasing can often be cheaper than borrowing because:
- Large leasing companies have great bargaining power with suppliers so the asset costs them less than it would cost the lessee. This can be partially passed on to the leasee.
- Leasing companies have effective ways of disposing of old assets, but lessees normally do not.
- If the lease payments are not made, the leasing company has a form of built- in security insofar as it can reclaim its asset.
- The cost of finance to a large, established leasing company is likely to be lower than the cost to a start-up company.
It is important for businesses to try to decide whether loan finance or a lease would be cheaper. (This is a separate topic in the Financial Management syllabus, but it is not covered in this article.)
This simply means taking credit from suppliers – typically 30 days. That is obviously a very short period, but it can be very helpful to new businesses. Typically, credit suppliers to new businesses will want some sort of reference, either from a bank or from other suppliers (trade references). However, some will be prepared to offer modest credit initially without references, and as trust grows this can be increased.
Government grants, loans and guarantees
Governments often encourage the formation of new businesses and, from time to time and from region to region, help is offered. Government grants are usually very small, and direct loans are rare because governments see loan provision as the job of financial institutions.
Currently in the UK, the Government runs the Enterprise Finance Guarantee Scheme (EFGS). This is a loan guarantee scheme intended to facilitate additional bank lending to viable small and medium-sized entities (SMEs) with insufficient security for a normal commercial loan. The borrower must be able to demonstrate to the lender that they should be able to repay the loan in full. The Government provides the lender with a guarantee for which the borrower pays a premium.
The scheme is not a mechanism through which businesses or their owners can choose to withhold the security a lender would normally lend against; nor is it intended to facilitate lending to businesses which are not viable and that banks have declined to lend to on that basis.
EFGS supports lending to viable businesses with an annual turnover of up to £25m seeking loans of between £1,000 and £1m.
Venture capitalists and business angels
These are either companies (usually known as venture capitalists) or wealthy individuals (business angels) who are prepared to invest in new or young businesses. They provide equity (private equity as opposed to public equity in listed companies), not loans. The equity is not normally secured on any assets and the private equity firm faces the risk of losses just like the other shareholders. Because of the high risk associated with start-up equity, private equity suppliers typically look for returns on their investment in the order of 30% pa. The overall return takes into account capital redemptions (for example preference shares being redeemed at a premium), possible capital gains on exiting their investment (for example through sale of shares to a private buyer or after listing the company on a stock exchange), and income through fees and dividends.
Typically, venture capitalists will require 25%–49% of the equity and a seat on the board so that their investment can be monitored and advice given. However, the investors do not seek to take over management of their investment.
Invoice discounting and factoring
Before these methods can be used turnover usually has to be in the region of at least $200,000. Amounts due from customers, as evidenced by invoices, are advanced to the company. Typically 80% of an invoice will be paid within 24 hours. In addition to this service, factors also look after the administration of the company’s receivables ledger.
Fees are charged on advancing the cash (roughly at overdraft interest rates), and also factors will charge about 1% of turnover for running the receivables ledger (the exact amount depends on how many invoices and customers there are). Credit insurance can be taken out for an additional fee. Unless that is taken out the invoicing company remains liable for any bad debts.
Retained profits are no good for start-ups, and often no good for the first few years of a business’s life when only losses or very modest profits are made. However, assuming the business is successful, profits should be made and retaining those in the business can allow the company to repay debt capital and to invest in expansion.
How much capital is needed?
Capital is needed:
- for investment in non-current assets
- to sustain the company through initial loss-making periods
- for investment in current assets.
Cash-flow forecasts are an essential tool in planning capital needs. Typically, suppliers of capital will want forecasts for three to five years. One of the biggest dangers facing new successful businesses is overtrading, where they try to do too much with too little capital. Most businesses know that capital will be needed to finance non-current assets, but many overlook that finance is also needed for current assets.
Look at this example: