ROOM 123

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:

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• internal money raised from the business’s own assets or from profits left in the business (ploughed-back or retained profits)

• external money raised from sources outside the business.

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Another classification is also often made, that of short-, medium- and long-term finance; this distinction is made clearer by considering

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INTERNAL SOURCES OF FINANCE

 

Profits Retained by 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 share-holders (dividends). If any profit remains, it is kept in the business and this retained profit 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, retained profits are a very significant source of funds for expansion – see again the Coca-Cola situation in ‘Setting the scene’ case study above. Once invested back into the business, these retained profits will not be paid out to shareholders, so they represent a permanent source of finance.

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Sale 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 t he company. This will raise  capital – but there will be an additional fixed cost in the leasing and rental payment.

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In 2008, AIG insurance company planned to sell off some of its subsidiaries to raise cash to help the company through difficult times. For example, the sale of one of the world’s largest aircraft leasing companies, International Lease Finance, could raise several billion dollars. In the previous year, HSBC sold its huge London head-quarters for $2 billion, but will stay in the building and lease it back from the new owners – at an annual rent of $80 million.

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Managing Working Capital More Efficiently

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 in cutting down on working capital, however. Managing working capital by 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.

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Evaluating Internal Sources of Finance

This type of capital has no direct cost to the business, although there may be an opportunity cost and if assets are leased back after being sold, there will be leasing charges. Internal finance does not increase the liabilities or debts of the business. There is no risk of loss of control by the original owners as no shares are sold. 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.

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EXTERNAL SOURCES OF FINANCING

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Short-Term Finance

There are three main sources of short-term external finance:

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• bank overdrafts

• trade credit

• debt factoring

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Bank Overdrafts

A bank overdraft is the most ‘flexible’ of all sources of finance. The amount of finance can vary from day to day, depending on the needs of the business. The bank allows the business to ‘overdraw’ on its account at the bank by writing checks 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. In extreme cases, this may lead to business failure.

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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 providing goods and services without receiving immediate payment. The downside to these periods of credit is that they are not ‘free’ – discounts for quick payment and supplier confidence are often lost if the business takes too long to pay its suppliers.

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Debt Factoring

When a business sells goods on credit, it creates a debtor. The longer the time allowed to this debtor to pay, the more finance the business has to find to carry on trading. One option is to sell these claims on debtors 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 debt to credit-loan firms, so that the credit agreement is never with the firm but with the specialist provider.

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Medium-Term Finance

There are two main sources of medium-term external finance:

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• hire purchase and leasing

• medium-term bank loan

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Hire Purchase and Leasing

These methods are often used to obtain fixed assets with a medium life span – one to five years. Hire purchase is a form of credit for purchasing an asset over a period of time. This avoids making a large initial cash payment to buy the asset.

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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 firms to avoid cash purchase of the asset. The risk of using unreliable or outdated equipment is reduced as the leasing company will repair and update the asset 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.

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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:

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• long-term loans from banks

• debentures (also known as loan stock or corporate bonds).

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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 is given to the bank, if the company cannot repay the debt. 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.

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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 can be up to 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 usually not ‘secured’ on a particular asset. When they are secured the debentures are known as mortgage debentures. Debentures can be a very important source of long-term finance – in BT’s 2007 accounts, for example, the total value of issued loan stock amounted to £3000 million. Convertible debentures can be, if the borrower wants to, switched into shares after a certain period of time and this means that the company issuing them will never have to pay the debenture back.

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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 private and public limited companies are able to sell further shares – up to the limit of their authorized share capital – in order to raise additional permanent finance. This capital never has to be repaid unless the company is completely wound up as a result of ceasing to trade. 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 – but with the risk of some loss of control to the new shareholders.

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By not introducing new shareholders, the ownership of the business does not change and the company raises capital relatively cheaply as no public promotion or advertising of the share offer is necessary. 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 shareholders too much confidence in the business if the share price falls too sharply.

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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.

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Debt finance has the following advantages:

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• As no shares are sold, the ownership of the company does not change and is not ‘diluted’ by the issue of additional shares.

• Loans will be repaid eventually (apart from convertible debentures), so there is no permanent increase in the liabilities of the business.

• Lenders have no voting rights at annual general meetings.

• Interest charges are an expense of the business and 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 returns in the future.

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Equity capital has the following advantages:

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• 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.

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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. Usually, grants from these two bodies are given to small businesses or those expanding in developing regions of the country. Grants often come with ‘strings attached’, such as location and the number of jobs to be created, but if these conditions are met, grants do not have to be repaid.

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Venture Capital

Small companies that are not listed on the Stock Exchange can gain long-term investment funds from venture capitalists. These specialist organizations, or sometimes wealthy individuals, are prepared to lend risk capital to, or purchase shares in, business start-ups or small to medium-sized businesses that might find it difficult to raise capital from other sources. This could be because of risks of the business. These risks could come from the new technology that the company is dealing in or the complex research it is planning, in 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. Venture capitalists generally expect a share of the future profits or a sizeable stake in the business in return for their investment.

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FINANCE FOR SOLE TRADERS AND PARTNERSHIPS

 

Unincorporated businesses – sole traders and partner-ships – 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.

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An 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.

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Grants are available to small and newly formed businesses as part of most governments’ assistance to small businesses.

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Micro-finance

This approach to providing small capital sums to entrepreneurs has grown in importance in recent years. In 1974, an economics lecturer at the University of Chittagong, Bangladesh, lent $27 to a group of very poor villagers. Not only did they repay this loan in full after their business ideas had been successful, but it led to the lecturer, Muhammad Yunus, eventually winning the Nobel Peace Prize. He founded the Grameen Bank in 1983 to make very small loans – perhaps $20 a time – to poor people with no bank accounts and no chance of obtaining finance through traditional means. Since its foundation, the Grameen Bank has lent $6 billion to over 6 million Asian people, many of whom have set up their own very small enterprises with the capital.

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Many business entrepreneurs in Bangladesh and other Asian countries have received micro-fi nance to help start their business.