Last reviewed 21 March 2019
John Davison looks at what the self-employed and small businesses need to finance, run, expand or start their business.
Choosing the method of finance is important as it can determine what stake third parties have in your business, the schedule to repay the debt and the cost of the debt in fees and interest. Without the correct financing, the normal operations of the business cannot be funded and there is no scope for expansion.
How much cash do you need?
Before a business can think of financing, it needs to know how much cash it requires. The first step, therefore, is to undertake a cash flow analysis. It is necessary to determine when cash will come into the business and when it goes out.
Cash in — what sales are expected to be made? When will sales be made; are they seasonal or evenly spread over the year? How long do customers take to pay? How many bad debts can be expected?
Cash out — what expenses are regular (wages, rates, rent, etc); these can be included in the cash flow forecast each month. Irregular expenses include costs for materials or goods for resale purchased (if any) and capital items. It needs to be calculated when these are to be purchased and when they are to be paid for. Tax and VAT payments also need to be included. The timing of capital goods acquisition (and if on finance or purchased at full cost) also needs to be added to the cash flow analysis.
The cash flow analysis needs to show the monthly cash requirement when planning for a year (or longer). More detailed analysis has to be undertaken to calculate what the daily requirement is, as expenses may be incurred through the month (such as weekly wages) but income may not come in until after these costs have been paid. This analysis shows the cash requirement for each day.
Frequently, a bank overdraft is used to provide operating finance. The cash flow analysis should show the maximum amount of overdraft you need for the year. Overdrafts are an easy form of finance and gives a facility to be used at the business’s discretion. They can, however, be expensive so reducing the size of overdraft is a useful cost saving.
Operating finance needs can be reduced by managing costs (for instance, using a purchase manager to monitor costs and ensure cheaper alternatives are sought). A further reduction in the operating finance needed can be achieved by appointing a credit manager to chase debts and ensure prompt payment by customers. Both the credit manager and purchasing manager can be rewarded through bonuses on the basis of how quickly customers pay and reductions in costs respectively.
Prompt payment of invoices issued can also be achieved through invoice factoring and invoice discounting. This is where third parties collect the debts on behalf of the business but pay the business prior to collection of the debt. There is a charge for this so there is a need to balance the cost against the advantage of prompt payment of invoices. Some customers also do not like being chased by third parties, so customer relationships need to be considered. Depending on the arrangement with the factoring agent or the discounter, the debt can be passed to the agent or discounter with them taking responsibility for unpaid amounts, or the debt may remain with the business and unpaid amounts ultimately remain a cost to the business.
Assets can be purchased outright, acquired through a hire purchase agreement or leased. There are many names for finance packages, but they are either deferred purchase agreements (such as HP) or lease/rental agreements; each has their own tax and accounting issues that need to be investigated to ensure they are suitable for the business. The main difference (but not the only difference) for accounting and tax is that an asset that is owned (either outright or through purchase finance) appears on the balance sheet and the full cost is not claimed as an expense or tax deduction. A depreciation expense is claimed instead. Under a rental or lease agreement the rental or lease cost is shown as an expense and is tax deductible.
Many small businesses like to purchase so that they own the asset. The disadvantage of purchase is that the full cost is payable and this depletes cash reserves. Hence, leasing is popular as this allows the business to retain cash to use in its business and this enables the cash to be used to earn more income.
Finance for start-ups or expansion
Obtaining finance for start-ups can be difficult and expensive as the business does not have a track record. Other sources of finance can be obtained including:
Family and friends
Family and friends can often provide funds, although the amounts are frequently small. This usually has the advantage of being cheap, or interest free and not repayable until the business becomes established. Where the funds provided are substantial the family member or friend may be offered a stake or share in the business often as a sleeping partner.
Crowd funding — An increasing popular method of financing. It is particularly useful when promoting a specific product. There are several models of crowd funding including straight donation, reward-based crowd funding, loans (such as peer-to-peer lending) and equity based, where the funder obtains a stake in the business. Crowd funding also helps publicise the business idea, but if the business plan is complicated it may be difficult to get the business plan over to the general public. There are many crowdfunding websites and 10 are identified in the article on the following link.
Peer-to-peer lending is where numerous lenders (mostly private individuals) lend through an internet site to an applicant for funds. Many borrowers are looking for private finance (such as to fund a holiday or a house renovation), but business loans are also given. A list of Peer to Peer Lenders is shown at www.investitin.com.
Angel funding is provided by investors looking for a return. They often have a higher tolerance to risk than banks and provide funds and also, sometimes, advice. The angel may have a greater expectation of returns than a bank. Business angels have had prominent exposure through programmes such as Dragons’ Den. Business angels can be accessed through a number of portals such as Angels Den which is an online platform that puts investors and small and medium businesses together; there are other portals and angels available.
More information about angels can be found at the UK Business Angels Association website.
Grants and low interest loans
It is possible to obtain grants to help small businesses and start-ups. Many of these grants are aimed at specific businesses (such as those in Wales or Scotland, or women, or the unemployed). The Prince of Wales Trust, for example, will provide small low-interest loans to those aged between 18–30. A list of grant providers is provided at startups.co.uk.
This is similar to business angels, but is provided by wealthy individuals or specialised financial institutions. This can be a source of both funds and advice. The venture capitalist will be looking for quick growth of the business and a sale of the business in three or four years in order for the venture capitalist to obtain their return. This type of financing may not be for everybody as a significant element of control is lost when venture capital is used. The trade association for venture capital is available at BVCA website.
The traditional way of financing a business is through a bank loan. Banks have been fairly risk adverse over recent years, but still provide significant funds to businesses. In order to get a loan, it will be necessary to provide a good business plan and copies of any contracts the business may have showing the potential for future income. Any track record of the business (or its main directors or owners) may also be useful. Furthermore, the bank will want to know how it can secure its lending and may want to take a charge over business assets, or if these are insufficient, over the owners’ or directors’ personal assets such as their homes.
This newsletter can only provide a brief introduction to the different sources of finance for businesses. As can be seen there are many different types of finance and they are provided for different purposes. The most appropriate type of finance will depend upon the business, the risk and the purpose of the finance. Consequently, the business needs to research what type of finance is best for its needs. This research should be undertaken in advance of the requirement arising, so that the business does not rush into the first offer for finance that it receives. Advance preparation also allows the business to be able to gather the necessary documents and plans that the finance provider will want in order for it to provide the finance.