Reasons for requiring funds

• Businesses need finance for two main reasons:

• Working capital finance
– to purchase stock
– to finance other working capital items
– this is known as revenue expenditure
• Fixed asset finance
– to finance capital investment
– to finance R&D
– to pay off debts
– to finance exports
– to deal with unexpected problems.
– This is known as capital expenditure
 Revenue expenditure
• Revenue expenditure is payment for a current year’s
goods and services
• It is expenditure incurred in the day to day running of
a business
• It is used to pay for day to day running costs
• It covers the cost of fuel, components, raw materials,
labour costs
• These are items that will be used up in the short run
• This expenditure is charged to the profit and loss
account - i.e. it is a negative item on the P&L Account
 Capital expenditure
• Capital expenditure is a payment to purchase an
asset with a long life
• Expenditure to acquire fixed assets which will be
used over a long period of time: property, vehicles
and production equipment
• These items appear as fixed assets on the balance
sheet
• In any one year the value shown in the balance sheet
is historical cost less accumulated depreciation
• Annual depreciation is shown as a negative item on
the profit and loss account
 Sources of finance
• Internal • Short term-up to one
– generated from within year
the business by its – working capital
operations – investment in short lived
• External equipment
– secured from outside • Medium term-1-5 years
the business – purchase of assets with
a medium term life
• Long term- 5 years +
– purchase of long term
assets
 Summary of sources
Short term Long term

Internal Controlling working capital Retained profit

Cash management
Debtor management - tighter credit control
Stock management - reduced stock levels
Retained profit
External Overdraft Leasing
Short term loan Share issue
Invoice discounting Long term loans
Debt factoring Sale and leaseback
Trade credit Debentures
Hire purchase Venture capital
Leasing rather than buying Government grants and
Sale of assets loans
Sale and lease back
 Factors affecting the ability to raise finance

• The track record of the business seeking

finance
• Market expectations
• Gearing - existing interest commitments
• Relationship with providers of finance
• The security available to guarantee a loan
• The purpose for which it needs the finance
Factors in the choice of finance (1)
• The type of business
– legal status: sole trader, partnership, private company, public company
• Size of the business
– some sources of finance are only available to large companies
• The stage of business development
– the age and history of the business
• Objectives of the owner
– does the owner seek growth or just a satisfactory return
– is it an entrepreneurial or a proprietorial business?
– the extent to which owners wish to retain control
– share issues or taking on partners will weaken the founder’s control of
the business
Factors in the choice of finance (2)
• Current financial position of the business
– willingness of banks and others to lend
• The availability of collateral (assets that could be sold) to
guarantee a loan
– lenders might be unwilling to lend unless the loan is secured. against
assets
• Market conditions
– is the market expanding or depressed?
• The terms of the finance
– rate of interest and schedule for repayment
• Level of gearing and the interest rate commitment
– high gearing (high interest commitments) will be off putting to lender
Questions to be asked before deciding on source

• How much is required?

• What is the finance is needed for?
• How soon is the finance required?
• How long is the finance needed?
• What is the cost of finance?.
• What are the risks involved?
• What are the tax implications?
 The matching principle
• The source of finance should be matched to
its purpose
• Capital investment should be financed by long
term loans or equity
• Working capital should be financed by short
term loans and overdrafts
Sources of short term finance

Sources

Internal External
Overdraft
Working capital
Bank loan
management
Debt factoring
 Trade credit
• Careful management of this and other working capital items
will make available funds for investment
• The purchase of stocks on credit
• Period trade creditors allow for payment varies widely – e.g.
14 -70 days
• It is equivalent to a loan from the supplier and is interest free
• It allows companies to use money for other purposes
• But there are usually discounts for prompt payments
• And failure to pay on time can present problems on future
orders
 Debt factoring
• This involves a firm which has sold goods on credit
selling its debts to another business (a factor)
specialising in collecting debts
• Advantages
– ensures early payment
– reduces uncertainty- the factor takes on bad debts
– reduces need for overdraft
– reduces cost of chasing late payments
• But the factor buys at a discount
• Factors typically pay 80% of the value of debtors and
in addition will charge a fee of 5% of the debt
 Bank overdraft
• This is where the firm’s bank account is permitted to
go into deficit up to an agreed limit
• It allows firms to borrow up to agreed limits without
notification for as long as they wish
• Overdrafts are flexible and easy to obtain
• Overcomes temporary cash flow problems
• Only pay interest on the amount and the time
overdrawn
• Interest charged is 2 - 4% above base rate
• But repayable on demand and as result overdrafts
are treated as current liabilities
 Short term loan
• A short term bank loan from a bank or other
financial institution
• Repayment and interest are formally agreed
• Tend to be more expensive than an overdraft
• Security is often required
• Small businesses often pay higher interest
 Asset sale
• Sale of a fixed asset for cash
• Sale of idle assets is desirable - avoids interest charges
• But crisis sale of needed assets jeopardises the future of the
business
• Sale and leaseback
• Raises cash but allows the firm to continue to use the asset
• Some agreements include maintenance and upgrading
• But the drawback is that it creates a liability for the future
• Asset will no longer be owned and will no longer appears on
the balance sheet
 Long term finance

Sources
of finance

External External
Internal External
Long term Leasing/sale
Retained profits Share issues
borrowing and lease back
 Retained profit
• Re-investment of past profit
• A proportion of profit will be retained rather than distributed
as dividend. This is available to reinvest in the business
• The advantage is that no interest is paid on finance raised in
this way but the opportunity cost in terms of interest
foregone should be taken into account
• Shareholders may resent retention of profits which is at
expense of dividends – if the profit reinvested does not go on
to earn a satisfactory return
• Reliance upon retained profits will mean that expansion will
be slow and limited if profits are low or non-existent
 Example - Marks and Spencer
• The profit and loss account for the year end 2nd April 2005
reports profits attributable to shareholders as £442m
• Out of this M and S paid out dividends totalling £203m
• This meant that £239m was retained to reinvest within the
business
• The balance sheet at 2nd April 2005 records the cumulative
total of retained profits (a reserve shown as transferred from
the P&L Account) as £4,032m
• In effect this means that over the years M and S has withheld
from shareholder a total in excess of £4b-they have done so
in order to finance the expansion of the business
 Share issue
• Selling shares to raise finance
• Shareholders are seen as risk takers and therefore
only receive dividends out of profit
• The company does not have a commitment to
meeting fixed interest payments
• But shareholders have rights of participation
• High administrative cost involved in issuing shares
• Difficult to estimate the market price of shares and,
as share prices rise or fall, a shares issue might not
raise sufficient finance
• Share issue dilutes ownership
 Long/Medium term loan
• From high street banks and specialist finance
companies
• Repaid in instalments
• Makes financial planning easier
• Borrowers will be expected to provide security
(collateral)
• Interest can be fixed or can be variable
• Small businesses often pay high interest rate
 Mortgages
• These are loans secured against property
• Mortgages are used to purchase property - up
to 85% of the value of the property
• Repayment is over 20/25 years
• Flexible interest rates but can be fixed for
medium terms
• Only available for large sums
 Distinguishing features of loan
capital
• Loan capital is repaid
• Interest on loans is a deduction from profits -
not a distribution of profits
• Holders of loan capital do not own the
business
• Most loans will be secured either on general
assets or on a specific asset
• Loan holders have first call on company assets
in the event of liquidation
 Leasing
• A methods of acquiring assets without owning them
• Firms sign a rental agreement with the owners of the asset
• Ownership of the asset remains with the finance company
• Phases the payment over a long time
• It avoids large initial cash outflow but is more expensive over
the long run
• Leasing payments can be offset against tax
• Contract provides for maintenance and allows for upgrading
• As the asset is not owned it will not show up in the firm’s
balance sheet and cannot be used as collateral for future
loans
 Advantages of leasing
• Additional credit is obtained above normal debt capacity
• No capital outlay is required
• Reduces capital tied up in fixed assets
• Availability of certain assets may be possible only through
leasing
• Easier to obtain than a loan since the asset remains the
property of the lessor
• Fixed rentals provide a hedge against inflation
• Fixed contract - unlike an overdraft, a finance lease contract
cannot be withdrawn
• Leasing pays for equipment out of pre-tax expenditure rather
than after tax
• Provides hedge against obsolescence
 Hire purchase
• Purchase of assets by instalment payments
• The business does not own the asset until the final
payment is made
• Finance provided by finance houses
• Unlike leasing ownership is eventually transferred
• The asset acquired without large capital outflow
• Over the long run the asset will cost more than if
purchased outright for cash
 Debentures
• A debenture is in effect a long term loan
• It can be secured against specified assets or
can be unsecured
• Fixed rate of interest and repayable on a
specific date
• Only large companies can issue debentures
 Venture capitalists
• Venture capitalists are specialist providers of risk capital
- they accept some risk as inevitable
• Finance is offered on a medium term basis
• Management support also available
• VCs expect non controlling equity stake of 20-40% in the
firm’s capital as the return for investment
• They require a negotiating charge for arranging the
finance
• VCs usually exit (i.e. sell their investment) in the
medium-term (e.g. 5-10 years)
 Government/EU support
• Private sector firms might enjoy some limited top up
financial assistance in the form of loans grants and
subsidies from the government, the EU and the various
lottery funds
• But these forms of assistance
– tends to be very selective
– are only available if the firm demonstrates that it activities
benefit the community and economy (e.g. investment, job
creation, spin off benefits)
– are usually based on the principle of additionally (additional
to money secure from sources)