Different sources of Finance for Businesses
Different sources of
Finance for Businesses
Introduction
This assignment will look at the different sources of finance that are available to a small business or a big company. With each source of finance listed the report will assess the implications that can arise and along with this the report will look at the cost to the business to taking a curtain source of finance.
All businesses need short-term finance from the very beginning to start up the business and to cover day-to-day running costs. This provides the business with working capital. However businesses also need long-term capital to help them to grow and expand, and this is paid back over a number of years. Without finance a business would find it difficult to accomplish anything, for example someone who decided to start up a shop would need finance at first to just buy the shop and the stock. Even a window cleaner would need finance to buy equipment such as ladders and buckets. But this can be taken onto a larger scale, as all businesses need finance at some point.
Different sources of finance
The report will now list the different sources of finance available, starting with sources available to small and new businesses to sources only obtainable to big companies.
External Sources of Finance
This source of finance comes from outside the business and involves the business owing money to an outside individual(s) or companies.
Personal Savings
This mainly applies to sole traders, partnerships and small private companies. Owners may use some of their own money as capital to invest in the business. Usually this option is used by the person(s) who will be running the business as it is a cheaper option than trying to get a loan from the bank. The downside being that if the business does not succeed then the person(s) will loose everything.
This is considered an external source as it is assumed that the money lent to the business will eventually be paid back to the private individual, sometimes with an extra amount to compensate the individual for the loan of the capital.
It can be a short or long term source of finance, depending upon the amount invested and the decision of the person using their savings.
Retail Banks
This source of finance is mainly used by new and small businesses as this heading includes the retail banks such as HSBC, NatWest, Barkley's and RBS. The reason that small businesses use these banks is that they offer different types of accounts such as a current or savings account as well as being able to offer overdrafts. Also money is easily transferable through electronic transactions, thus making it easer to pay suppliers and employees.
Whole sale Banks
These banks such as Morgan Stanley and Benson offer the same products and advantages as a retail bank, but the service comes at a premium as the minimum deposit that a business can make is £250,000.
Other whole sale banks include the foreign banks. They offer the same service, but as the currency is different a business could end up making extra or loosing revenue made through the currency changes.
Building Societies
A building society is a form of financial institution that is similar to a bank. It also provides loans but specialises in providing mortgages and usually its interest rates are lower than the level than that offered by a bank.
A mortgage is a special type of loan used to buy property (factories, shops, etc). Mortgages tend to be paid back over a long period of time, usually several years, at an interest rate. The idea is that the building society owns the property until the mortgage is paid off. This is so that if the person is late or cannot make payment on their mortgage the building society will have first rights from the sale of the property.
In recent years, the differences between banks and building societies have reduced and both are now very similar. Both can offer mortgages and loans.
Factoring Services
Businesses are often owed money from customers who have made a purchase on credit. The payment for the products would then be maid within a set amount of time. Usually a set amount of time will be about 30 days, which would be interest free to give a bigger incentive for the customer to pay the bill on time. After this time the company can charge a rate of interest on the money owed to them. Even with the threat of interest a business may have difficulty in collecting its debts from its customers, which could cause some financial difficulty for the company. For the company to be able to retrieve their money a special factoring company may offer to handle the debt collection process for a charge. The factoring company pays the business around 80% of the value of the debt first and would then collect the money from the debtor on behalf of the company. The factoring company would then take their 80% back and some profit from the 20% left over.
Share Issue
This is an easy and important source of finance for public limited companies. A share issue involves a business creating new shares that will either be sold to existing shareholders or be sold to people or institutions through the stock exchange. Each share gives the shareholder a vote on the direction of the company. This means that the shareholder can elect the board of directors of the company each year. If the shareholder doesn't like the way the directors are running the business, they can elect new directors. This is a good incentive to the ...
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Share Issue
This is an easy and important source of finance for public limited companies. A share issue involves a business creating new shares that will either be sold to existing shareholders or be sold to people or institutions through the stock exchange. Each share gives the shareholder a vote on the direction of the company. This means that the shareholder can elect the board of directors of the company each year. If the shareholder doesn't like the way the directors are running the business, they can elect new directors. This is a good incentive to the directors to run the business well and make a profit which will be paid to the shareholders in the form of dividends and the directors usually have share options themselves as an incentive as the more the shares go up the more return they will receive when cashing them in.
The more shares a person holds, the more of a voice they have over the decisions the company makes. If one company wanted to take another company over, it could buy around 30% of that company's shares. By doing this they would have the option of taking over the rest of the shares from the shareholders.
Issuing new shares can raise a lot of capital that can be used to help the business grow and expand into new areas using research and development. It is a long term source of finance as the shares are in circulation and the people who hold the new shares will expect some sort of return on them in the form of a dividend. The only way to end the loan is for the company to buy the shares back. Also, as the total number of shares rises, the votes of existing shareholders will have slightly less significance and they will have less control. This situation is minimised as the existing shareholders are offered the new shares first, so they can keep the same percentage as they already have of the business.
Debentures
This is a form of long-term loan that can be taken out by a public limited company for a large sum and it will be paid back over several years. It is usually borrowed from specialist financial institutions.
Venture capital is where a group of wealthy individuals join together to provide finance for new businesses that are just starting-up. They look for promising businesses and invest in them, hoping that the businesses will grow and that they will make a profit. This is similar to issuing shares.
Leasing and Hire Purchase
Leasing involves businesses renting equipment that it may use for several years or months but never own outright. Businesses will have a contract with a company over the machine being used and in some circumstances some contracts may offer the company to upgrade the machine if a newer model is available. The benefit to leasing machinery is that the company does not have to pay of the maintenance or servicing of the machine throughout the time the company use it. Equipment often leased to companies are such items as photocopiers, paper shredders, etc...
Hire purchase involves a company paying for equipment through instalments. The company usually will use a finance to purchase the machine for them and then the company will pay the finance house back (plus interest) to own the machine. The business will not own the item until all the payments have been made. It usually works out more expensive to buy an item on hire purchase than paying all at once, but it does mean that the business doesn't have to spend a large amount of money at once and can start to make money with the machine, thus the machine pays for itself.
Internal Sources of Finance
These sources of finance come from the business' assets or activities.
Retained Profit
If the business had a successful trading year and made a profit after paying all its areas of expenditure, it could use some of that profit to finance future activities. This can be a very useful source of long term and on going finance, provided the business is generating profit.
Sale of Assets
The business can help finance new activities or pay-off debts by selling its assets such as property, fixtures & fittings, machinery, vehicles etc... as long as they are not key to the running of the business.
It is often used as a short term source of finance (e.g. selling an old vehicle to go towards a new one) but could provide more longer term finance if the assets being sold are very valuable (e.g. land or buildings).
Reducing Stocks
Stock is a type of asset and can be sold to raise finance. Stock includes the business' holdings of raw materials (inputs), semi-finished products and also finished products that it has not yet forwarded onto retail/business outlets.
Businesses will usually hold some stock. It can be useful if there is an unexpected increase in demand from customers, thus they will be able to keep up with demand at a short notice. But with the chance of an increase of sales comes an equal chance of a decrease of sales. This would mean a companies retained stock levels would rise during the down turn as goods are not sold and 'pile-up' instead, which will mean extra storage costs for the business.
Trade Credit
Usually a business does not pay for things before it takes possession. Instead, it will usually place an order for supplies and will pay after receiving the items. It is good practice to pay quickly (often within one month) as this will help the business develop a good relationship with its suppliers. Also as sum supplier's offer the first month as an interest free period to entice customers to pay quickly.
This source of finance appears on the balance sheet as trade credit. This method of delaying payment to a future date is a form of very short term borrowing and helps with a businesses cash-flow throughout the businesses financial year.
Sources of funds
A company might raise new funds from the sources, which have been discussed below.
Ordinary (equity) shares
Ordinary shares are issued to the owners of a company. They have a nominal or 'face' value, typically of £1 or 50 pence when the company is started. The market value of a quoted company's shares bears no relationship to their nominal value, except that when ordinary shares are issued for cash, the issue price must be equal to or be more than the nominal value of the shares. Also the fewer shares that are issued for a company/business the more they will be worth each.
Deferred ordinary shares
These are a form of ordinary shares, which are entitled to a dividend. A dividend is paid through the profits the company has made over the financial year. Usually the dividend is split into two payments over the following financial year.
Ordinary shareholders can help the business by funding the company through:
* The purchase of new shares
* Receiving less dividend, which allows more profit to be reinvested into the business.
By retaining more of the company's year end profits, which would have usually been paid out in dividend to share holders, it can be used as a source of extra investment for the business. Although this method may not provide enough funds it can help the business out if the companies cash flow does not start well they will still be able to pay any suppliers on time.
Through the issue of new shares (dependant on the amount raised) the company could use the extra capital gained to expand the business through the acquisition of development land, property or buying out another company such as Tesco purchasing the 'One Stop' corner shop chain.
New shares issues
A new share issue may be undertaken by a company for the following reasons:
* An unquoted company wishing to obtain a Stock Exchange quotation
* An unquoted company wishing to issue new shares, but without obtaining a Stock Exchange quotation.
* A company which is already listed on the Stock Exchange wishing to issue additional new shares.
The methods by which an unquoted company can obtain a quotation on the stock market are:
An offer for sale - An offer for sale is a means of selling the shares of a company to the public. An unquoted company may issue shares to raise cash for the company. All the shares in the company, not just the new ones, would then become marketable.
Rights issues
A rights issue provides a way of raising new share capital by means of an offer to existing shareholders, inviting them to inject more cash into the business for new shares in proportion to their existing holdings.
A company making a rights issue must set a price, which is low enough to secure the acceptance of shareholders. This must be done right otherwise the shareholders will either not go ahead with the idea of new shares as they are too expensive or because they have been valued to low, which would mean a dilution of the earnings per share.
Preference shares
Preference shares have a fixed percentage dividend and the dividend to these shares is paid before any other shares. As with ordinary shares a preference dividend will only be paid if the company has maid sufficient profits over the financial year. The up side to these shares are that if the level of profit maid over the year is of a reasonable statute the dividend will still be paid in full (if possible). Whereas ordinary shareholders will not receive a dividend subject to how much profit is left.
Loan stock
Loan stock is a form of a long-term loan, which some companies chose to take out as the interest on the loan is of a set amount.
Loan stock has a nominal value, which is the debt owed by the company, and interest is paid at a stated amount. An example of this is if a company issues 10% loan stock the interest will be 10% of the nominal value of the stock, so that £1000 of stock will receive £100 interest each year. (The example shown is the gross rate, before tax).
Debentures with a floating rate of interest
This type of debenture has a rate of interest that can be changed by the issuer inline with changes that have been made to the flat interest rate of the country. These debentures may be attractive to both lenders and borrowers when interest rates are volatile as big gains can be made on them in the means of profit.
Debentures and loan stocks will often be secured. Security may take the form of either a fixed charge, where security would be related to a specific asset or group of assets. This is where a business taking out the loan stock or debenture secures it by allowing the issuer to have the rights over an asset if the business gets into trouble.
The other means of security are in the way of a floating charge. A floating charge can be made on certain assets of the company usually stocks and debtors who haven't paid yet. The lender's security in the event of a default payment is whatever assets of the appropriate class the company then owns.
The redemption of loan stock
Loan stock and debentures are usually redeemable. They are issued for a term of ten years or more, and perhaps 25 to 30 years. At the end of this period, they will "mature" and become redeemable usually for the amount that they were issued at.
Retained earnings
For any company, the amount of earnings retained within the business has a direct impact on what the business is able to finance over the next financial year. A good reason for companies to have some retained profit is that many companies believe that retained earnings are funds which do not cost anything. Although this is not true, it is true that the use of retained earnings as a source of funds that do not have the burden on the company such as interest payments.
Bank lending
Borrowings from banks are an important source of finance to companies. Bank lending is still mainly short term through the use of overdrafts, although medium-term lending is quite common as banks try to accommodate more of to days businesses needs...
Short term lending
A business may need short-term lending if their monthly cash flow is not guaranteed, thus a short-term loan will cover the businesses expenditure and keep their suppliers happy. Types of short-term lending are:
* An overdraft - This is usually a set amount, which is agreed upon between the company and the bank. Interest is charged at a variable rate, which the bank will calculate due to the risk they will be taking. The interest will then be calculated daily to give an average level over the month. The interest is then paid on a monthly basis.
* A short-term loan - The loan amount is decided by the bank and the current financial position of the business. The stronger it is the less risk there is for the bank, thus the loan amount will have a lower level of interest to pay during the length of the loan. Usually a short-term loan will last up to 3 or 4 years.
Medium-term loans
These loans are used for a period of between five and ten years. The rate of interest charged on medium-term bank lending to large companies will be a set margin, with the size of the margin depending on the credit standing and risk of the borrower. A loan may have a fixed rate of interest or a variable interest rate, so that the rate of interest charged will be adjusted every three, six, nine or twelve months in line with recent movements in the Base Lending Rate.
Long-term loans
Long-term bank loans will sometimes be available, usually for the purchase of property, where the loan takes the form of a mortgage. Not too dissimilar to the mortgage that a member of the general public may be offered.
Leasing
A lease is an agreement between two parties, the "lesser" and the "lessee". The lesser owns the asset that is being leased out. The lessee makes payments under the terms of the lease to the lesser, for a specified period of time.
Leasing is, therefore, a form of rental. Leased assets are usually items like machinery, cars/commercial vehicles and office equipment. There are two basic forms of lease: "operating leases" and "finance leases".
Operating leases
Operating leases are rental agreements between the lesser and the lessee whereby:
* The lesser supplies the equipment to the lessee
* The lesser is responsible for servicing and maintaining the leased equipment.
The period of the lease is fairly short, less than the economic life of the asset.
Finance leases
This type of lease is where a lease agreement is made between the user of the leased asset (the lessee) and a provider of finance (the lesser) for most, or all, of the asset's expected useful life. This type of lease is not that different to the operating lease, but at the end of the lease period the finance company will offer the product to the company using the asset at a reasonable price.
Other important characteristics of a finance lease:
* The lessee is responsible for the upkeep, servicing and maintenance of the asset. The lesser is not involved in this at all.
* The lease has a primary period, which covers all or most of the economic life of the asset. At the end of the lease, the lesser would not be able to lease the asset to someone else, as the asset would be worn out. The lesser must, therefore, ensure that the lease payments during the primary period pay for the full cost of the asset as well as providing the lesser with a suitable return on their investment.
* It is usual at the end of the primary lease period to allow the lessee to continue to lease the asset for an indefinite secondary period, in return for a very low nominal rent. Alternatively, the lessee might be allowed to sell the asset on the lassoer's behalf (since the lesser is the owner) and to keep most of the sale proceeds, paying only a small fee as the asset is now affectively second hand goods.
Why might leasing be popular?
The advantages of leasing to businesses are:
* If the lessee does not have enough cash to pay for the asset, and would have difficulty obtaining a bank loan to buy it, and so has to rent it in one way or another if he is to have the use of it at all.
* If finance leasing is cheaper than a bank loan. The cost of payments under a loan might exceed the cost of a lease.
* The leased equipment does not need to be shown in the lessee's published balance sheet, and so the lessee's balance sheet shows no increase in its gearing ratio.
* The equipment is leased for a shorter period than its expected useful life. In the case of high-technology equipment, if the equipment becomes out-of-date before the end of its expected life, the lessee does not have to keep on using it, and it is the lesser that must bear the risk of having to sell obsolete equipment second-hand. The lessee will be able to deduct the lease payments in computing his taxable profits.
Venture capital
Venture capital is money put into an enterprise which may all be lost if the enterprise fails. A businessman starting up a new business will invest venture capital of his own, but he will probably need extra funding from a source other than his own pocket. However, the term 'venture capital' is more specifically associated with putting money into new business ventures and acting like a silent partner to the business.
The institution that puts in the money recognises the gamble situated with new businesses. There is a serious risk of losing the entire investment as most new businesses fail. Also it may take a long time before any return is made from the initial investment. Although, there is also the prospect of very high returns on the initial investment. A venture capitalist will require a high expected rate of return on investments, to compensate for the high risk.
A venture capital organisation will not want to retain its investment in a business indefinitely, and when it considers putting money into a business venture, it will also consider its "exit", that is, how it will be able to pull out of the business eventually (after five to seven years, say) and realise its profits. Examples of venture capital organisations are: Merchant Bank of Central Africa Ltd and Anglo American Corporation Services Ltd.
When a company's directors look for help from a venture capital institution, they must recognise that:
* The institution will want a stake in the company, but purely so it can have a share of the companies profits and will act as a silent partner.
* It will need convincing that the company can be successful.
* It may want to have a representative appointed to the company's board, to look after its interests.
A venture capital organisation will only give funds to a company that it believes can succeed, and before it will make any definite offer, it will want from the company management:
* A business plan
* Details of how much finance is needed and how it will be used
* The most recent trading figures of the company, a balance sheet, a cash flow forecast and a profit forecast
* Details of the management team, with evidence of a wide range of management skills
* Details of major shareholders
* Details of the company's current banking arrangements and any other sources of finance
* Any sales literature or publicity material that the company has issued.
A high percentage of requests for venture capital are rejected on an initial screening. Thus only a small percentage of all requests survive both this screening and further investigation and result in actual investments. Recent successes in this area if financing include the internet search engine 'Google'.
James Pitcher 04/05/2007
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