Financing a business:

Business finance

When starting up a business, the purpose of finance is to fund the Fixed Assets (Premises, Land, Machinery, Vehicles) and the Fixed costs of the business (i.e. the overheads – electricity, rent, water, wages) as well as the Working Capital needs (cash. credit, cash at the bank, petty cash,) of the business.  To achieve this objective, various documents and plans will be required to outline the purpose of the business, projected turnover and profits, a break even analysis, a projected balance sheet and trading profit and loss accounts,  cash flow forecasts and a business plan.  The business plan covers such aspects as the business idea, the market to be penetrated, the people involved and what they’ll be doing, competitor analysis (including marketing and advertising), sales and pricing, location of the premises, the equipment required and setting up costs, overheads and a break even analysis.

These pages outline the business idea, the projected turnover (which should be estimated since no true figures are available other than from similar trades, therefore extensive market research will need to be undertaken), profit margins expected to be received from the sale of the goods less the overheads, anticipated cash inflow and outflow, any fixed/current assets and the liabilities of the business which in turn help prospective lenders to decide the viability of the venture and whether to risk investment.  Much of this will form the overall business plan, giving the lenders a guide to the knowledge of  the owner and feasibility of business before they go ahead and lend any capital.

 Investment and loans can be approached in the following manner. Firstly the internal funds available should be exhausted as this is the cheapest method available, next the business should look externally to the Banks, Building Societies and Finance Houses etc., for the cheapest method on offer which matches their individual requirements and the term needed to repay the money borrowed.   Such publications as The Financial Times, Moneyfacts and Business Moneyfacts provide a useful source of information on most financial institutions and is published monthly as well as Teletext on Channel 4 which offers share prices and bank interest rates on their business pages

 
It is often necessary to plan finance by selecting a mixture of short and long term debt, and to compare the cost of each source available as these can vary immensely.  However, problems can arise due to the lack of support towards new businesses from many external sources who view them as a far greater risk than an established business and therefore will require collateral and security.  With young people just starting out, this will often involve a guarantor (e.g. a parent) who will be held liable should the individual default the loan.  Collateral can be found in various forms,  although generally premises, property (i.e. machinery, vehicles etc), or at the extreme even the actual business will be repossessed to clear outstanding debts.  The main sources of finance available to private sector new businesses such as Sole Traders, Partnerships, Limited Companies and PLC’s are as follows-  

Short term Capital (Working Capital) Trade Credit -

A good source of finance for all business types, if available, offering deferred payment arrangement from a businesses creditors (typically 1 – 2 months), with the main purpose of allowing the business to sell the product before paying for the goods, therefore supplying an important source of short term finance. It can be very difficult for new businesses to obtain immediate credit, therefore paying cash on delivery would be standard practice for a few months until you establish your credit worthiness.  

Overdraft -

A very useful short term source of finance and the bank  holding the current account may be able to link an overdraft to the existing account. The bank is more likely to approve of such funding when the projected cash flow and capital is recognised as healthy.  It has to be accepted however that the bank can call in the overdraft and demand payment within 24 hours. Interest is charged at a rate related to the base rate of interest, on outstanding balances and are often provided on an indefinite basis with the sole purpose of providing the borrower with a continuous line of credit mainly to finance working capital needs.  This facility is available to all types of business from Sole Traders to PLC’s, although the amount of finance available will vary immensely, depending on the size of the business and its financial needs/resources as well as the ability to repay on demand.  Credit Cards - These are methods of finance available mainly to Sole Traders and Partnerships as a short term means of raising capital for up to 2 months interest free credit as well as the added bonus of carrying insurance on most purchases over £50.  

Owners Capital -

Working capital is needed for the day to day running costs of the business including wages, advertising costs, heat, electricity and other costs encountered.  In a Sole Trader or Partnership finance is usually provided by the owners from their own funds.  It may also be found from additional owners cash from the business or from internal sources within limited companies and plc’s(cash management).

Friends and family -

Partnerships and Sole Traders can approach family and friends initially to invest in the start up of the business, offering attractive returns in exchange for supporting and risking capital in the new business idea.  

Factoring -

Only certain types of business are suited to factoring (it is suitable for all private sector businesses) although retail is not suitable.  Generally the business needs to be a medium sized company with only a small amount of customers. A factoring company manages your sale ledger, advancing up to 80% of the monthly invoiced sales.  The advantage that there are almost no debtors to be financed, since the factor looks after the collection of debts.  

Invoice discounting -

A related service whereby sales invoices are sold at a discount to a discount house.  The main difference between factoring and invoice discounting is that the latter does not involve managing the sales ledger.  

Bill Finance - 

This is a short term method of raising finance whereby funds are given by the financier on the understanding that the debt will be paid on the due date (either 30/60/90 days) , this is usually issued by a financial institution and is available to all 4 types of business.

Medium Term Credit (3—5 years):

Equipment Leasing -

If this facility is available then it is worth pursuing, but most leasing companies are extremely dubious about dealing with businesses that have been trading for less than 3 years. The leasing of such items as vehicles and computers could prove to be a good decision, since this covers the servicing of the items as well as being able to update the items when necessary, these items depreciate in value at extraordinary rates therefore the leasing could prove more cost effective.   There are many finance houses that would supply products on lease, subject to status of the company.  Leasing can benefit many different businesses from one car for a Sole Trader/Partnership to a fleet for the Sales Representatives within a PLC or Limited Company. 

 Term loan -

A loan for a fixed term at a fixed rate usually for a medium period of time (approximately 3 – 5 years) is another option for all businesses however especially appealing to sole traders and partnerships since overdrafts can be risky for the fear of being recalled.

 HP (Hire Purchase) -

The finance houses and leasing companies offer hire purchase but it can be an expensive way of funding purchases unless interest free credit is an option, with the interest rates being around 29.9% APR.  Non payment will lead to the item being repossessed and it must be stressed that the term of the loan should not exceed the expected life of the equipment being bought.   This method is available to all private sector companies.

 Corporate investors -

Larger businesses may invest in smaller ones.  This may mean a take-over or a partnership and would generally apply to sole traders, partnerships and limited companies.  Larger companies solely invest for commercial reasons but there are funds run by large companies who have other investment criteria, such as creating jobs in areas where the company has made redundancies.  Such publications as Acquisitions Monthly would be a worthwhile offer some information.

Long Term Credit (over 5 years):

For the funding of Fixed Assets:

 Commercial Mortgage -

This is available to all 4 types of business within the private sector. It is a form of credit extended for a specified period on either fixed terms or more usually variable interest rates, payable by regular instalments. Commercial mortgages are supplied by most lenders (i.e. Banks and Insurance Companies). 

 With the majority of Commercial Mortgages the amount allowed to be borrowed varies from 50% – 100%, with 70% being the mode.  There is a whole range of suppliers who offer such mortgages (over 64), with the minimum advance being around £15000 and the maximum £50m.  The interest rates vary generally between 5.5 -7.45% and the term from 1 month to 30 years although most lenders opt for 25 years.  The deeds remain with the building society or Bank as collateral security (against default on the loan) and when it is paid in full they are transferred to mortgagor who then becomes the legal owner.

 Loans -

Will be available to all 4 types of business, however the Sole Trader and Partnership will often find it more difficult to arrange financing and will certainly be required to provide some sort of security.  Most banks do offer business start up loans and the interest rate is fixed with the term ranging from 1 – 10 years, interest rates will be lower if the loan is secured, against property, land, premises, cash, personal assets or the business, with a new business it will prove almost impossible to raise a loan without security.  Where no security or proven track record  is available, Loan Guarantee Schemes are offered by several banks which is a Government-guaranteed loan may be on offer.

 Shares -

For Limited Company’s and PLC’S, shares are an option (for limited company’s funds are raised through  family and friends), whereas within a plc shares are issued on the stock market to the general public.  Sometimes referred to as a rights issue when existing shareholders are given preferential purchase opportunities.  Ordinary shares are the most important and are issued by all limited companies. Sometimes known as equity as each share entitles the owner to an equal share of the profits of the company.  Deferred, Preference and Directors shares also get issued.

 Venture Capital -

The main purpose being to lend out risk or venture capital to entrepreneurs who can convince the company (lender) that a particular venture is likely to return  on a capital investment. This carries an appropriate degree of risk and in return may levy around 70 – 80% interest per annum.  It is subscribed mainly in the form of share capital and loan  capital to finance new firms and activities considered to be of an especially risky nature, hence being unable to attract finance from the more conventional sources.  Special institutions cover this sector of the market including, 3i and venture capital arms of the Commercial Banks and Merchant Banks.  There are few who will consider amounts below £100,000, hence will generally apply to medium sized businesses (Partnerships and Sole Traders wishing to become a Partnership).

 Business Angels -

In addition to friends, family relatives, and business associates, angel networks can provide access to prospective investors who are likely to become involved in private financing (i.e. supplying capital for start-ups).   Entities that become involved in angel networks include businesses, academic institutions, government agencies, economic development authorities, and profit making organisations.  The viability of the venture will be the determining factor although would appeal more to medium -sized organisations which usually would include larger Partnerships and Sole Traders.

 Debentures -

All for types of private sector organisations can issue debentures.  These are not shares, since debenture holders do not share in the ownership of the company.  Debentures are simply loans to the company on which a fixed rate of interest is paid before preference or ordinary shareholders receive anything.  They are normally secured against some property owned by the firm.  If the company fails, the agreed property must be sold and the proceeds used to repay the debenture holders. The purpose of debentures are to fund long term investments for fixed assets (i.e. a loan) which has secured repayments. 

 Grants -

There are various grants available to all businesses depending on the size, age of the owner and many other varying factors. They are available from public or voluntary sector services and normally not repayable, do not attract interest payments and thus constitute the cheapest form of finance.  Consequently they are not easy to obtain.  Grant making authorities are likely to apply special criteria although in general it may be necessary to show  that the business is unable to raise capital having tried the other sources.  The major sources being Borough Councils and local enterprise agencies, European Community Grants and the Princes Trust and the Craft Council as well as Government Departments.

 If you qualify for a grant it is a good method since you do not have to repay grants.  Although it is seen as a cheap method of finance, there may be conditions attached (i.e. number of employees, location, age etc.,) limiting the eligibility of many businesses.  Grants would normally be available to all 4 types of business provided they match the necessary criteria.

 Sale & Lease back -

Funds could be raised by this method for each of the 4 business types, if one of their properties is a viable proposition for an insurance company or an organisation specialising in the restoration of old buildings.