6.1.1 Sources of finance

Internal sources of finance

1. Retained profit: profit the business has already made and held on to is spent on new equipment, extra stock or expansion, which suits an established, profitable firm such as Greggs funding new shop fit-outs from the profit its existing shops generate.
   1. Advantage: there is no interest to pay and no outsider gains a say in decisions.
   2. Drawback: the money only exists after profitable trading, and using it means the owners take less out this year.
2. Owner's savings: the owner pays money in from their own bank account, which suits a start-up with no trading record that a bank would refuse.
   1. Advantage: the money is available at once, with no interest and no lender to convince.
   2. Drawback: the amount is limited by how much the owner has, and their personal money is now at risk.
3. Selling unwanted assets: machinery, vehicles, land or premises the business owns but no longer uses are sold for cash, which suits a firm with surplus equipment standing idle.
   1. Advantage: cash comes in without creating any debt or interest.
   2. Drawback: a business with nothing spare to sell cannot use it, and a rushed sale fetches a low price.

External finance from a bank

1. Bank loan: the business receives a known sum on a known repayment schedule, which suits a planned one-off purchase such as a £40,000 delivery lorry that will be used for years.
   1. Advantage: the instalments are fixed and predictable, so the owner can budget for them, and no ownership is given away.
   2. Drawback: the bank usually wants security, an asset it can seize if the business defaults, and the instalments still have to be paid in a month when sales collapse.
2. Mortgage: the cost of buying premises is spread over 25 years or more, which suits a chain of salons buying a freehold unit rather than renting it.
   1. Advantage: the monthly amount is manageable, and the business ends up owning an asset instead of paying rent for ever.
   2. Drawback: the building itself is the security, so it can be repossessed if repayments are missed.
3. Overdraft: the account is allowed to dip below zero up to an agreed limit, which suits a short cash gap such as paying wages the week before a large customer settles an invoice.
   1. Advantage: interest is charged only on the amount actually used, and only for the days it is used.
   2. Drawback: the interest rate is high and the bank can demand repayment at any time.

External finance from suppliers and finance companies

1. Trade credit: goods arrive now and are paid for 30 to 60 days later, which suits any firm that buys stock regularly, such as a convenience store taking weekly deliveries.
   1. Advantage: the business can sell the stock and collect the cash before the supplier has to be paid, and no interest is charged.
   2. Drawback: new businesses are rarely offered it because the supplier has no evidence they will pay, and a firm that pays late loses discounts and can have its credit withdrawn.
2. Hire purchase: an asset is paid for by deposit and instalments, which suits an expensive item the business needs immediately but cannot pay for outright, such as a van or a commercial fridge.
   1. Advantage: the asset starts earning revenue from day one, while it is still being paid for.
   2. Drawback: interest is added to each instalment, so the total paid ends up above the cash price, and the item can be taken back if payments stop.

External finance from people and the government

1. Family and friends: money is lent or invested by people who already know the owner, which suits a start-up a bank would turn down.
   1. Advantage: the terms are far softer than a bank's, often interest-free and with no security demanded.
   2. Drawback: if the business struggles, the money and the relationship are both at risk.
2. New share issue: newly created shares are sold to investors, which suits a company funding major expansion, such as a plc opening 30 new stores.
   1. Advantage: large amounts are raised that are never repaid and carry no interest.
   2. Drawback: the new shareholders dilute the existing owners' control and expect a share of future profit as dividends.
   3. Who can use it: only a limited company can issue shares at all, and only a plc can offer them to the general public, so a sole trader or partnership cannot use this source.
3. Government grants: a public body hands over a sum to encourage an activity it wants to see, such as training apprentices or installing energy-efficient equipment.
   1. Advantage: the money never has to be repaid and costs no interest.
   2. Drawback: grants are competitive, come with conditions on how the money is spent, and are rarely large enough to fund a whole project.

6.1.2 Appropriateness of sources of finance

Matching the source to the purpose and the time period

1. The finance should last as long as the need it is paying for, so the first question is always what the money is for and how long it will be tied up.
2. A short-term cash gap of a few weeks, such as paying £9,000 of wages before a big customer settles up, is best met by an overdraft or by trade credit.
   1. Both let the business borrow only for the days it is short, so the charge stops as soon as the money arrives.
3. A long-term asset needs long-term finance, so a £40,000 lorry that will run for eight years is matched with a bank loan.
   1. Premises costing £300,000 are matched with a mortgage repaid over 25 years, because the building and the borrowing both last for decades.
4. Permanent expansion with no repayment date attached is matched with retained profit or a new share issue, which is why a plc opening 40 stores raises share capital rather than taking an overdraft.

Weighing cost, control and risk

1. Cost: retained profit and a government grant cost nothing to service, a bank loan or mortgage charges interest at an agreed rate, and an overdraft is the dearest way to borrow for any length of time.
   1. A share issue charges no interest at all, but it commits the company to paying dividends for as long as those shares exist.
2. Control: borrowing leaves ownership untouched, because a bank has no vote on how the business is run.
   1. Selling shares or bringing in an outside investor raises money without repayments, but the newcomers gain a say in decisions and a permanent slice of future profit.
3. Risk: loans and mortgages usually require security, so a missed run of repayments can cost the business its premises or its equipment.
   1. A firm already carrying heavy repayments should think hard before adding more, because fixed outflows have to be met in bad months as well as good ones.

Sources suited to a new business

1. A start-up has no retained profit, no spare assets to sell and no trading record, so most of the internal menu is closed to it and lenders treat it as high risk.
2. That leaves four realistic options: the owner's savings, money from family and friends, a government grant, or a loan the owner backs with security such as their own house.
   1. Owner's savings and family money: these need no credit history and cost no interest, but the sums are small and the owner's personal finances are on the line if the business fails.
   2. A government grant: it never has to be repaid, which is why a start-up chases one, but it is competitive and carries conditions on how the money is spent.
3. Two external sources stay out of reach until the business has a record to show.
   1. Trade credit: suppliers rarely offer it to a firm with no payment history, so a new business often has to pay for its first deliveries in cash, which makes the early months harder.
   2. A share issue: a new business cannot sell shares to the public, because that requires plc status, and even a small private company will struggle to find buyers with no accounts to show them.

Sources suited to an established business

1. An established firm can show several years of accounts and offer real assets as security, so it is offered more sources, larger sums and lower interest rates than a start-up.
2. Retained profit: this is usually the first choice, because it is free, immediate and costs no control, which is how Warburtons funds most new bakery equipment.
3. Selling unwanted assets: this is only open to a business that has accumulated them, so an older firm with an unused warehouse can raise cash a start-up simply does not have.
4. A new share issue: for sums beyond what profit can supply, an established limited company can issue new shares, which is the only realistic route to several million pounds with no repayment date attached.
5. Being established is not a blank cheque, because a firm whose profits are already swallowed by existing loan repayments will be refused further borrowing however long it has traded.

Reaching a decision for a given situation

1. Start from the amount required, because it rules options out on its own: £800 for a repair can come from retained profit, while £2 million for a new factory cannot.
2. Check the legal structure next, since a sole trader or partnership cannot issue shares at all, so recommending one is a wasted answer.
3. Then ask whether this business could survive the fixed repayments in a bad month.
   1. A firm with unstable sales is safer with finance that flexes, such as an overdraft, while a firm with steady sales can carry a loan comfortably.
4. Finish by choosing one source and explaining why its drawback is acceptable for this business, rather than listing good and bad points and leaving the decision open.