Ch# 25 Business Finance

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Introduction  No business activity can take place without some finance - or the means of purchasing the materials and assets needed before the production of a good or provision of a service can take place.  Finance decisions are some of the most important that managers have to take. Inadequate or inappropriate finance can lead to business failure - indeed shortage of liquid funds is the main reason for businesses failing.  The range and choice of finance sources is extensive and skilled managers will be able to match accurately the needs of their business for particular types of finance with the sources available. Why business activity requires finance Finance is required for many business activities. Here is a list of just some of the main circumstances in which businesses will require finance:  Setting up a business will require cash injections from the owner(s) to purchase essential capital equipment and, possibly, premises. This is called startup capital.  All businesses will have a need to finance their working capital - the day-to-day finance needed to pay bills and expenses and to build up stocks.  When businesses expand, further finance will be needed to increase the capital assets held by the firm — and, often, expansion will involve higher working capital needs.  Expansion can be achieved by taking over other businesses. Finance is then needed to buy out the owners of the other firm.  Special situations will often lead to a need for greater finance. For example, a decline in sales, possibly a result of economic recession, could lead to cash needs to keep the business stable; or a large customs could fail to pay for goods, and finance is quickly needed to pay for essential expenses.  Apart from purchasing fixed assets, finance is often used to pay for research and development into new products or to invest in new marketing strategies, such as opening up overseas markets. Some of these situations will need investment in the business for many years or even permanently. Other cases will need only short-term fundingthis is usually defined as being for around one year or less. Some financial requirements of the business are for between one and five years and this is referred to as medium-term finance. Capital and revenue expenditure Capital expenditure involves the purchase of assets that are expected to last for more than one year, such as building and machinery. Revenue

Chapter 25 Business Finance

expenditure is spending on alt costs and assets other than fixed assets and includes wages and salaries and materials bought for stock. These two types of spending will almost certainly be financed in different ways and the length of time that the money is 'tied up’ will be a major factor influencing the final finance choiceWorking capital - meaning and significance:  Working capital is often described as the 'life blood' of a business. It is the finance needed for everyday expenses, such as the payment of wages and buying of stock. Without sufficient working capital a business will be illiquid.  This position can be measured and analysed by using the two liquidity ratios; the results of these will be low when illiquidity is a problem.  The simple calculation of working capital is: current assets less current liabilities.  You will see from the section on the balance sheet that current assets are stocks, debtors and cash in the bank and the tills. Virtually no business could survive without these three assets,  Most businesses will obtain some of this finance in the form of current liabilities - overdrafts and creditors are the main forms. However,  it would be unwise to obtain all of the funds needed from these sources. For one thing, the liquidity ratios would be at very low levels. Another point against this approach is that it will leave no working capital for buying additional stocks or extending further credit to customers when required. How much working capital is needed?  Sufficient working capital is essential to prevent a business from becoming illiquid and unable to pay its debts.  Too high a level of working capital is a disadvantage; the opportunity cost of too much capital tied up in stocks, debtors and idle cash is the return that money could earn elsewhere in the business - invested in fixed assets perhaps.  The working capital requirement for any business will depend upon the 'length' of this 'working capital cycle'.  Figure 25.1 shows the simple cycle in a business that makes things, but neither asks for nor offers credit. Credit to purchasers given by the business will lengthen the time before a sale is turned into cash.  Credit received by the business will lengthen the time before stock bought has to be paid for. To give more credit than is received is to increase the need for working capital. To receive more credit than is given is to reduce the need for working capital. Managing working capital

There are business dangers from both too much working capital and too little. Working capital therefore needs to be managed. It is managed by concentrating on the four main components of the cycle: I. debtors; II. creditors; III. stock; IV. Cash. i. Debtors Debtors can be managed in many different ways, as follows:  Not extending credit to customers - or extending it for shorter time periods. Will they still buy from this business? Will a major aspect of this business's marketing mix have been removed? There are dangers in this approach. Many customers now expect credit and will go elsewhere if it is not offered.  Selling debts to specialist financial institutions acting as debt factors. These businesses will 'buy' debts from other concerns having an immediate need for cash. This will involve a cost, however, as the factors will not pay 100% of the value. They must make a profit for themselves.  By being careful to discover whether new customers are creditworthy. This can be done by requiring references - from traders or from the bank is common - or by using the services of a credit enquiry agency.  By offering a discount to clients who pay promptly. ii. Credit Credit can be managed in two main ways:  Increasing the range of goods and services bought on credit. If a business has a good credit rating this may be easy, but in other circumstances it is difficult. The danger is that an unpaid creditor may refuse to supply.  Extend the period of time taken to pay. The larger a business is, the easier it is to extend the credit taken. This is often a great burden for small businesses that trade with larger ones. iii. Stock Stock can be managed in the following ways:  keeping smaller stock balances;  using computer systems to record sales and therefore stock levels, and ordering as required;  efficient stock control, stock use and stock handling so as to reduce losses through damage wastage and shrinkage;  Just-in-time stock ordering. There are dangers here if demand has not been forecast correctly, if there is a sudden change in demand, if suppliers are unreliable or if there are delivery difficulties. iv. Cash Cash can be managed by:

Use of cash-flow forecasts, wise use or investment of excess cash; planning for too little cash and provision for overdraft facilities made with the bank. A permanent increase in working capital When businesses expand, they generally need higher stock levels and will sell a higher value of products on credit. This increase in working capital is likely to be permanent, so long-term or permanent sources of finance will be needed, such as long-term lo; share capital. Loans or even share capital Where does finance come from?  This section deals initially with sources of finance for limited companies - and then considers sole traders and partnerships.  Companies are able to raise finance from a wide range of sources. It is useful to classify these into:  Internal Money raised from the business's own assets or from profits left in the business (ploughed-back profits), t  External Money raised from sources outside the business.  Another classification is also often made, as was seen above, that of short-, medium- and long-term finance; this distinction is made clearer by considering Figure 25.2. Internal sources of finance Profits retained in the business If a company is trading profitably, some of these profits will be taken in tax by the government (corporation tax) and some is nearly always paid out to the owners or shareholders (dividends). If any profit remains, this is kept (retained) in the business and becomes a source of finance for future activities. Clearly, a newly formed company or one trading at a loss will not have access to this source of finance. For other companies in the UK, retained profits are a very significant source of funds for expansion. Once invested back into the business, these retained profits will not be paid out to shareholders, so they represent a permanent source of financeSale of assets Established companies often find that they have assets that are no longer fully employed. These could be sold to raise cash. In addition, some businesses will sell assets that they still intend to use but which they do not need to own. In these cases, the assets might be sold to a leasing specialist and leased back by the company. In 1999, Somerfield, the grocery retail company, announced the sale of 50 of its stores to raise finance for investing in other areas of the business. This is called 'sale and leaseback'. Reductions in working capital

  

When businesses increase stock levels or sell goods on credit to customers (debtors) they use a source of finance. When companies reduce these assets -by reducing their working capital - capital is released, which acts as a source of finance for other uses. There are risks with cutting down on working capital, however. As will be seen in Chapter 30, cutting back on current assets by selling stocks or reducing debts owed to the business may reduce the firm's liquidity - its ability to pay short-term debts - to risky levels. Internal sources of finance - an evaluation This type of capital has no direct cost to the business, although, if assets are leased back once sold, there will be leasing charges. Internal finance does not increase the liabilities or debts of the business. However, it is not available for all companies, for example newly formed ones or unprofitable ones with few 'spare' assets. Solely depending on internal sources of finance for expansion can slow down business growth as the pace of development will be limited by the annual profits or the value of assets to be sold. Thus, rapidly expanding companies are often dependent on external sources for much of their finance. External sources of finance Short-term sources There are three main sources of short-term external finance: a) bank overdrafts; b) trade credit; c) Debt factoring. a) Bank overdrafts:  A bank overdraft is the most 'flexible' of all sources of finance.  This means that the amount raised can vary from day to day, depending on the particular needs of the business.  The bank allows the business to 'overdraw' its account at the bank by writing cheque to a greater value than the balance in the account.  This overdrawn amount should always be agreed in advance and always has a limit beyond which the firm should not go. Businesses may need to increase the overdraft for short periods of time if customers do not pay as quickly as expected or if a large delivery of stocks has to be paid for. This form of finance often carries high interest charges.  In addition, if a bank becomes concerned about the stability of one of its customers it can 'call in' the overdraft and force the firm to pay it back. This, in extreme cases, can lead to business failure. b) Trade credit:  By delaying the payment of bills for goods or services received, a business is, in effect, obtaining finance. Its suppliers, or creditors, are

 c)

 

Sources of medium-term finance

providing goods and services without receiving immediate payment and this are as good as 'lending money'. The downside to these periods of credit is that they are not 'free1 discounts for quick payment and supplier confident are often lost if the business takes too long to pay u-suppliers. Debt factoring: When a business sells goods on train it creates a debtor. The longer the time allowed to the-debtor to pay up, the more finance the business has to find to carry on trading. One option, if it is commercially unwise to insist on cash payments, is to sell these debts to a debt factor. In this way immediate cash is obtained, but not for the full amount of the debt, this is because the debt-factoring company's profits are made by discounting the debts and not paying their full value. When full payment is received from the original customer, the debt factor makes a profit. Smaller firms who sell goods on hire purchase often sell the ili credit loan firms, so that the credit agreement i-with the firm but with the specialist provider.

There are two main sources of medium-term finance: a) hire purchase and leasing; b) Medium-term bank loan. a) Hire purchase and leasing :  These methods are often used to obtain fixed assets with a medium span — one to five years. Hire purchase is a form of credit for purchasing an asset over a period of n; This avoids making a large initial cash payment to buy the asset.  Leasing involves a contract with a leasing or finance company to acquire, but not necessarily to purchase, assets over the medium term, A periodic payment is made over the life of the agreement, but the business does not have to purchase the asset at the end.  This agreement allows the firm to avoid cash purchase of the asset. The risk of unreliable or outdated equipment is reduced as the leasing company will repair and update as part of the agreement.  Neither hire purchase nor leasing is a cheap option, but they do improve the short-term cash flow position of a company compared to outright purchase of an asset for cash. b) Medium-term bank loan:  This will have the same advantages and disadvantages as long-term loans referred to below. Long-term finance The two main choices here are debt or equity finance.

Debt finance increases the liabilities of a company. Debt finance can be raised in two main ways: I) long-term loans from banks; II) Debentures (also known as loan stock or corporate bonds). I) Long-term loans from banks:  These may be offered at either a variable or a fixed interest rate. Fixed rates provide more certainty, but they can turn out to be expensive if the loan is agreed at a time of high interest rates.  Companies borrowing from banks will often have to provide security or collateral for the loan; this means the right to sell an asset, if the company cannot repay ihe debt, is given to the bank. Businesses with few assets to act as security may find it difficult to obtain loans -or may be asked to pay higher rates of interest.  Banks will be more willing to lend if a company has been successful in this application because it gives the bank security of repayment. Merchant banks are specialist lending institutions. They provide advice as well as finance to firms engaging in expansion or merger/takeover plans. II) Debentures:  A company wishing to raise funds will issue or sell these to interested investors. The company agrees to pay a fixed rate of interest each year for the life of the debenture, which is often 25 years. The buyers may resell to other investors if they do not wish to wait until maturity before getting their original investment back.  Debentures are often secured on a particular asset, which means that the investors have the right, if the company ceases trading, to sell that particular asset to gain repayment. When this is part of the agreement, the debentures are known as mortgage debentures. Debentures can be a very important source of long-term finance - in the British Telecom 1999 accounts the total value of issued loan stock amounted to £3,000 million. Sale of shares - equity finance  All limited companies issue shares when they are first formed. The capital raised will be used to purchase essential assets. Both of these organisations are able to sell further shares - up to the limit of their authorised share capital - in order to raise additional permanent finance.  Private limited companies can sell further shares to existing shareholders. This has the advantage of not changing the control or ownership of the company - as long as all shareholders buy shares in the same proportion to those already owned. Owners of a private limited company can also decide to 'go public' and obtain the necessary authority to sell shares to the wider public. This would

obviously have the potential to raise much more capital than from just the existing shareholders. This can be done in two ways:  Obtain a listing on the Alternative Investment Market (AIM), which is that part of the Stock Exchange concerned with smaller companies that want to raise only limited amounts of additional capital. The strict requirements for a full Stock Exchange listing are relaxed.  Apply for a full listing on the Stock Exchange by satisfying the criteria of (a) Selling at least £50,000 worth of shares and (b) Having a satisfactory trading record to give investors some confidence in the security of their investment. This sale of shares can be undertaken in two main ways:  Public issue by prospectus: this advertises the company and its share sale to the public and invites them to apply for the new shares. This is expensive as the prospectus has to be prepared and issued. The share issue is often underwritten or guaranteed by a merchant bank, which charges for its services.  Arranging a placing of shares with institutional investors without the expense of a full public issue.  Once a company has gained pic status it is still possible; it to raise further capital by selling additional shares. This is often done by means of a rights issue of shares.  Existing shareholders are given the right to buy additional shaft a discounted price. By not introducing new shareholder -the ownership of the business does not change and the company raises capital relatively cheaply. Debt or equity capital - an evaluation: Which method of long-term finance should a company choose? There is no easy answer to this question. And, as seen above, some businesses will use both debt and equity finance for very large projects. Debt finance has the following advantages:  As no shares are sold, the ownership of the company does not change or is not 'diluted' by the issue of additional shares.  Loans will be repaid eventually, so there is no permanent increase in the liabilities of the business.  Lenders have no voting rights at the annual general meetings.  Interest charges are an expense of the business, are paid out before corporation tax is deducted, while dividends on shares have to be paid from profits after tax.  The gearing of the company increases and this gives shareholders the chance of higher return in the future. Equity capital has the following advantages:  It never has to be repaid; it is permanent capital

• Dividends do not have to be paid every year; in contrast, interest on loans must be paid when demanded by the lender. Other sources of long-term finance Grants:  There are many agencies that are prepared, under certain circumstances, to grant funds to businesses. The two major sources in most European countries are the central government and the European Union.  grants from these two bodies are given to small businesses or those expanding in developing regions of the country. Grants often come with 'strings attached1, such as location and the number of jobs to be created, but if these conditions are met grants do not have to be repaid, Venture capital:  Small companies that are not listed on the Stock Exchange 'unquoted companies' - can gain long-term investment funds from venture capitalists. These are specialist organisations, or sometimes wealthy individuals, who are prepared to lend risk capital to, or purchase shares in, small to medium-sized businesses that might find it difficult to raise capital from other sources.  This could be because of the new technology that the company is dealing in, with which other providers of finance are not prepared to get involved.  Venture capitalists take great risks and could lose all of their money but the rewards can be great. The value of certain 'high tech' businesses has grown rapidly and many were financed, at least in part, by venture capitalists. Finance for unincorporated businesses Unincorporated businesses:  Sole traders and partnerships - cannot raise finance from the sale of shares and are most unlikely to be successful in selling debentures as they are likely to be relatively unknown firms.  Owners of these businesses will have access to bank overdrafts, loans and credit from suppliers. They may borrow from family and friends, use the savings and profits made by the owners and, if a sole trader wishes to do this, take on partners to inject further capital.  Any owner or partner in an unincorporated business runs the risk of losing all property owned if the firm fails. Lenders are often reluctant to lend to smaller businesses, which is what sole traders and partnerships tend to be, unless the owners give personal guarantees, supported by their own assets, should the business fail.  Grants are available to small and newly formed businesses as part of most governments' assistance to small businesses.

Providing finance to a business creates a stakeholder relationship with that business. All stakeholders have certain rights, responsibilities and objectives, but these will differ between the various sources of finance. This is made clear in Table which looks at the three main providers of company finance. Rights Responsibilities Objectives Share holders Part ownership of The capital  To received an the company in invested cannot annual return proportion to the be claimed back on investment number of shares from the in shares - the owned company dividend To attend the except when it  To receive ACM and vote, ceases trading capital growth e.g. on through an election of increase in directors share price To receive Possibly, to dividend as influence recommended by company policy the Board through pressure at AGM Banks To receive a To check on  To make a share of the business viability profit from the capital if the before loan or loan. business is overdraft is  To receive wound up after agreed; this is repayment of all debts have both a capital the end been paid responsibility to of the loan To receive the bank's term. interest shareholders and  To establish a payments as laid to the business long-term down in the loan advice to relationship, of or overdraft customers is an mutual benefit. agreement To be important with the repaid before responsibility business shareholders if the company is 'wound up' creditors To receive To provide  To provide payment as regular credit to agreed To be statements of encourage the paid before amount owing business to shareholders in and terms of purchase stock

the event of the business being wound up To attend creditors' meetings if the business is put into liquidation


 To establish a relationship built on trust so that credit can be offered with confidence

Raising external finance - the importance of a business plan  A business plan is a detailed document giving evidence about a new or existing business that aims to convince external lenders and investors to extend finance to the business.  Without some evidence that the business managers have thought about and planned for the future it is most unlikely that bankers, venture capitalists or potential shareholders will invest money into the business. The main content sections of a typical business plan are: 1. Introduction - this will contain the nature of the business, its main aims and objectives, the amount of finance required and the specific use to which this finance will be put. 2. A business description containing evidence of past performance (if it is an existing business), legal structure, capital structure and the background and business experience of the main personnel. 3. Market research and marketing plan - this section will provide evidence of the research the business has undertaken to support the view that the good or service will be successful. The business will have to make a sales forecast for the new good or service, li addition, the marketing strategies that will be adopted for the successful launch and market growl of the product will be outlined. These will include not just details about the actual product but also pricing strategies and promotional techniques. 4. An operations plan will detail how the firm intendj to produce the good or service in sufficient quantiti and to the necessary quality levels. Lenders and future investors will look for evidence that the owners/ managers of the business have carefully considered the dayto-day issues that are likely to arise that may prevent successful production from being sustained 5. Financial information regarding, as a minimum, the first year of operation of the business or venture. Forecasted cash flow budgets, a projected profit and loss account and balance sheet and even a forecasted break-even analysis will all help to convince investor that this business proposal is worth supporting. If the business plan lacks important details or sections of it are not sufficiently well supported by background research, such as market analysis, then the prospective

creditors and investors can delay taking a finance decision until the plan is brought up to the desired standard. Business plans do not guarantee the success of a new business proposal but they are likely to increase the chances of avoiding failure. The business planning process not only provides essential evidence to investors and lenders and makes the finance application more likely to be successful but it also:  forces the owners to think long and hard about the proposal, its strengths and potential weaknesses -it might actually dissuade some people from progressing with their proposal thus avoiding a near certain business flop;  Gives the owners and managers a clear plan of action to guide their actions and decisions at least in the early months and years of the business. Long-term sources of finance - additional considerations  Strategic changes are, by their very nature, of long-term duration. Most changes to business strategy will therefore require long-term sources of finance.  This does not mean that there will be no need for short-term finance. For example, if the firm expands abroad there could be a need to allow for an increase in the bank overdraft before newly established foreign operations become revenue earners. However, changes in business plans are likely to lead to financing needs lasting for more than one year.  Companies - as opposed to unincorporated businesses - have two main options available to them for external long-term finance, loans or equity finance. Equity finance - the sale of shares - can be achieved in 1 A private limited company can 'go public' and obtain a listing on the Stock Exchange. This change in legal structure will give it access to potentially substantial sums of capital as the general public and financial institutions can be appealed to for finance via the sale of shares. 2 Existing public limited companies can raise further share capital. One of the main ways to do this is to organise a rights issue of shares.  This gives existing shareholders the right to buy more shares before they are offered to other potential investors.  This is a relatively cheap form of raising additional capital as there is little need for an expensive public prospectus, and bankers' and advisers' fees are kept to a minimum. The company will usually fix the price of the rights issue at below current market levels in order to attract shareholders to invest further funds.

However, as the rights issue increases the supply of shares to the stock exchange, the short-term effect is often to reduce the existing share price which is unlikely to give existing or potential shareholders too much confidence in the business if the share price falls too sharply.

Making the financing decision  Equity finance is only one option for a business engage in strategic change. Loan capital is another source of funds. In addition, internal long-term sources can be gained either by releasing finance tied up in current assets, for example permanent reductions in stock levels, or by retaining more profits. This latter objective could be achieved by reducing dividends to shareholders.  The size and the profitability of the business are clearly key considerations when managers make a financing choice. Small businesses are unlikely to be able to justify the costs of converting to pic status. They might also have limited internal funds available if the existing profit levels are low. These and other factors that are considered before making the financing choice are summed up in Table Factor influencing finance choice Why important Time period for which finance is It would be most unwise to pay for requires long-term growth plans with short-term funding, such as an overdraft. Banks reserve the right to withdraw such funding at short notice. Similarly, short-term capital needs, such as financing stock build ups in anticipation of a strike amongst suppliers, should not be paid for by an increase in a permanent capital through share sales. Amount required This could be linked to gearing. Very substantial sums of mo, could be difficult to raise from just loan capital - banks and other lenders might be too cautious. Equity finance is likely to be needed - of a combination of loans and equity.

Risk involved in the projects

The greater the risk associated with the project the more likely it Is that speculative funding, such as venture capital or share capital will be required. If companies are already heavily dependent on loans for the total funding needs, as identified by the gearing ratio, then the chances of securing additional loan capital might be small. Share capital or retained profits might be the only long-term options Small businesses may not be able to justify the cost of a si;exchange listing (prospectuses and advisors' fees) and may therefore be restricted to not raising equity capital from the general public. The original owners of a business will find it difficult to retdi control if a pic is created. This is true also for sole traders that decide to accept partners into the business to inject additional capital. Relying on loans ot retained profits may avoid this dilemma

Gearing ratio

Size of business

Legal structure and the desire of owners to retain control

Financial institutions  The main financial institutions involved in raising finance for a business activity have been considered: commercial banks, merchant banks, debt factors, finance houses (hire purchase) and the stock exchange. In addition to these organisations there are some very powerful international institutions that influence world finance and development, such as the United Nations, the World Bank and the International Monetary Fund.  They are all more concerned with providing funds to governments than directly to private businesses but their lending activities can have a great impact on business activity in the countries that they decide to

lend to. Conversely, in the countries where finance is not provided, due to the government being unable to offer iufiMt.'nt guarantees that it will be spent wisely, business will not receive any chance of this type of support

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