BUSINESS: The Ultimate Resource™

July 2006 Upgrade 46

GOOD SMALL BUSINESS ACTIONLIST

Financing a New Business

GETTING STARTED
New businesses need finance to cover the cost of equipment and expenses
before sales generate enough cash to make the operation self-supporting. This
actionlist describes the main ways of financing your business (equity finance,
loan finance, and grants). It explains how to work out the amount of finance you
need, and what proportion of debt to equity is advisable.

FAQS
What is a business angel?
A business angel is someone who is willing to invest money in a business. The amount
available from angels is usually much less than from venture capitalists, but they are
often willing to take bigger risks.
What is equity finance?
Equity, or shareholder capital, is the money introduced into a business by the owners. If it
is a company, then the equity is introduced in exchange for shares. Investors expect a
share of the business’s profit. In the case of limited companies, this takes the form of
dividends. The person starting a business will normally introduce equity capital, but it
can also be raised from external investors, including business angels and venture
capitalists. Investors will be looking for an annual dividend, which often can be quite
small, and a good return when they sell their shares. Equity is best suited, therefore, to
businesses that expect to grow quickly.
What is loan finance?
Loan finance is money that is borrowed from a finance company, such as a bank. Loans
are repaid over a period of time, at either fixed or variable rates of interest. The lender
will usually require security against a business or personal asset. Terms can vary in
length from one year to 25 years, and will usually be determined by the asset that is being
financed. The interest rate will reflect the lender’s perception of the risk in providing the
loan. Loan finance can be provided in different ways.
An overdraft is money that a business can borrow from a bank up to an agreed limit. It
provides a business with short-term finance, effectively by running a negative balance on
the bank account. This is a particularly good way of funding short-term requirements,
such as providing working capital during the course of each month.

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BUSINESS: The Ultimate Resource™
July 2006 Upgrade 46

Term loans are funds borrowed for a fixed term. Usually, such loans are repayable in
equal instalments over the term of the loan, although sometimes they can be repaid in a
lump sum at the end of the term. Term loans are more attractive than overdrafts for long-
term borrowing because repayments are fixed and the cost is usually less. However,
lenders are increasingly writing into the small print that term loans are repayable on
demand. If the loan has been used to finance capital assets, this could cause problems.
Creditor finance is an excellent way of ‘borrowing’ money, effectively at no cost.
Typically, suppliers may give 30 to 60 days’ credit for their goods or services before
payment is due. If you can sell your product or service and get paid before paying your
creditors, then it will generate cash into the business. Your business may have to establish
a trading record before credit is given, and it can be withdrawn at any time.
Debtor finance is particularly useful if your business is growing rapidly and is providing
credit accounts to its customers. Instead of waiting for your own customers to pay your
invoices within a 30– or 60-day period, you can use the services of a third party invoice
discounting or factoring firm. Factoring can be an expensive way of speeding up cash
flow, but it may reduce administration costs since the factor normally takes on the role of
invoice clerk.
Grants are usually ‘one off’ payments providing a percentage of the costs towards a
specific purpose, usually for capital expenditure, but sometimes for a specific activity
such as taking part in an exhibition or trade fair. Amounts vary depending on the scheme.
A grant may be available from the government, the European Union, the local authority,
or a related organisation. Grants are usually treated as income to the business and, as
such, are shown on the profit and loss account. There are several sources of grant aid
worth investigating when starting in business, and whenever you are buying equipment.
Capital asset finance can often be done through ‘off-balance-sheet’ finance. There are
different ways of doing this. Financial leasing allows you to finance the use of an asset
rather than owning it. The equipment remains the property of the leasing company; the
business has the legal right to use the equipment for the period of the lease, provided that
the lease payments are up to date. In a lease purchase arrangement, you have an option to
purchase the equipment at the end of the lease period. Through hire purchase, you pay
regular instalments to a third party, normally a finance house, to purchase ownership of
plant and machinery from a supplier. The finance house will own the equipment
throughout the period of the agreement, until the last instalment has been paid.

MAKING IT HAPPEN
Work out how much capital you need
The working capital of a business is its current assets (typically stock, cash at the bank,
and debtors) minus its current liabilities (typically trade creditors, other creditors such as
PAYE and VAT, and your bank overdraft). This information is summarised on the
balance sheet, although this only gives a snapshot of the working capital requirements at
a specific moment in time. Generally, this is the finance required for the short-term
running of the business.

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The amount of working capital needed will vary during the course of the year and even
during the course of a month. You need to allow for the maximum likely working capital
requirement. Consideration needs to be given to the variation that can occur within each
month. As a rule of thumb, it makes sense to aim for minimum working capital of a
month’s average sales multiplied by the number of months it takes to collect payment. If
you want to be more accurate, then use the following procedure:
1. Determine the average number of weeks that the raw material is in stock.
2. Deduct from this figure the credit period from suppliers, in weeks.
3. Then add the average number of weeks to produce goods or service, the
average number of weeks finished goods are in stock, and the average
time customers take to pay.
4. Take the total, and divide it by 52 (the number of weeks in the year).
Multiply the result by your estimated sales for the year. The answer will
give you a figure for the maximum working capital required.
It would be more accurate to use the cost of sales (direct and fixed), rather than the full
selling price, but the above calculation is close enough. If your business is growing, then
you need to use the budgeted sales figures, and it is advisable to calculate your working
capital needs on a regular basis.
Understand gearing and interest cover
Gearing is the proportion of debt to total capital in the business. The more debt there is
relative to equity, the higher the gearing. Introducing more equity, or retaining more of
the profits, can reduce the gearing ratio. Most banks look for a gearing of no more than
50%; in other words, your debt should be no more than half of the total capital.
Once you have built up a track record with your bank, you should be able to attract
medium-term loans (three- to seven-year loans) to cover the cost of plant and equipment.
Established companies may be able to raise long-term debt as a debenture or convertible
loan stock, which normally receives a fixed rate of interest and is repayable in full at the
end of the term. Long-term debt is usually included with the capital on the balance sheet.
The banks will also be more comfortable with a higher gearing, though they still do not
like to see it too high. Lease and hire purchase companies will not have as great a concern
about gearing as the banks. They will, however, be interested in your cash flow and
whether you can afford the repayments.
If you expect to grow quickly and do not have enough of your own money to provide the
necessary finance, then you may need to look for equity early on. Banks will be reluctant
to keep on providing additional working capital as that simply increases the gearing and
increases their risk. Growing too quickly is often known as ‘over-trading’ and is a major
cause of business failure. The banks will also want to reassure themselves that you can
afford the interest on the loan. So they will look for profits that are at least three or four
times the expected interest charge.

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BUSINESS: The Ultimate Resource™
July 2006 Upgrade 46

COMMON MISTAKES
Not thinking ahead
Regularly calculate the total level of funding required for the next year, and split the
funding into fixed asset requirements and working capital requirements. Think carefully
about the term, the cost, the suitability, the timescale, and any security required.
Remember that cost should not be the sole criterion. Keep your lenders informed of your
financial position, giving ample warning if you are likely to need to increase your
overdraft, for example.
Not changing with the times
In times of recession, keep as much of your debt as possible as fixed medium-term loans,
and keep your overdraft requirement to the minimum. In times of expansion, when
finance is more readily available, it may be more cost effective to use an overdraft.

THE BEST SOURCES OF HELP

British Venture Capital Association: www.bvca.co.uk
Factors and Discounters Association: www.factors.org.uk
The Prince’s Trust: www.princes-trust.org.uk

© A & C Black Publishers Ltd 2006