Nearly all businesses have a current account at a bank. A business uses the cash in the account to finance its day to day running using cheques. If a business has money within the account, it is said to be in the black. If it spends more than what is in the account, then it is said to be in the red. Current accounts can be used to borrow money from a bank. Sometimes, businesses are forced to go into the red, for instance to make urgent payments. The bank can then give the business an overdraft. This meant that the bank will allow the business to withdraw more money than it has in its account. The maximum amount it can be overdrawn is its overdraft limit. If the business goes over its overdraft limit, the bank may refuse to pay cheques issued by the business. At worst, the bank could call in the overdraft, which means that it will demand immediate repayment of the money borrowed. This generally leads to the failure of the business as it can no longer make repayments. The main advantage of overdrafts is that money is only borrowed when it is needed. This cuts down on the interest bill. It is also an extra option if a business needs to make urgent payments. However, overdrafts can be more expensive than they seem, especially for small businesses. Banks often charge an arrangement fee for overdrafts, or a fee per quarter to maintain the overdraft. Banks may also make higher charges for cheques issued when the account is overdrawn. Finally, if a business goes over its overdraft, the bank will demand repayment.
The next section discusses the sources of finance used by medium and large sized businesses. Larger-sized and more successful businesses have less difficulty raising large amounts of money because banks see their success as a sign of less risk.
Small and medium sized businesses often have difficulty raising equity capital. This is one of the main reasons why some medium sized businesses become public limited companies. A plc is able to offer shares for sale to individual investors and corporate investors like assurance companies. When a business goes public, it often offers shares in the company for sale. The money raised by the sale of these shares can be used by the company for investment. This is known as share capital. The advantage of using share capital is that money is easily raised through the sale of shares. The drawback is that dividends must then be paid on those shares to the shareholders. Dividends are a share of a company’s profits which are received by those who own shares in it (the shareholders).
Large public limited companies can also borrow money through the City of London. They do this by issuing debentures. Debentures are usually long term loans, normally for between five and 25 years. Interest must be paid on the loan. Debentures borrowed in other currencies are known as Eurobonds. Large private limited companies can also issue debentures, which are typically bought by banks. The advantages of debentures are that money is acquired by the business instantly. A debenture is a long term loan, so when finance is low, there is still income for the business. However, interest must be paid on the loan, so money is ultimately lost. Eurobonds are risky because money might be lost when the money changes currency.
One way large businesses raise finance is by selling its assets. For example, a growing business might sell a factory and use the money to buy large premises. Large businesses might be able to negotiate a sale and lease back scheme. Here, the business sells some or all of its property to another company. At the same time, it signs an agreement to lease back the property for a fixed annual rent. This is useful for large businesses because they receive a lump sum of money, which could be used to fund expansion. One problem however, is that the business now has to pay rent on the property it owned.
Businesses often get trade credit from suppliers. Typically, a business does not have to pay for goods until one month after they have been delivered. Trade credit is a form of ‘loan’ from a supplier to a business buying goods. The advantage of trade credit is that the loan is free of interest charges to the buying business, without immediate payment having to be made. Also, the more a business purchases, the more trade credit it is likely to get. Therefore, trade credit is a way of increasing a business’ working capital. However, suppliers may stop selling goods to a business if it owes too much money. They may be worried that the business is in danger of going bankrupt or into liquidation, leaving unpaid debts.
A business might use a factor to reduce the amount of money it has to borrow on overdraft. A factor is a specialist finance company, often owned by a larger bank. It collects the money which is owed to a business on trade credit. The factor then charges a fee for its services. The factor will advance money to the business even if an invoice hasn’t been paid by a customer. The business is therefore guaranteed regular payment of its invoices. It also doesn’t have to employ staff to chase and collect those bills. However, a factor will only give the business a percentage of the value of the invoice, usually 80 per cent, if it is unpaid. The other 20 per cent is given when its customers pay the factor. The advantage of using a factor is that it speeds up the cash flow through a business.
If a business needs equipment, like a photocopier, it could lease or rent instead of buying it outright. Leasing is therefore a way of financing investment in a business. Many leasing contracts include maintenance contracts. This is where the leasing company maintains and repairs the machines as part of the rental price. Leasing equipment is usually more expensive over the lifetime of the machine than buying it outright. On the other hand, it could work out cheaper if the leasing firm can buy machines in bulk and pass on the discount to customers. There can also be tax advantages to renting equipment rather than buying outright. Maintenance contracts included in a leasing deal can be expensive. But they may reduce the risk of sudden large bills if the machine breaks down. Hire purchase is an alternative way of borrowing money. If a business bought a photocopier on hire purchase, it would pay a fixed number of instalments. Legally, each instalment is a rental payment. A finance house, a type of bank which specialises in hire purchase deals, would own the photocopier until the last instalment was made.
If a company is growing and its sales turnover is in millions of pounds, it might attract a venture capitalist to invest in the business. Venture capital companies specialise in buying shares of small but growing businesses, most of which are private limited companies. The venture capitalist hopes that in 3-5 years, the business will have grown further and it will be able to sell its shareholding at a profit. For the business, the venture capitalist can provide much needed funds to invest in expansion. However, the original owners will own a smaller share of the business. But they hope that this smaller share will be much more valuable after a while because of the growth of the company.
Grants to businesses are given by a wide number of bodies. In the UK, these include the UK government, Princes Youth Business Trust and the European Union. Grants are offered by Learning and Skills Councils to unemployed people who set up their own businesses. They also provide training and support. Other grants are available to businesses which operate in areas of low income and high unemployment. Grants are good for businesses because they are given for free, with no interest or payment charges. However, they are fairly uncommon for everyday businesses and are only given to businesses which need the boost in funds.
For a business to succeed, it needs to find the right balance of finance. It is important that it is well-placed to survive any financial problems it might go through. In my business, it is vital to carry out extensive research to ensure that I will have the right amount of funds to carry out everyday running of the business. If this does not happen and I do not find the correct sources of finance then my business will fail.
