Business Finance

WHAT IS FINANCE?
Finance is the money available to spend on business needs. Right from the moment someone thinks of a business idea, there needs to be cash. As the business grows there are inevitably greater calls for more money to finance expansion. The day to day running of the business also needs money. The main reasons a business needs finance are to: START A BUSINESS Depending on the type of business, it will need to finance the purchase of assets, materials and employing people. There will also need to be money to cover the running costs. It may be some time before the business generates enough cash from sales to pay for these costs. Link to cash flow forecasting. FINANCE EXPANSIONS TO PRODUCTION CAPACITY As a business grows, it needs higher capacity and new technology to cut unit costs and keep up with competitors. New technology can be relatively expensive to the business and is seen as a long term investment, because the costs will outweigh the money saved or generated for a considerable period of time. And remember new technology is not just dealing with computer systems, but also new machinery and tools to perform processes quicker, more efficiently and with greater quality. TO DEVELOP AND MARKET NEW PRODUCTS In fast moving markets, where competitors are constantly updating their products, a business needs to spend money on developing and marketing new products e.g. to do marketing research and test new products in pilot markets. These costs are not normally covered by sales of the products for some time (if at all), so money needs to be raised to pay for the research. TO ENTER NEW MARKETS When a business seeks to expand it may look to sell their products into new markets. These can be new geographical areas to sell to (e.g. export markets) or new types of customers. This costs money in terms of research and marketing e.g. advertising campaigns and setting up retail outlets. TAKE-OVER OR ACQUISITION When a business buys another business, it will need to find money to pay for the acquisition (acquisitions involve significant investment). This money will be used to pay owners of the business which is being bought. MOVING TO NEW PREMISES Finance is needed to pay for simple expenses such as the cost of renting of removal vans, through to relocation packages for employees and the installation of machinery. TO PAY FOR THE DAY TO DAY RUNNING OF BUSINESS

Prof. Kashif Saeed

Business Finance
A business has many calls on its cash on a day to day basis, from paying a supplier for raw materials, paying the wages through to buying a new printer cartridge.

A business needs to assess the different types of finance based on the following criteria: AMOUNT OF MONEY REQUIRED a large amount of money is not available through some sources and the other sources of finance may not offer enough flexibility for a smaller amount. HOW QUICKLY THE MONEY IS NEEDED the longer a business can spend trying to raise the money, normally the cheaper it is. However it may need the money very quickly (say if had to pay a big wage bill which if not paid would mean the factory would close down). The business would then have to accept a higher cost. THE CHEAPEST OPTION AVAILABLE the cost of finance is normally measured in terms of the extra money that needs to be paid to secure the initial amount the typical cost is the interest that has to be paid on the borrowed amount. The cheapest form of money to a business comes from its trading profits. THE AMOUNT OF RISK INVOLVED IN THE REASON FOR THE CASH a project which has less chance of leading to a profit is deemed more risky than one that does. Potential sources of finance (especially external sources) take this into account and may not lend money to higher risk business projects; unless there is some sort of guarantee that their money will be returned. THE LENGTH OF TIME OF THE REQUIREMENT FOR FINANCE a good entrepreneur will judge whether the finance needed is for a long-term project or short term and therefore decide what type of finance they wish to use.

CHOOSING THE RIGHT SOURCE OF FINANCE

Internal and External Finance

INTERNAL FINANCE - comes from the trading of the business. Internal finance tends to be the cheapest form of finance since a business does not need to pay interest on the money. However it may not be able to generate the sums of money the business is looking for, especially for larger uses of finance. Examples of internal finance are: Day to day cash from sales to customers. Money loaned from trade suppliers through extended credit. Reductions in the amount of stock held by the business.

Prof. Kashif Saeed

Business Finance
Disposal (sale) of any surplus assets no longer needed (e.g. selling a company car).

EXTERNAL FINANCE- comes from individuals or organizations that do not trade directly with the business e.g. banks. Examples of external finance are: An overdraft from the bank. A loan from a bank or building society. The sale of new shares through a share issue.

Short Term and Long Term Finance SHORT TERM

Finance is needed to cover the day to day running of the business. It will be paid back in a short period of time, so less risky for lenders. The main types of short term finance are: Overdraft Trade Credit Working capital

BANK LOANS AND OVERDRAFTS

A bank overdraft is a limit on borrowing on a bank current account. With an overdraft the amount of borrowing may vary on a daily basis. A bank loan is a fixed amount for a fixed term with regular fixed repayments. The interest on a loan tends to be lower than an overdraft. Example of a loan: A business borrows 12,000 from a bank over 3 years at an interest rate of 5%. The approximate repayments on this loan would be 392 a month for 36 months (14,112). A fixed term means how many months or years before the loan has to be repaid in full. Normally a fixed term loan will be for a greater amount than an overdraft.

Prof. Kashif Saeed

Business Finance

TRADE CREDIT
A business does not always have to pay their bills as soon as they receive them. They are given period of credit, normally around 3060 days. By trying to extend this period they can improve their short term finance position. Small businesses now have some protection under law that prevents larger firms exploiting their credit terms. Trade credit is an important source of finance for nearly all businesses since it is effectively a free source of finance.

WORKING CAPITAL
Working capital is the amount of money available for the day to day running of the business. It is the difference between current assets and current liabilities. See below for more details of how working capital can be used.

LONG TERM

Finance tends to be spent on large projects that will pay back over a longer period of time. More risky so lenders tend to ask for some form of insurance or security if the company is unable to repay the loan. A mortgage is an example of secured long term finance. The main types of long term finance that are available for to a business are: Mortgages Bank loans Share issue Debentures Retained profits Hire purchase

DEBENTURES
A debenture is a long term loan which is usually secured against a specific asset (e.g. the factory) or the overall assets of a business. A debenture is repayable at a fixed date and has a fixed rate of interest. Debentures are different from ordinary shares because: The lender has no voting rights in the company. The loan attracts interests whereas holders of ordinary shares get dividends. The providers of loans are paid out before ordinary shareholders in the event that the business fails (assuming there is some cash left).

EQUITY FINANCE
Equity finance is the money provided by the owners of the business. SOLE TRADERS AND PARTNERSHIPS A sole trader will provide money from his or her own savings. A sole trader may find it difficult to raise much money from this source and therefore may take on a partner who brings money into the business. LIMITED COMPANIES

Prof. Kashif Saeed

Business Finance
A limited company can sell shares, which represent how much of the business the shareholder owns. There are two types of limited company that define the way that money can be raised through shares. . A private limited company can sell shares only to designated people and there is a limit how much capital they can raise through this method. . A public limited company can issue shares to the public. This means anyone can have a share in the company. It is important to note that once a share is issued, it only raises money for the company the first time it is sold. After that the proceeds any sale of that share goes to the owner of the share. It is like a second hand car. When a BMW is sold second hand, then the money goes to the owner of the car and not BMW. A company may wish to issue shares because: . A large amount of money can be raised through a share issue. . Unlike a loan the money does not have to be repaid over a fixed period of time. A company may issue two types of shares: Ordinary shares Ordinary shareholders can vote at company meeting. The amount of the dividend received varies. Preference shares Preference shareholders do not have a vote at company meetings. The dividend is usually fixed (e.g. 5% of the value of shares held paid as dividend each year). Preference shareholders receive their dividend before ordinary shareholders. Shares are bought because they provide a return to the shareholder. There are two parts to the returns earned by shareholders: Dividends paid out on each share held by the company (e.g. companies on the Stock Exchange usually pay out two dividends each year). Increases in the value of each share as the company itself grows in value (this is often known as a capital gain). In conclusion: A business will issue shares to raise large sums of money. By doing this they are diluting the ownership which means that the control of the business is spread amongst more people. However they only have to pay dividends and dont have to pay out dividends at all, especially if they make a loss. But a shareholder has the right to vote off a board of directors, if they can gain 50.1% of support of the rest of the shareholders.

LEASING
Leasing is like renting a piece of equipment or machinery. The business pays a regular amount for a period of time, but the item belongs to the leasing company. Most company cars are leased to businesses. The business pays a monthly fee for the car and at the end of the period (normally about two years), the business swaps the car for a newer model. The advantages of leasing are: R Cheaper in the short run than buying a piece of equipment outright.

Prof. Kashif Saeed

Business Finance
R If technology is changing quickly or equipment wears out quickly it can be regularly updated or replaced. R Cash flow management easier because of regular payments. The disadvantages of leasing are: Q More expensive in the long run, because the leasing company charges fees which make the total cost greater than the original cost.

HIRE PURCHASE
Business hires the equipment for a period of time making fixed regular payments. Once payments have finished it then owns the piece of equipment. Hire purchase is different to leasing in that the business owns the equipment when it has finished making payments. With an equipment lease, the equipment is handed back to the leasing provider.

DEBT FACTORING
A business sells its outstanding customer accounts (those who have not paid their debts to the business) to a debt factoring company. The factoring company pays the business say 8090% of face value of the debts and then collects the full amount of the debts. Once it has done this it will pay the remaining amount to the business less a charge. It is a good way of raising cash quickly, without the hassle of chasing payments. BUT it is not so good for profits since it reduces the total revenue received from those sales.

GOVERNMENT FINANCE
The government and the European Union provide help to businesses for the following reasons: Protect jobs in failing/declining industries. Help create jobs in areas of high unemployment. Help start up new businesses. Help businesses relocate to areas of high unemployment. Some of the main sources of funds are: . European Structural Fund

RETAINED PROFITS
The cheapest form of finance is the business own profits. In the UK over 80% of retained profits are reinvested back into the business. Since it is not being borrowed from anyone, it does not cost money to use.

OWN CAPITAL
For sole traders and partnerships a common source of finance, especially for start up is money from the individuals who are forming the business. They may also borrow money from family and friends. Own capital is a costless form of finance, but carries the risk of the money being lost.

Prof. Kashif Saeed

Business Finance

SOURCES OF FINANCE ORGANISATIONS

FOR

PUBLIC

SECTOR

Public sector organizations receive from both the normal sources that most businesses receive money, but also from tax revenues. Most public sector organizations, such as schools and hospitals obtain more straight from the government who have previously collected the money from tax payers. Other organisations gain money from sales, e.g. stamps for the Post Office, and licences for the BBC.

Prof. Kashif Saeed