Theme 1: Sources of finance The need for finance Internal or external sources of finance External methods of finance

Introduction to Finance - summary In Finance we look at: Sources of finance Why and how much finance is needed, where does it come from Financial planning Forecasting sales (revenues) and costs, understanding break-even and constructing and using budgets Managing finance Calculating and assessing profit, looking at liquidity and understanding business failure

Introduction to finance Can consider finance in terms of the type or age of a business: Start-up 20% of businesses fail in their first year of operation, 50% within 5 years Many/most fail because of a lack of cash, often because the entrepreneur is too optimistic on revenues and on costs Start-ups have start-up costs, then fixed and variable costs each month

Introduction to finance Established business When a business is operating fully, cash from customers should provide the money for daily operations But businesses will want to manage finances properly, so they need budgets to control spending and to properly estimate future revenues And if they expand, they will need to know whether they need to buy new equipment/premises/material, whether expansion is worthwhile, and how to find the money for the expansion

The need for finance What do we mean by finance? Money/cash/funds Why do firms need finance? To buy assets eg buildings and machinery. (Most) retailers need shops/outlets, most producers need factories and all need somewhere for management To buy materials. Tesco buys food, Topshop clothes, BMW steel etc To pay for day to day expenses like wages, rent and electricity etc To advertise

The need for finance by type of business Can consider the need for finance in terms of the type or age of a business: Start-up company, ie a new business Need money to buy long-term assets such as buildings and equipment. Think of a new restaurant… Need cash to pay for raw materials/stocks. Cannot provide a meal without food New entrepreneurs with no experience often underestimate how much money is needed

The need for finance by type of business Established business For growth Will have income from sales. If revenues are greater than costs, then the business will make a profit and this can be kept in the business to pay for new equipment if the business wants to expand But may not have enough finance to pay for new assets etc, so may need to find more Other reasons Shortage of cash flow (we will learn what this means). Perhaps a customer delays payment, or does not pay at all

Sources and methods of finance Sources are internal or external Internal This means from inside the business External This means the finance is from outside the business Methods of finance means how the finance is provided Examples include loans or selling shares

Internal finance From inside the business Owner’s own funds, ie savings Typically for a new business, or for a small one Retained profits (we will learn more about profits) In the long run this is the most important and most common form of finance. Over 60% of business investment comes from retained profits As a business makes profits (which means revenues are higher than costs), these can be retained in the business and used to buy assets Selling assets Particularly for larger firms (after all a new firm will be buying assets), they may have assets which are not used much Managing working capital This means making sure existing finance is used efficiently, so collecting money owed, or asking to pay bills later

External sources of capital When a business cannot generate sufficient money from inside, it needs to obtain money comes from outside the firm Family and friends Can lend money, or can provide share capital (buy shares in the company, giving money in return for a share of the profits) Can be on good terms, ie low interest rate and flexibility in repaying Many start-ups get most of their finance from own savings and family and friends

External Sources of Finance Banks Banks take deposits from savers and then lend to businesses (and individuals) But banks less willing to lend after the financial crisis Nearly always ask for collateral, so that if the borrower cannot repay the bank, the bank takes ownership of an asset it can sell

External Sources of Finance Crowd funding Online platforms allowing entrepreneurs to ask for donations to fund their business idea Donations can be without conditions, or in return for shares/products Target is set for the funding and must be met for any funds to be raised Business angels Think Dragon’s Den At the earliest stage of a new business, where investors take huge risks

External sources of finance Peer to peer funding Especially with the unwillingness of banks to lend, peer to peer takes the middleman out, so that investors lend money to firms directly rather than putting savings in a bank which then lends Can be directly or through a P2P lending company

External methods of finance The form the finance takes Loans, share capital, venture capital, overdraft, leasing, trade credit, grants

External methods of finance Loans The best known and most normal method of finance is through bank borrowing, which can be a bank loan or overdraft Loans are usually for a set period of time, paid back in instalments, or more often at the end of the loan period, which can be: Short term, which is 1-2 years Medium term 3-5 years. Most typical Long term more than 5 years Borrowers pay an interest rate on the loan Can be fixed or variable rate of interest Riskier businesses pay a higher rate of interest - why Banks often ask for collateral (see previously)

External methods of finance Share capital If a business is a limited company, as an alternative to debt (loan), investors give money to the business in return for a share of the profits Can come from private investors, a venture capital firm, or if the business is a public limited company, from stock market investors A start-up may use own money, receive finance from private investors when it is a limited company and grows, and float on the stock market to receive substantially more funds to fund even more growth

External methods of finance Venture capital Can also be thought of as a source of finance. A way of getting finance when banks will not lend Venture capital firms (most venture capital is through firms) will help finance risky businesses Mostly includes both equity (share capital) and loans Venture capitalists will often want to contribute to the managing of the business

Overdraft An agreement with a bank that allows a company (or person) to spend more than is in its account. In other words, a negative balance on current account When the bank balance is negative, interest is paid Interest rates are very high But interest is only paid when the company nis overdrawn Useful when a business may be short of cash for short periods of time But overdrafts can be recalled/withdrawn at very short notice (24 hours)

Leasing Small and growing companies have to watch cash flow very closely Buying equipment (vans, machines etc) can take a lot of cash An answer to this is to lease the equipment This means paying a monthly lease charge instead of buying the equipment outright The company leasing the equipment does need to make a profit on this, so can be expensive Short term this helps cash flow, but in the long run it is nearly always cheaper to buy equipment

Trade credit Simplest form of external finance A business “buys” goods from another business Does it pay with cash in brown envelopes? No, businesses are given an invoice and pay later Typically the terms are 30 days Do big firms abuse this? Will firms trade with a company which does not pay for a long time?

Grants Hand-outs from local or national governments May be to encourage new firms, or to boost a local economy

Evaluation Each type of finance has advantages and disadvantages Finance needs to be appropriate The right amount Matching the type of finance (method) with the reason for the finance Much of this is based on how long and for what the finance is needed

Time period Short-term finance for short term requirements (less than 1 year) Seasonal problems (eg lack of cash in the winter for a hotel on the South Coast) At the early stages of a business, buying raw materials before receiving revenues from a customer Medium-term finance (2-5 years) For assets which may last a few years, eg machine/car/van Long-term finance (5+ years) For long term assets! Buildings, land, equipment which last a long time

Questions Why might a business finance expansion with debt (loans) rather than equity (issuing new shares)? Why should businesses be careful about over-using an overdraft facility? Why might a bank refuse to lend to a business? Why might a business collapse from over-trading (growing too quickly)? Why do venture capital companies invest in some companies but not in others? How might crowdfunding prove harmful to a small new business?