Growth finance: what changes once a business is already trading
- A start-up is funded on the strength of a plan, while a business already trading is funded on the strength of its record, which is why growth finance is usually cheaper and easier to get.
- A trading record: accounts and bank statements let a lender check that the business really makes money, so the loan is less of a gamble and the interest rate is lower.
- Assets: premises, machinery and vehicles can be offered as security, so the bank can recover its money if repayments stop and will lend a larger sum.
- Past profits: years of profitable trading build a fund inside the business that the owners can spend without asking a bank or an investor at all.
Internal sources: money the business has already made or already owns
Definition
Retained profit: profit kept in the business from previous years instead of being taken out by the owners as drawings or paid to shareholders as dividends.
- Retained profit is the first place a profitable firm looks, because the money is already sitting in the business and needs nobody's permission to spend.
- Advantage: there is no interest to pay and no ownership given away, so the whole return on the new oven, van or shop stays with the existing owners.
- Drawback: the amount is capped by how profitable the business has been, and a pound put back into growth is a pound the owners cannot take out this year.
- Selling assets turns equipment, vehicles or property the business no longer needs into cash, with no interest charged and no repayments to follow.
- Drawback: the asset has gone for good, so the business must buy or hire again if it needs that machine back, and a sale raises money once rather than every year.
Example
- Greggs sells cheap hot food in high volume from shops on high streets and retail parks, so profit those shops have already earned is the obvious money to fund the next shop with.
- A bakery in Leeds trading for eight years buys a second oven for £7,000 out of retained profit, doubling what it can bake with no interest to pay.
- When it replaces its delivery van it sells the old one, and that cash cuts what it has to find for the new one.
- Neither route existed in year one, when there were no past profits to keep and no spare equipment to sell.
External sources: loan capital and share capital
Definition
Loan capital: a fixed sum borrowed from a bank and repaid in instalments with interest over an agreed number of years.
Share capital: money raised by selling shares in a company, which makes the buyer a part-owner entitled to a share of the profit.
- Loan capital for growth is usually secured on premises or machinery, which is exactly what a trading business has and a start-up does not.
- Advantage: control is kept, because the bank votes on nothing and takes no share of the profit once the loan is repaid.
- Drawback: repayments fall due whatever the trading, so a quiet quarter costs the same as a busy one, and missed payments can cost the business the secured asset.
- Share capital never has to be repaid and carries no interest, so instalments do not drain the cash while the expansion is still costing more than it earns.
- A private limited company sells shares privately to invited investors, and only a public limited company can go further and float on the stock market, selling shares to the public and raising far larger sums.
- Drawback: ownership, profit and control are all shared, because every new shareholder takes a slice of future dividends and a vote on how the company is run.
Judging which source suits a growing business
Set the four sources side by side and the trade-off is size against cost and control.
| Retained profit | Selling assets | Loan capital | Share capital | |
|---|---|---|---|---|
| Internal or external | Internal | Internal | External | External |
| Repaid | No | No | Yes, with interest | No |
| Control given up | None | None | None | Yes, ownership shared |
| Sum available | Capped by past profit | One-off, usually small | Large if secured | Very large if floated |
- The internal two cost nothing and give nothing away, but neither stretches: retained profit only exists if trading has been profitable, and an asset can only be sold once.
- How much is needed therefore decides first, because an £8,000 delivery van can come out of retained profit while a £2 million second factory cannot.
- After that it depends on whether the owners will give up control, and on whether the business can carry fixed repayments in the months when the new site is still costing more than it brings in.
- Overall, an established firm expanding steadily should fund growth from retained profit first and top it up with a secured loan, because that is the cheapest money and leaves ownership whole; a firm whose growth plan is far bigger than its past profits has to sell shares and accept sharing the profit that growth creates.
Exam technique
- Name the source, then say why it fits this firm: "it has traded for six years and owns its premises, so it can secure a bank loan" is what earns the application mark.
- Do not answer a growth question with an overdraft or trade credit, because those cover day-to-day cash gaps rather than the cost of a second site.
- Build the chain: retained profit costs no interest, therefore more of the profit from the new shop stays in the business, therefore the shop after that can be funded the same way.
- When the question says justify or evaluate, weigh one internal source against one external one and finish by naming the source the business should use and why.
Self review
- Name the two internal sources of finance a growing business can use.
- Why can an established business usually borrow at a lower interest rate than a start-up?
- Give one drawback of funding growth by selling shares.
- What is a stock market flotation, and which type of company can use one?
- State two things that decide whether a firm should fund growth from retained profit or from a loan.
