There are a number of ways of raising finance for a business. The type of finance chosen depends on the nature of the business. Large organisations are able to use a wider variety of finance sources than are smaller ones. Savings are an obvious way of putting money into a business. A small business can also borrow from families and friends. In contrast, companies raise finance by issuing shares. Large companies often have thousands of different shareholders.
Sources of finance Uses of finance
Shareholders Finance to set up and expand a business
Bank Loans to finance capital projects. Overdrafts to manage cashflow
Creditors Short term credit until goods have been sold
To gain extra finance, a business can take out a loan from a bank or other or other financial institution. A loan is a sum of money lent for a given period of time. Repayment is made with interest. The lender of money needs to know all the business opportunities and risks involved and will therefore want to see a detailed business plan. The lender may also want some form of security should the business run into financial difficulty, and may therefore prefer to provide a secured loan.
Another way of raising short-term finance is through an overdraft facility with a bank. The borrower is given permission to take out more from their account than they have put in. The bank fixes a maximum limit for the overdraft. Interest is charged on the overdraft daily.
A further way of raising funds that has become popular is through venture capital. Merchant banks and investment specialists may be willing to provide finance for a promising and fast-growing smaller business. This usually involves a package that is a mix of share and loan capital.
Businesses may also qualify for grants. Government (or EU) assistance and funding is sometimes made available to businesses that meet certain conditions. For example, grants and loans may be available to firms setting up in rural areas or where there is high unemployment.
Once a business is up and running there are various ways of financing its expenditures. Expensive items of equipment can be leased. Rather than buying the equipment the business hires it from a leasing company. This saves having to lay out sums of money and the business does not have to worry about having to carry out major repairs itself. Motor vehicles, machines and office equipment are often leased.
Hire Purchase is an alternative way of purchasing items of equipment. With a leased item you use and pay for the item but never own it. With hire-purchase you put down a deposit on an item and then pay off the rest in instalments. When the last instalment has been paid you become the owner of the item.
Another common way in which firms can finance their business in the short term is through trade credit. In business it is common practice to purchase items and pay for them later. The supplier will normally send the purchaser a statement at the end of each month saying how much is owed. The buyer is then given a period of time in which to pay.
Advantages and disadvantages of equity finance
Equity finance can sometimes be more appropriate than other sources of finance, eg bank loans, but it can place different demands on you and your business.
The main advantages of equity finance are:
The funding is committed to your business and your intended projects. Investors only realise their investment if the business is doing well, eg through stock market flotation or a sale to new investors.
The right business angels and venture capitalists can bring valuable skills, contacts and experience to your business. They can also assist with strategy and key decision making.
In common with you, investors have a vested interest in the business’ success, ie its growth, profitability and increase in value.
Investors are often prepared to provide follow-up funding as the business grows.
The principal disadvantages of equity finance are:
Raising equity finance is demanding, costly and time consuming. Your business may suffer as you devote time to the deal. Potential investors will seek background information on you and your business – they will closely scrutinise past results and forecasts and will probe the management team. However, many businesses find this discipline useful regardless of whether or not they actually receive any funding.
Depending on the investor, you will lose a certain amount of your power to make management decisions.
You will have to invest management time to provide regular information for the investor to monitor.
At first you will have a smaller share in the business – both as a percentage and in absolute monetary terms. However, your reduced share may become worth a lot more in absolute monetary terms if the investment leads to your business becoming more successful.
There can be legal and regulatory issues to comply with when raising finance, eg when promoting investments.
TASK (2) a,b & c
A financial plan consists of sets of financial statements that forecast the resource implications of making business decisions. For example, a company that is deciding to expand e.g. by buying and fitting out a new factory will create a financial plan which considers the resources required and the financial performance that will justify their use. You can see from this statement that the financial plan will need to take into account sources of finance, costs of finance, costs of developing the project, as well as the revenues and likely profits to justify the expansion programme.
Planning models may consist of thousands of calculations. Typically these plans will be constructed with the aid of forecasting models and spreadsheets that can calculate and recalculate figures such as profit, cash flows and balance sheets simply by changing the assumptions. For example, the business may want to do one set of calculations for low, medium, and high demand figures for its products.
Long and short term plans
Financial plans are typically made out for a given time period, e.g. one, three or five years. The length of the time considered depends on the importance of projecting into the future and the reliability of estimates the further we consider the future.
Long-term plans are created for major strategic decisions made by a business such as:
take over and merger activity
expansion of capacity
development of new products
In addition financial planning will be carried out for shorter time spans. For example, annual budgets will be created which can be analysed by month and by cost centre.
Short term financial plans then provide targets for junior and middle management, and a measure against which actual performance can be monitored and controlled. In addition it is normal practice for a business to prepare a three- or five-year plan in less detail, which is updated annually.
A budget is a short term financial plan. It is sometimes referred to as a plan expressed in money – but it is more accurately described as a plan involving numbers.
A cost centre is defined by CIMA as ‘a production or service location, function, activity or item of equipment whose costs may be attributed to cost units’.
The profit and loss account (P & L), called the income statement in the US, shows the profit or loss a company has made over a period of time. The ratios investors look at most often, such as the PE and yield, are calculated using numbers from the P & L
Also called revenues. Not always synonymous with turnover. Revenue recognition is not always simple.
Cost of sales
The direct costs of things sold
Sales minus cost of sales
Other operating expenses
Depreciation, admin, marketing etc.
Gross profit less other expenses
Interest payable less receivable
Operating profit less interest
Profit after tax
Pre tax profit less tax
Profit after tax less dividends
Earnings per share
The most detailed profit and loss account is given in the annual report, but UK listed companies are required to make annual and half year results announcements as well. The full year results announcement is shorter and covers the same period as the annual report, but it is released earlier.
Many companies make quarterly announcements, as companies in the US and many other countries are required to. Unsurprisingly, UK listed companies that also have a secondary or dual listing in a country that requires quarterly announcements.
As can be seen, the P & L contains several profit numbers. Each of these gives us different, and useful, information. In addition, the P & L (perhaps together with other information) usually gives us enough information to calculate several other profit numbers such as EBITDA and EBITA
Many companies will show exceptionals separately. If there were any discontinued business, or plans to dispose of a business within a short period, these are also shown separately.
These can give investors a better idea of the underlying business (the justification for doing it). For example, if the company has decided to sell a particular operation and the price has been agreed, shareholders do not really need to worry too much about that operation’s performance.
A group balance sheet will need to be consolidated, which requires extra lines such as those for share or profit in associates and joint ventures, and the deduction of minority interests.
As well as the valuation ratios, the P & L provides the numbers for measures of the performance and efficiency of the business, such as margins, ROCE, and some measures of financial stability such as interest cover.
The P & L is backward looking and investors will need to consider correcting some items such as amortisation that are not useful for modelling future cash flows. From an investor’s point of view the P & L is essential, but can be misleading and should not be looked at in isolation.
Related pages: Accrual principle | Accruals | Consolidated accounts | Deferred income | Depreciation | Impairment | Minority interests | Post balance sheet events | Prepayments | Pro-forma | Purchase method | Revenue recognition | Cashflow statement | Statement of total recognised gains and losses
The balance sheet is one of the most important statements in a company’s accounts. It shows what assets and liabilities a company has, and how the business is funded (by shareholders and by debt: the financial structure of the company). Book values are usually historical cost or fair value.
The balance sheet provides information that is useful when assessing the financial stability of a company. A number of financial ratios use numbers from the balance sheet including gearing, the current assets ratio and the quick assets ratio. However, ratios based on profits and cash flow are at least as important for assessing financial stability: the most important of these are interest cover and cash interest cover.
If any assets or (more commonly) liabilities that belong to the company in their economic effect do not appear on the balance sheet because accounting standards do not require it, they are referred to as off-balance sheet.