INTRODUCTION TO BUSINESS FINANCE

When you start up in business you will need finance. Should you use your own

money, borrow from family and friends, or go straight to the bank? What about

invoice financing and factoring? Do you want a business angel? Understand the

different forms of borrowing and choose the best financial option for your

business.

DEFINITION OF BUSINESS FINANCE

Raising and managing of funds by business organizations. Such activities are

usually the concern of senior managers, who must use financial forecasting to

develop a long-term plan for the firm. Shorter-term budgets are then devised to

meet the plan's goals. When a company plans to expand, it may rely on cash

reserves, expected increases in sales, or bank loans and trade credits extended by

suppliers. Managers may also decide to raise long-term capital in the form of

either debt (bonds) orequity (stock). The value of the company's stock is a constant

concern, and managers must decide whether to reinvest profits or to pay dividends.

Other duties of financial managers include managing accounts and fixing the

optimum level of inventories. When deciding how to deploy corporate assets to

increase growth, financial managers must also consider the benefits of mergers and

acquisitions, analyzing economies of scale and the ability of businesses to

complement each other.

CONCEPT OF BUSINESS FINANCE

Business finance is the area of finance dealing with the sources of funding and

the capital structure of Business and the actions that managers take to increase the

value of the firm to the shareholders, as well as the tools and analysis used to

allocate financial resources. Although it is in principle different from managerial

finance which studies the financial management of all firms, rather than Business

alone, the main concepts in the study of Business finance are applicable to the

financial problems of all kinds of firms. Business finance generally involves

balancing risk and profitability, while attempting to maximize an entity's wealth

and the value of itsstock, and generically entails three primary areas of capital

resource allocation. In the first, "capital budgeting", management must choose

which "projects" (if any) to undertake. The discipline of capital budgeting may

employ standard business valuation techniques or even extend to real options

valuation; see Financial modeling. The second, "sources of capital" relates to how

these investments are to be funded: investment capital can be provided through

different sources, such as by shareholders, in the form of equity (privately or via

an initial public offering), creditors, often in the form of bonds, and the firm's

operations (cash flow). Short-term funding or working capitalis mostly provided by

banks extending a line of credit. The balance between these elements forms the

company's capital structure. The third, "the dividend policy", requires management

to determine whether any unappropriated profit (excess cash) is to be retained for

future investment / operational requirements, or instead to be distributed to

shareholders, and if so in what form. Short term financial management is often

termed "working capital management", and relates to cash-, inventory-

and debtors management.

FINANCIAL MANAGEMENT

Financial management overlaps with the financial function of the Accounting

profession. However, financial accounting is the reporting of historical financial

information, while financial management is concerned with the allocation of

capital resources to increase a firm's value to the shareholders.

Financial risk management, an element of corporate finance, is the practice of

creating and protecting economic value in a firm by usingfinancial instruments to

manage exposure to risk, particularly credit risk and market risk. (Other risk types

include Foreign exchange, Shape, Volatility, Sector, Liquidity, Inflation risks, etc.)

It focuses on when and how to hedge using financial instruments; in this sense it

overlaps with financial engineering. Similar to general risk management, financial

risk management requires identifying its sources, measuring it (see: Risk measure:

Well known risk measures), and formulating plans to address these, and can be

qualitative and quantitative. In the banking sector worldwide, the Basel

Accords are generally adopted by internationally active banks for tracking,

reporting and exposing operational, credit and market risks

HOW MUCH DO YOU NEED?

To work this out you need a business plan. The business plan will help you work

out your financial needs, including the initial start up costs and running expense.

You can draw up a budget that shows your forecast sales, expenditure and –

absolutely vital – your cash position for each month.

Consider possible peaks and troughs in the business (perhaps seasonal) and

remember that many start-ups spend more than they earn in the first couple of

years. Customers may not pay you immediately but you still have to pay all your

bills to keep trading. Make sure you have a contingency fund in case things go

wrong. Try to have at least enough capital to cover projected expenses for at least

six months – the nature of your particular business may mean you need more.

HOW THE CHOICE OF FINANCE IS MADE IN A BUSINESS

These are the factors that managers consider when choosing the type of finance

they need.

Purpose And Time Period: Managers need to match the source of finance to

its purpose. It is quite simple, short-term finance is used to buy current assets

and things like that, while long-term finance for fixed assets and similar things.

Amount Needed: Different types of finance depends on how much is needed.

Status And Size: Bigger companies have more choices of finance. They pay

less interest to banks.

Control: owners lose control if they own less than 51% of shares in their

company.

Risk And Gearing: loans raise the gearing of a business, meaning that their

risk is increased. Gearing is can be obtained by calculating the percentage of

long-term loans compared to total capital. If long-term loans take up more than

50% of total capital, then the business would be called highly geared. This is

very risky because the business will have to pay back a lot of its loans and has

to succeed to do so. Banks are less willing to lend to these businesses, so they

will have to find other types of finance.

FINANCIAL ECONOMICS

Financial economics is the branch of economics studying the interrelation of

financial variables, such as prices, interest rates and shares, as opposed to those

concerning the real economy. Financial economics concentrates on influences

of real economic variables on financial ones, in contrast to pure finance. It centres

on managing risk in the context of the financial markets, and the

resultanteconomic and financial models. It essentially explores how rational

investors would apply risk and return to the problem of aninvestment policy. Here,

the twin assumptions of rationality and market efficiency lead to modern portfolio

theory (the CAPM), and to the Black–Scholes theory for option valuation; it

further studies phenomena and models where these assumptions do not hold, or are

extended. "Financial economics", at least formally, also considers investment

under "certainty" (Fisher separation theorem, "theory of investment

value", Modigliani-Miller theorem) and hence also contributes to corporate finance

theory. Financial econometrics is the branch of financial economics that uses

econometric techniques to parameterize the relationships suggested.

Although closely related, the disciplines of economics and finance are distinctive.

The ―economy‖ is a social institution that organizes a society’s production,

distribution, and consumption of goods and services,‖ all of which must be

financed.

Economists make a number of abstract assumptions for purposes of their analyses

and predictions. They generally regard financial markets that function for the

financial system as an efficient mechanism (Efficient-market hypothesis). Instead,

financial markets are subject to human error and emotion.[3]

New research

discloses the mischaracterization of investment safety and measures of financial

products and markets so complex that their effects, especially under conditions of

uncertainty, are impossible to predict. The study of finance is subsumed under

economics as financial economics, but the scope, speed, power relations and

practices of the financial system can uplift or cripple whole economies and the

well-being of households, businesses and governing bodies within them—

sometimes in a single day.

FINANCIAL MATHEMATICS

Financial mathematics is a field of applied mathematics, concerned with financial

markets. The subject has a close relationship with the discipline of financial

economics, which is concerned with much of the underlying theory.

Generally, mathematical finance will derive, and extend,

the mathematical or numerical models suggested by financial economics. In terms

of practice, mathematical finance also overlaps heavily with the field

of computational finance (also known as financial engineering). Arguably, these

are largely synonymous, although the latter focuses on application, while the

former focuses on modeling and derivation (see: Quantitative analyst). The field is

largely focused on the modelling of derivatives, although other important subfields

include insurance mathematicsand quantitative portfolio problems. See Outline of

finance: Mathematical tools; Outline of finance: Derivatives pricing.

EXPERIMENTAL FINANCE

Experimental finance aims to establish different market settings and environments

to observe experimentally and provide a lens through which science can analyze

agents' behavior and the resulting characteristics of trading flows, information

diffusion and aggregation, price setting mechanisms, and returns processes.

Researchers in experimental finance can study to what extent existing financial

economics theory makes valid predictions, and attempt to discover new principles

on which such theory can be extended. Research may proceed by conducting

trading simulations or by establishing and studying the behaviour of people in

artificial competitive market-like settings.

BUSINESS SUSTAINABILITY

Business sustainability is often defined as managing the triple bottom line - a

process by which companies manage their financial, social and environmental

risks, obligations and opportunities. These three impacts are sometimes referred to

as profits, people and planet.

However, this approach relies on an accounting based perspective and does not

fully capture the time element that is inherent within business sustainability. A

more robust definition is that business sustainability represents resiliency over time

– businesses that can survive shocks because they are intimately connected to

healthy economic, social and environmental systems. These businesses create

economic value and contribute to healthy ecosystems and strong communities.

Business sustainability requires firms to adhere to the principles of sustainable

development. According to the World Council for Economic Development

(WCED), sustainable development is development that ―meets the needs of the

present without compromising the ability of future generations to meet their own

needs.‖ So, for industrial development to be sustainable, it must address important

issues at the macro level, such as: economic efficiency (innovation, prosperity,

productivity), social equity (poverty, community, health and wellness, human

rights) and environmental accountability (climate change, land use, biodiversity).

There are a number of best practices that foster business sustainability, and help

organisations move along the path from laggards to leaders. These practices

include:

• Stakeholder engagement: Organisations can learn from customers, employees and

their surrounding community. Engagement is not only about pushing out messages,

but understanding opposition, finding common ground and involving stakeholders

in joint decision-making;

• Environmental management systems: These systems provide the structures and

processes that help embed environmental efficiency into a firm’s culture and

mitigate risks. The most widely recognized standard worldwide is ISO 14001, but

numerous other industry-specific and country-specific standards exist;

• Reporting and disclosure: Measurement and control are at the heart of instituting

sustainable practices. Not only can organisations collect and collate the

information, they can also be entirely transparent with outsiders. The Global

Reporting Initiative is one of many examples of well-recognised reporting

standards;

• Life cycle analysis: Those organisations wanting to take a large leap forward

should systematically analyse the environmental and social impact of the products

they use and produce through life cycle analysis, which measure more accurately

impacts.

Firms that are sustainable have been shown to attract and retain employees more

easily and experience less financial and reputation risk. These firms are also more

innovative and adaptive to their environments.

Example

Tech or financial firms going to a paperless office environment;

A cell phone manufacturer pursuing a ―conflict-free‖ mineral resource

supply chain

A bank committing to and accomplishing carbon-free operations

Businesses need finance, or money, to pay for their overhead costs as well as their

day to day and variable expenses. Here are three situations when businesses need

finance the most:

Starting a business: Huge amounts of finance is needed to start a business which

requires buying fixed assets, paying rent and other overheads as well as producing

or buying the first products to sell. The finance required to start up a business is

called start-up capital.

Expanding a business: When expanding, a lot of capital is needed in order to buy

more fixed assets or fund a takeover. Internal growth by developing new products

also requires a notable amount of finance for R&D.

A business in difficulties: For example, for loss making businesses money is

needed to buy more efficient machinery, or money is needed to cover negative

cash flow. However, it is usually difficult for these firms to get loans.

All all cases, businesses need finance for either capital expenditure or revenue

expenditure:

Capital expenditure: Money spent on fixed assets.

Revenue expenditure: Money spent on day-to-day expenses.

SOURCES OF FINANCE

There are many ways to obtain finance, and they can be grouped in these ways.:

Internal Or External.

Short-term, medium-term or long-term.

INTERNAL FINANCE:

This is finance that can be taken from within the business itself. There are

advantages and disadvantages to each of them:

Retained Profit: Profit reinvested into a business after part of the net profit has

been distributed to its owners.

1. Retained profit does not have to be repaid unlike a loan.

2. New businesses do not have much retained profit.

3. Retained profit from small firms are not enough for expansion.

4. Reduces payment to owners/shareholders.

Sale Of Existing Assets: Firms can get rid of their unwanted assets for cash.

1. Makes better use of capital that is not used for anything.

2. Takes time to sell all of these assets.

3. New businesses do not have these assets to sell.

Running Down Stocks: Sell everything in the current existing inventory.

1. Reduces opportunity cost and storage costs of having inventory.

2. Risks disappointing customers if there are not enough stock left.

Owners' Savings: Only applies to businesses that do not have limited liability.

Since the legal identity of the business and owners are the same, this method is

considered to be internal.

1. Available quickly.

2. No interest paid.

3. Limited capital.

4. Increases risks for owners.

EXTERNAL FINANCE:

This is money raised from individuals or organisations outside a business. It is the

most common way to raise finance.

Issue Of Shares: Same as owners' savings, but only available to limited

companies.

1. A permanent source of capital that does not have to be repaid.

2. No interest paid.

3. Dividends will have to be paid.

4. Ownership of the company could change hands to the majority shareholder.

Bank Loans: money borrowed from the bank.

1. Quick to arrange.

2. Variable lengths of time.

3. Lower rates offered if a large company borrows large sums.

4. Must be repaid with interest.

5. Collateral is needed to secure a loan and may be lost.

Selling Debentures: These are long-term loan certificates issued by limited

companies.

1. These can be used to raise long-term finance, e.g. 25 years.

2. No collateral is required, just the trustworthiness of a big company.

3. Must be repaid with interest.

Factoring Of Debts: Some businesses (debt factors) "buy" debts of a firm's

debtors (e.g. customers) and pay the firm cash in return. The firm now does not

worry about worrying about whether their customers will pay or not and 100% of

all the debts goes to the factor. Factoring debt is very difficult for me to understand

and explain, so explore http://business-debt.cleardebts.co.uk/factoring.html for

more information.

1. Immediate cash is obtained.

2. Risk of collecting debt becomes the factor's.

3. The firm does not receive 100% value of the debt.

Grants And Subsidies: can be obtained from outside agencies like the

government.

1. Do not have to be repaid.

2. They have conditions that you have to fulfill (e.g. locating in poor areas).

SHORT-TERM FINANCE

This is working capital required to pay current liabilities that is needed up to three

years. There are three main ways of acquiring short-term finance:

Overdrafts: Allows you do draw more from your bank account than you have.

1. Overdrafts can vary every month, making it flexible.

2. Interest only needs to be paid only to the amount overdrawn.

3. They can turn out cheaper than loans.

4. Interest rates are variable, and often higher than loans.

5. The bank can ask for the overdraft back immediately anytime.

Trade Credits: Delaying payment to your creditors, which leaves the company

with better cash flow for that month.

1. It is almost a short-term interest free loan.

2. The supplier could refuse to give discounts or to supply you at all if your

payments are delayed too much.

3. Factoring of debts

TYPES OF FINANCE

Most new businesses use a mixture of finance - savings, borrowing from friends or

family, personal loans and bank borrowing. Overdrafts and fixed term loans are

popular. New start-ups can also apply for grants and interest free loans and bigger

businesses with good prospects might attract an outside investor, like a business

angel. Raising money from shareholders may also be an option. If you are short of

cash at the outset you can consider leasing and hire purchase for vehicles and

equipment, rather than buying. If your business has lots of unpaid invoices you

may want to consider invoice financing. All methods of finance bring their own

advantages and disadvantages and you should take advice before making a

decision.

1. Bank Finance – Loan Or Overdraft?

It is increasingly difficult to borrow from banks – even with a good track record.

Since the credit crunch began, banks have been trying to increase deposits and are

not keen to lend. Rates are high and banks are nervous about losing yet more

money. So you will have to be a good risk before a bank will part with any cash.

Before lending, a bank will want to see a credible business plan, evidence of a

successful track record in business (this is often the chicken and egg situation for

start-ups – how can you establish a good track record without borrowing money to

start?). You will have to offer security for any money lent (either business assets or

personal guarantee) and you will have to show commitment by investing your own

money as well. Increasingly banks expect you to invest larger percentages of your

own money before they will commit. If they will commit at all.

2. OVERDRAFTS

These are very useful for financing temporary or fluctuating cash shortages and are

generally a flexible way of funding day to day requirements. Interest is paid only

on the amount you are overdrawn each day. But they have higher interest rates than

loans, and exceeding your overdraft limit is costly. In theory, the bank could

demand repayment any time – even 24 hours notice.

3. Loans

Loans are often the best way to finance a longer term business needs. They are

usually fixed for one to ten years (although mortgages and some other loans may

be for as long as 25 years). Repayments are agreed in advance so at least you can

match the term of a loan to your requirements and can budget for repayments. On

the downside there is no flexibility - if you are not using the funds you will still

pay interest. You may also have to offer security.

4. Costs

Costs can vary widely. Both overdrafts and loans are set at a margin over the bank

base rate (which itself fluctuates). You will probably pay an arrangement fee to set

up the loan or overdraft, usually about 1.25% of the total amount requirement.

Sometimes you may have to pay a renewal fee if an overdraft facility is extended

and you may also have to pay costs arranging security.

Banks will look at your business assets, but you will not get more than 80% of the

value of the business property (and realistically quite a lot less). Any equipment

will only be valued at resale price – usually its price at auction. Banks may lend up

to 60% of the value of your trade debtors, but will not be interested in old debts or

small debts which are difficult to collect. Any other loans, factoring services or

leasing arrangements will also reduce the amount of security you can offer the

bank and therefore the amount they will lend.

FINANCE FROM OUTSIDE INVESTORS

1. Shareholders

You could issue ordinary shares (standard shares with no special rights or

restrictions) to investors in return for money. Unlike loans and overdrafts you do

not normally have to make payments to investors until the business can afford

them. In addition shareholders might bring in additional expertise, and will share

the decline if your business fails. In addition if you increase the capital invested in

the business it might be easier to borrow from the bank.

On the downside your share of the business and its profits will be lower. You

might lose some control if investors want to be involved in how you manage the

company. Investors may want the business structured in a way that makes it easier

to sell their shares in future.

2. Business Angels

Wealthy individuals will typically invest £10,000 or more and may also offer

business expertise. But you are unlikely to interest outside investors unless you can

show a strong track record and credible business plan. Investment will come at a

price – they will expect high potential returns to compensate for the risks they are

taking on.

3. Other Venture Capital

Government backed venture capital funds will invest up to £500,000 in English

companies. Check with your local regional development agency for details. Banks

may also be interested.

British Venture Capitalist Association British Venture Capital Association website

www.bvca.co.uk

4. Grants

Grants and government support may be available. You can get subsidised or no

interest loans or cash. Often support schemes provide lots of free advice you might

otherwise have to pay for.

But there may be stiff competition, you will have to meet specific criteria and

usually have to provide funds yourself. Grant applications can be time consuming,

but there is money out there for grabs. See Duport’s grant section.

SMALL FIRMS LOAN GUARANTEE SCHEME

Businesses which would not normally qualify for a loan can get help.

1. Additional Sources Of Finance

There are small amounts of money – micro finance or micro credit – can be

available, usually only for businesses setting up in a disadvantaged area or sector

normally not helped by mainstream lenders.

2. Leasing

This can be a good way of financing a vehicle and you have the option of fixing

costs as part of the agreement. Instead of buying you can lease – usually for a fixed

period of three to five years. Payments are spread out over the period helping cash

flow. You get full tax relief on lease payments, except for cars costing more than

£12,000.

3. Hire Purchase

Used for equipment. You buy the equipment but payments of capital and interest

are spread over a fixed period (usually 3–5 years). You can claim capital

allowances on the equipment and the interest payments receive full tax relief.

4. Factoring

Factoring can free up the cash tied up in unpaid invoices. Factoring firms normally

give up to 80% of the value of each sales invoice within 24 hours. The firm then

collects outstanding payments on your behalf from your customers. Factoring is

particularly useful for fast growing businesses or those that have very high value

invoices but have to wait 30–90 days for customer payment.

5. Invoice Financing

This provides you with finance against invoices that customers have not yet paid.

You can receive up to 85% of the face value of each invoice immediately and the

balance (less charges) when the invoice is paid by the customer. Unlike factoring,

you have to chase up the invoices yourself.

6. Stock Finance

Cash is raised against the value of stock held by a manufacturing company.

7. Security For Borrowings

For any type of borrowing you will need to show you can afford to pay it back and

that you can offer security to ensure the loan is repaid if things go wrong. Security

can take different forms. You might be able to offer:

• a personal guarantee from an individual (be aware that if the guarantee is called

on and has been supported by a legal charge over your personal assets, these assets,

including your house, can be at risk)

• a guarantee from a third party. This person will be liable for the debt if you

default. Sole traders (and partners) are already personally liable for all business

debts and directors of limited companies may have to provide personal guarantees

in case the company fails

• Small Firms Loan Guarantee for start-ups and young businesses that have been

trading for fewer than five years. Run by the Small Business Service this can be

used to guarantee loans of up to £250,000 (turnover must be under £5.6 million),

but you have to pay a premium of 2% a year on the outstanding balance as well as

the repayment terms and interest rates set by the bank or institution you borrow

from, and you may have to take out insurance.