If an existing plc is thinking of expanding -buying some new equipment or machinery, setting up a new plant or branch or buying another business (a takeover or acquisition) etc; it needs money which is called business finance.
This assignment will look at some of the possibilities for business finance. When the company is making a decision through the business finance, it has to been remembered that some sort of finance will be appropriate for some businesses but not for others.
The choice of source of finance that a business makes will depend on a number of factors. These are cost, financial outlook, legal status and time period.
Company needs finance for the short-term or the long/medium-term. The way in which it may raise this finance will differ a great deal and it may look at the different sources and what area of business activity it may be useful for.
Two key sources of finance are internal sources -money which can raise from within the company and includes profit, reducing working capital, sale of assets, perhaps sale and leaseback the assets or better management of existing resources; and external sources -mean raising money from outside the company.
External sources differ as ownership capital and non-ownership capital.
Long/Medium Term - Ownership Capital
1. Ordinary Shares:
Also known as equity shares, voting shares or common shares. It gives the right to the owner to share in the profits (dividends) -it can be an advantage for a plc as well a disadvantage; because the profit of the company can vary wildly, so the dividends can be paid to ordinary shareholders vary.
Also it gives right to vote in proportion of the percentage at annual general meetings. This includes the right to cast votes for those who are seeking a seat on the corporation's board of directors. It's a disadvantage for a plc to share the power of driving the company.
When the investors see the long-term developing potential and want to be a part of the process, they will provide a long-term capital for the plc to achieve its improvements. However the ordinary shareholders share the profit, they share the risk of the business. If the plc doesn't make a profit, the dividend won't be paid to ordinary shareholders.
Buying and selling of the ordinary shares does not affect the business directly. So it's the advantage for plc. But it mustn't be forgotten that the stock market is a second hand share market and it's open for any manipulations, with such a depressed share price, companies will find it very difficult to raise additional finance or reassure existing creditors.
On the other hand the ordinary shareholders considered unsecured creditors so in the event of liquidation of the company, plc is not responsible to pay dividends.
2. Preference Shares:
They are shares which pay out a fixed dividend. But the preference shares dividend is not a legal obligation. When the company has a financial trouble, dividend won't be paid to preference share holders.
Main differences from ordinary shares are:
Preference shareholders (PHs) are entitled to a fixed annual dividend and they cannot vote at general meetings. PHs do not have access to the potential profits as ordinary shareholders, so they must satisfy the fixed dividend whether the company make more profit than expectation or not. It can be an advantage as well a disadvantage for plc. Not having the right to vote at general meetings is an advantage for a plc that not to share the power of driving the company.
The payment of dividends to PHs is priority rather than ordinary shareholders.
Preference shares are cumulative. It's a disadvantage for a plc. If one year's dividend wasn't paid, then it will be carried forward to next year.
A preference share is redeemable. It's an advantage for a plc. Because some time in the future, the company can effectively buy it back.
If a preference share is a participating preference share the owner has the right to participate in, or receive, additional dividends over and above the fixed percentage dividend discussed above if the company is performing well. This kind of preference share gives the opportunity to the plc, having more money by increasing the value of its shares.
Long/Medium Term - Non-ownership Capital
3. Debentures & Convertible Debentures
It's a loan, which is not backed by Collaterals and entitled to repayment on a set schedule. Between the issue of the debenture and the maturity date, the plc should pay a fixed level of interest whether or not profits are made. However this interest is a disadvantage, it's common and relatively lower risky way for the plc to raise capital.
The debenture is primarily unsecured. It means the lender of this debt is considered general creditors in the event of liquidation. It provides a lower risky way to raise capital for the plc. The issue of a secured debenture -tied to the financing of an asset; the debenture holder (DH) has a legal interest in that asset. If the business fails, the DHs will be entitled to the repayment of some or all of their money before the shareholders receive anything. It's a disadvantage for weak companies.
Convertible debenture means have the option of receiving its repayments in cash or stock. The advantage of convertible debenture is the lower interest rate.
4. Bank Loan:
Banks are important source of longer term business finance -over 5 years, possibly up to 25 years. The loans have a rate of interest attached to them. It is more expensive than an overdraft, but lasts longer.
It's an advantage that it can be secured quickly. On the other hand it's a disadvantage that interest rates can vary and high according in which the Bank of England sets interest rates.
It is a disadvantage that the bank may well want some sort of guarantee for this type of loan. It could perhaps be secured against an asset of the business or the personal assets of shareholders.
For businesses, using bank loans might be relatively easy but the cost of the loan can be high. If interest rates rise then it can add to businesses costs but it means ineffectiveness in business competition and having a bad affect on the cash flow of the business.
However there is another disadvantage that bank has the power to place a business into administration or bankruptcy, the main advantage of bank loan can define relatively longer for raising capital.
5. Mortgage:
A mortgage is a loan specifically for the purchase of assets such as property.
It's an advantage when company has a commercial mortgage instead of raising capital by selling shares in the business to an investor company can retain complete ownership. The lender is only interested in the interest return on its mortgage, not a percentage of ownership. The business can retain all the benefits of ownership in an asset that has the potential to increase in value.
It's another advantage that the interest payments are tax deductible and are made with pre-tax money. Mortgage can provide better cash flow and more predictable cash flow management because of the pre-set mortgage schedules.
On the other hand mortgage requires pledge the purchased asset to the lender. If there is a default on the mortgage, the lender is able to foreclose the asset and sell it to repay the outstanding money.
6. Venture Capital:
Venture Capital is a capital contributed generally at an early stage in the development of a developing company, which may have a significant chance of failure but also a significant chance of providing above average returns and especially where the provider of the capital expects to have some influence over the direction of the company as well a share in the profits made. However it seems as a disadvantage, it's the advantage that the venture capitalists or Private Equity Firms can provide operational, financial and strategic advices, contacts and experience to the business. They have a vested interest in the business' success for instance growth, profitability and increase in value.
However the main advantage is that the business is not obligated to repay the money, venture capitalists seek to realise their investment in three to five years. If the plc's business contemplates a longer timetable before providing liquidity, venture capital cannot be appropriate.
The other disadvantage is that the venture capitalists are more sophisticated and can drive harder bargain to reduce the price of the company.
7. Business Angels:
Business Angels are investors who are wealthy and entrepreneurial individuals looking to invest in new and growing businesses in return for a share of the equity.
The main advantages are that they are more permissive, geographically dispersed and seeking small deals (generally between £10.000 and £600.000). They add bonuses such as leveraging effect, loan guarantees and no high fees to the developing company.
They usually have considerable experience of running businesses that they can place at the disposal of the companies in which they invest. It's a disadvantage that company should give up some of the equity and allow an investor to take a 'hands-on' role.
However it's an advantage that the plc can offer the business angel an 'exit' (e.g. through a trade sale or the repurchase of their equity stake) at some future date, they could turn out to be devil because of their experiences.
8. Leasing:
Most businesses have to buy equipment, machinery or vehicle etc. Leasing is a contract between the leasing company, the lessor, and the customer, the lessee. The leasing company buys and owns the asset that the lessee requires. The customer hires (hiring) the asset from the leasing company and pays rental over a pre-determined period for the use of the asset but do not own it.
The advantages are fixed rate financing, improving the cash flow, it's cheaper than purchases, opportunities to keep touch with new technological equipments, having balance sheet benefits and tax benefits.
The disadvantages of leasing are that the leases may not be terminated before the original term is completed although the plc has a major financial problem. The other disadvantage is that the plc doesn't have the equity until it decides to purchase the equipment. Although the plc is not the owner of the equipment it is still responsible for maintaining the equipment. But if the firm has an agreement with lessor not to be responsible maintenance, it helps reduce costs for the business.
9. Hire Purchase:
Hire Purchase is acquiring assets without having to invest the full amount in buying them. It's an advantage that it allows the hire purchaser sole use of an asset for a period after which they have the right to buy them.
The benefit of this system is that companies gain immediate use of the asset without having to pay a large amount for it or without having to borrow a large amount. Usually fixed amount payments help the cash flow of the business.
The disadvantage is that the agreement cannot be withdrawn.
10. Government Grant:
If a company-eligible to get funds- has a specific issue that it wants or needs to deal with and then it could find that there are grants available from local authority and other bodies such as the national government or the European Union that will help to pay for it. These grants are often linked to incentives to firms to set up in areas that are in need of economic development.
Some advantages of grant are:
It can provide large monetary rewards with just one proposal.
The company who receive government grants once find it easier to raise money from other government or private sources.
It can be prestigious and give the company instant credibility and public exposure.
The disadvantages of grant are:
They are usually on a reimbursement system, so if the plc is a cash-strapped organization, it might face hardships.
Preparing proposals usually require hard work and tons of research and planning.
Grants come with requirements to spend the funds according to a complex set of regulations and laws that could increase the bottom line as company may need the expertise of an attorney, accountant, or other professional.
Government grants often come out with a set of rules for who are eligible to apply that can be so specific that it excludes many organizations.
11. Retained Profit:
Retained profit is a source that are kept by the company rather than distributed as dividends to shareholders. Profits from a business can be used to put back into the business. It is called ploughing back the profits.
They're the advantages that the company doesn't need to ask any outside group or individual, there are no issue costs involved in raising the funds and the company does not need to reveal its plans to outsiders such as banks in order to gain agreement.
The disadvantages are profits that are retained and not distributed to shareholders represent dividends foregone to the owners, owners may demand a regular dividend from the company, the company needs to be generating adequate profits, so this route is not suitable for those in financial difficulties.
Short Term - Non-ownership Capital
12. Bank Overdraft
When a company has the need for external finance, but not necessarily on a long-term basis to solve the small cash flow problems from time to time, it can use overdraft facility. Overdraft is a short-term source where company can spend money, to an agreed limit. Of course bank will charge interest on any overdraft amount. It's an advantage that It can be very valuable for firms to fill short-term shortages of working capital or any possible brief cash flow problems.
Bank overdrafts are given on current accounts and the advantage is that the interests is calculated on a daily basis. When the company borrows a small amount, it only pays a little interest.
Of course overdraft facility has its disadvantages. The interest rate can be quite high, especially for small companies where the risk to the bank that they might not get their money back is greater. In addition, the business is not allowed to exceed their overdraft limit.
13. Trade Credit:
It is a period of time given to a business to pay for goods that they have received.
When the company receive a delivery from its supplier it does not pay straight away. It will receive a trade credit period before having to settle the bill. It's an advantage for companies which can manage it, this effectively means they are getting some funds for free -interest free. Surely this gives the business the time to be able to manage its finances and balance its cash flows more effectively.
Of course the trade credit has the disadvantage when the company did not pay the debt after the trade credit period has past then there might be a penalty to pay. The supplier might charge a fee or start charging interest or even take the company to court.
We can summarize the advantages such reduced capital requirements, improved cash flows and increased business focus.
14. Invoice Discounting:
Invoice discounting is raising money using invoiced debtors as security. It enables company to retain the control and confidentiality of its own sales ledger operations. It provides an advantage that it is possible to keep the use of invoice discounting confidential.
The invoice discounter makes a proportion of the invoice available to company once it receives a copy of an invoice sent. Once the client receives payment, it must deposit the funds in a bank account controlled by the invoice discounter. It's the advantage that the invoice discounter will then pay the remainder of the invoice, less any charges.
It is the disadvantage that managing the cash flows is also difficult because of the need to pay the amount collected on each invoice to the invoice discounter.
There are some requirements for invoice discounting:
It must have an annual turnover of at least £500,000.
Be subject to an audit by the factor, usually every three months, to check that credit control procedures are adequate.
Must have a minimum net worth of at least £30,000.
Must be profitable.
15. Factoring:
Factoring means that the company sells its debts to the factoring company who pay them a proportion of the debts immediately. It's the advantage that factoring allows the company to raise finance based on the value of your outstanding invoices. It gives the company the opportunity to outsource its sales ledger operations and to use more sophisticated credit rating systems. In this way the company raises immediate finance. The debt factoring company make its money by collecting the whole debt when it is due.
The advantages of factoring:
Ability to maximise the cash flow as factoring enables company to raise the outstanding invoices.
By factoring company can reduce the time and money it spends on debt collection.
Company can use the factor's credit control system to help assess the creditworthiness of new and existing customers.
Factoring can be an efficient way to minimise the cost and risk of doing business overseas.
Of course, there are disadvantages to factoring:
The factor usually takes over the maintenance of the sales ledger. Customers may prefer to deal with the company it is trading with rather than a factor. However, if the factor's techniques are clearly agreed beforehand, there will usually be no problem.
Factoring may impose constraints on the way to do business. For non-recourse factoring, most factors will want to pre-approve customers, which may cause delays. The factor will apply credit limits to individual customers (though these should be no lower than prudent credit control would suggest).
The client company might only want the finance arrangements and yet it might feel it is paying for collection services they do not really need.
Ending a factoring arrangement can be difficult where the only exit route is to repurchase the sales ledger or to switch factors and that could cause a sudden shortfall in your working capital.
