Business Finance

How Business Finance Works

Whatever the business setting, the importance of financial resources are never far way. Many businesses, survive on external sources of funding: bank loans, commercial loans, investors, shareholders, and banking overdraft facilities to name just a few of the sources of finance.

However, before a business is able to secure finance, the ‘snapshot’ picture of either its’ previous trading accounts and/or its forecasting for growth and orders in the ensuing twelve months is a vital tool to be examined by external investors.

We will explore some of the important aspects of both: internal and external investments, financial incentives and other sources that are predominate in the UK and EU.

To start with, have a look at the diagram below; in which we can see a mapping of finance for a business – whatever, its size, shape or sector, all businesses will need to consider some, if not all, of these sources:-

where do businesses get money

External Sources

  • Shares: Limited companies could look to sell additional shares, to new or existing shareholders, in exchange for a return on their investment.

  • Loans: There are debenture loans, with fixed or variable interest, which are usually secured against the asset being invested in, so the loan company will have a legal shared interest in the investment. This means that the company would not be able to sell the asset without the lender’s prior agreement. In addition the lender will take priority over the owners and shareholders if the business should fail and the cost will have to be repaid even if a loss is made.

    There are other types of loan for fixed amounts with fixed repayment schedules. These may be considered a little more flexible than debenture loans.

  • Overdraft: A bank overdraft may be a good source of short-term finance to help a business flatten seasonal dips in cash-flow, which would not justify or need a long-term solution. The advantage here is that interest is calculated daily and an overdraft is therefore cheaper than a loan.

  • Hire purchase: Hire purchase arrangements enable a firm to acquire an asset quickly without paying the full-price for it. The company will have exclusive use of the item for a set period of time and then have the option to either return it or buy it at a reduced price. This is often used to fund purchases of vehicles, machinery and ICT Products.

  • Credit from suppliers: Many invoices have payment terms of 30 days or longer. A company can take the maximum amount of time to pay and use the money in the interim period to finance other things. This method should be treated with caution to ensure that the invoice is still paid on time or else the firm might risk upsetting the supplier and jeopardise the future working relationship and terms of business. It should also be remembered that it’s not ‘found’ money but rather a careful balancing act of cash-flow.

  • Grants: Grants are often available from councils and other Government bodies for specific issues. For example there may be a council priority to regenerate a particular area of a town and who are happy to help fund refurbishment of buildings. Alternatively there may be an organisation that specialises in helping young entrepreneurs to launch new businesses. Assessment for grants can be very competitive, is very individual and not automatic.

  • Venture capital: This source is most often used in the early stages of developing a new business. There may be a huge risk of failure but the potential returns may also be big. This is a high risk source as the venture capitalist will be looking for a share in the firm’s equity and a strong return on their investment. However the significant experience these investors have in running businesses could prove valuable to the company. This is what the TV programme ‘Dragon’s Den’ is all about!

  • Factoring: This involves a company outsourcing its invoicing arrangements to an external organisation. It immediately allows the company to receive money based on the value of its outstanding invoices as well as to receive payment of future invoices more quickly. It works by the firm making a sale, sending the invoice to the customer, copying the invoice to the factoring company and the factoring company paying an agreed percentage of that invoice, usually 80% within 24 hours.

    There are fees involved to cover credit management, administration charges, interest, and credit protection charges. This must be weighed up against the benefit gained in maximising cash flow, a reduction in the time spent chasing payments and access to a more sophisticated credit control system.

    The downside is that customers may prefer to deal direct with the company selling the goods or services. In addition ending the relationship could be tricky as the sales ledger would have to be repurchased.

handshake

Internal Sources

Internal sources of finance are often from within the business and can be a large part of ‘personal investment’ by the business owner, their family members and perhaps even friends! Although this is often the; most easy form of, investment – it does come with a personal ‘price’.

  • Personal savings: This is most often an option for small businesses where the owner has some savings available to use as they wish.
  • Retained profit: This is profit already made that has been set aside to reinvest in the business. It could be used for new machinery, marketing and advertising, vehicles or a new IT system.
  • Working capital: This is short-term money that is reserved for day-to-day expenses such as stationery, salaries, rent, bills and invoice payments.
  • Sales of assets: There may be surplus fixed assets, such as buildings and machinery that could be sold to generate money for new areas. Decisions to sell items that are still used should be made carefully as it could affect capacity to deliver existing products and services.

internal sources

The Scarce Resource: - Money!

the scarce resource - moneyMoney is a scarce resource and each source has its own advantages and disadvantages. Lenders will be looking for a return on investment, the size of the risk and the flexibility with which they can get their money back when they want or need it. For the company seeking money, the decision as to the best source will ultimately depend on what the money is for, how long the money is needed for, the cost of borrowing and whether the firm can afford the repayments.

In a market driven economy which is the UK and EU, there is often a reluctance; by larger financial services to invest in smaller business ventures. Therefore, the first call on investment is often from the ‘personal’ pockets of the business owner.

Obtaining funding from external sources like the banking sector requires a large and varied set of criteria being met and managed by the business before a bank will release and invest its capital. All UK banks support business but at a variety of degree, therefore, all businesses, first point of financing is frequently itself.

Further reading …

The following website offers a very comprehensive overview of all sorts of business finance – why not, have a surf through its pages, to learn more about how, business finance is raised, managed and secured.

http://www.smallbusiness.co.uk/channels/small-business-finance/government-grants/

Source: Essay UK - http://www.essay.uk.com/free-essays/accounting/sources-of-finance.php


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