Financing your business

Jul 7 2005 By the Evening Gazette

Your new businesses will need finance to cover the cost of equipment and expenses before sales generate enough cash to make your business self-supporting.

This article describes the main ways of financing your business.

Equity finance

Equity, or shareholder capital, is the money introduced into a business by the owners.

If it is a company, then the equity is introduced in exchange for shares. Investors expect a share of the business's profit, either as drawings or as dividends in the case of limited companies.

The person starting a business will normally introduce equity capital, but it can also be raised from external investors, including 'business angels' and venture capitalists.

Investors will be looking for an annual dividend, which often can be quite small, and a good return when they sell their shares. Equity is best suited for businesses that expect to grow quickly.

Loan finance

Loan finance is money borrowed from a finance company and is repaid over a period of time, at either fixed or variable rates of interest.

The lender will usually require security against a business or personal asset. Terms can vary in length from one year to 25 years and will usually be determined by the asset that is being financed.

The interest rate will reflect the lender's perception of the risk in providing the loan.

Overdraft - money that a business can borrow from a bank up to an agreed limit. It provides a business with short-term finance and a good way of funding short-term requirements.

The borrower will pay interest only on the amount borrowed, and sometimes an annual arrangement fee.

It is therefore expensive money, but because you are only borrowing the exact amount required, the total cost may be less than having a term loan but is repayable on demand.

Term loans - funds borrowed for a fixed term, usually, repayable in equal instalments over the term of the loan, although sometimes can be repaid in a lump sum at the end of the term.

Most businesses require capital assets that have a useful life of several years, these include equipment, machinery, vehicles and buildings.

Lenders are attracted to this type of finance because they can use the asset as security against the loan.

Creditor finance - a good way of 'borrowing' money, effectively at no cost. Typically, suppliers may give 30-60 days credit for their goods or services before payment is due.

If you can sell your product or service and get paid before paying your creditors, then it will generate cash into the business.

Your business may have to establish a trading record before credit is given and it can be withdrawn at any time.

Debtor finance - instead of waiting for customers to pay your invoices within a 30 or 60 day period, you can use the services of a third party invoice discounting or factoring firm.

This is particularly useful for businesses that are growing rapidly, and are providing credit accounts to their customers.

The factor or invoice discounter will provide a business with an advance on the value of its invoices (usually 80pc) as soon as the invoice is processed. Interest is charged on the balance drawn, plus a service charge.

Factoring can be an expensive way of speeding up cash flow, but it may reduce administration costs since the factor normally takes on the role of invoice clerk.

Grants

Grants are usually 'one-off' payments providing a percentage of the costs towards a specific purpose.

Amounts vary depending on the scheme and are usually treated as income to the business and, as such, are shown on the profit and loss account.

There are several sources of grant aid that you should investigate when starting in business and, particularly, whenever you are buying equipment.

Check with Business Link to see if they have any grants available for which you might qualify.

Capital asset finance

Financing capital assets can often be done through 'off-balance-sheet' finance:

Financial leasing is a way to finance the use of an asset rather than having ownership of the asset.

The equipment remains the property of the leasing company, your business has the legal right to use the equipment for the period of the lease, provided that the lease payments are up to date.

In a lease purchase arrangement, you have an option to purchase the equipment at the end of the lease period.

Hire purchase is a way for you to purchase ownership of plant and machinery from a supplier. You pay regular instalments to a third party, normally a finance house.

The finance house will own the equipment throughout the period of the agreement until you own the equipment after the last instalment has been paid.

How much capital do you need?

The working capital of a business is its current assets (typically stock, cash at the bank and debtors) minus its current liabilities (typically trade creditors, other creditors such as PAYE and VAT, and your bank overdraft).

This information is summarised on the balance sheet, although this only gives a snapshot of the working capital requirements at a specific moment in time.

Generally, this is the finance required for the short-term running of the business.

The amount of working capital needed will vary during the course of the year, and even during the course of a month.

Your business needs to allow for the maximum likely working capital requirement and consideration needs to be given to the variation that can occur within each month.

Gearing and interest cover

A key issue for any lender will be the proportion of debt to total capital in the business (gearing). The more debt there is relative to equity, the higher the gearing.

Most banks look for a gearing of no more than 50pc, so the debt should be no more than half of the total capital.

Once you have built up a track record with your bank, you should be able to attract medium term loans to cover the cost of plant and equipment.

Lease and hire purchase companies will not have as great a concern about gearing as the banks.

They will, however, be interested in your cash flow and whether you can afford the repayments.