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– generated from within

the business by its operations

• External– secured from outside

the business

• Short term-up to one year– working capital– investment in short lived

equipment• Medium term-1-5 years

– purchase of assets with a medium term life

• Long term- 5 years +– purchase of long term

assets

Summary of sourcesShort term Long term

Internal Controlling working capital

Cash management

Debtor management - tighter credit control

Stock management - reduced stock levels

Retained profit

Retained profit

External Overdraft

Short term loan

Invoice discounting

Debt factoring

Trade credit

Hire purchase

Leasing rather than buying

Sale of assets

Sale and lease back

Leasing

Share issue

Long term loans

Sale and leaseback

Debentures

Venture capital

Government grants and loans

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

InternalWorking capital management

External OverdraftBank loan

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

Sourcesof finance

Internal Retained profits

External Share issues

External Long termborrowing

ExternalLeasing/sale

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)