L5/6 Sources of finance

Financial pressures SMEs face (Business and Trade Committee found)

• late payment from consumers who buy via credit, nearly half of all invoices are paid late

• admin and tax burdens: high tax compliance costs

• energy costs

Why its difficult to finance new ventures?

• business plan is just a plan - no history to back up idea

• need to show evidence it will work

• bureaucracy: need to pitch business and compete for financing

• ignorance on the different sources available

• equity averse = may not be willing to give shares away

types of funding SMEs may require

initial capital investment - start ups

re-investment - for growth

working capital = money used to run business on a day to day basis

debt vs equity

debt is borrowing money:

dis: needs to be paid back WITH INTEREST, may have conditions attached, limited availability

adv: low risk (banks won’t lend if they don’t think your plan will work), no ownership loss

equity is a permanent source of capital within the business - involves selling shares

dis: dilutes ownership, pay dividends to shareholders (share profits); higher risk
adv: no direct repayment

debt/credit finance source of finance

• long and short term loans

• credit cards

• overdrafts = short term, high interest

• leasing = renting equipment, pay via instalments , may be option to buy after, can be expensive if total rent cost overall > upfront cost

• factoring

• trade credit - suppliers

what is factoring?

transfer ownership of debt aka late payments/trade receivables to a factoring company who then chase up the debt themselves

adv: able to receive cash flow immediately from customers, able to plan cash use

dis: loss of direct contact with customers and no control over how factoring company chases payments up (badgering or aggressive tactics), expensive as pay for service (company takes percentage)

financing from banks adv and dis

good relationship with bank is important so pay on time and COMMUNICATE if late (build trust)

adv:

stable funding

access to more money than raise alone

dis:

information asymmetry - may lack bank support if bank doesn’t understand my business

bureaucratic process - may need interview

approval is specifically bank dependent

interest

may have condtiions attached

Alternative Investment Market (AIM)

SMEs can trade here as they may not meet requirements to trade on public stock exchange

primary vs secondary market

primary: raise capital and initially sell shares (IPO)

secondary: investors buying/selling (trading) shares already in existence → impacts perceived value of business (is there high demand, share prices?)

Bootstrapping

start up accumulates finance through own resources and family e.g. selling assets, personal savings

adv: not such a bureaucratic process where you have to majorly pitch business, don’t have to repay or sell ownership, can show good qualities to future investors → demonstrates traction and ambition, shows own willingness to invest in idea

dis: take on lots of personal risk, hard to pull together sufficient funds,

frugal mindset

more cautious/careful with money → may have this with bootstrapping because it’s their own money

grants

public source of finance - could be from government, foundations etc.and no requirement to repay

but

comes with conditions → should show a return on investment for local community (create meanigful jobs)

very competitive, pitch business, lengthy and time consuming application process

grants can suddenly change with change in gov

lots available can be hard to find what’s applicable

Pecking order theory for hierarchy of financing Myers and Majluf

firms generally follow a hierarchal order when raising capital

1. internal financing - bootstrapping/ retained earnings etc. to help with starting up

2. debt financing - when internal funds are insufficient or as firm grows a bit more

3. equity financing - considered last resort as high costs of issuing new shares or if low demand in secondary market could give negative signal

Community Development Finance Institutions

not for profit that lends small amounts to usually smaller business who contribute something within the community e.g. social enterprises, employment created

community based, work with some retail banks, provide services like professional development and networking to support business

Types of entrepreneurial finance and explained

• crowdfunding: use sites to raise money from public in different ways → donations-based, reward-based (get certain reward e.g. get sample), lending-based (lend through platform but sort legalities), equity based (money for ownership) ADVANTAGES: can get feedback from public on product/service, can build market/awareness before selling DISADV: disclose idea to competitors risky unless patented or IP

NOTE: Wallmeroth said crowdfunding is better for incremental innovation than start ups as business is already in the works

• venture capitalists: organisations that invest in business, usually HIGH RISK HIGH RETURN, high risk so helpful for those unable to secure bank loan, different financing structures (equity, debt capital), provides network of contacts, dis. ethos/objectives may clash

• business angels: individuals that invest usually what they have knowledge/experience in, more personal and involved → Venture C vs B Angel depends on what firm wants (consider money provided, cost, experience, geographic reach)

• blockchain/cryptocurrencies - less relevant for strat ups

Short term financial management

Aims:

• SURVIVAL

• maintain liquidity

• increase profitability of business

Features of SMEs in contrast to large firms

• have lower fixed to total assets ratios

• have higher proportion of trade debt in total assets

• much higher proportion of current liabilities to total assets

• greater reliance on bank loans to finance assets; good stock management and good debtor/creditor relationships (to be paid quickly and delay payments further)

Death valley

sustained period of spending more than receiving creating accumulated cash flow

cash management

firm should find the optimum level of cash FOR THEM SPECIFICALLY

based on:

• cash flow forecasts

• efficiency with which cash flows are managed

• availability of liquid assets

• borrowing capability of the company

• company’s risk appetite

too much cash -→ opportunity cost of what the cash could have been used on and could draw larger business in to takeover

work towards optimum level by reducing float → time between initiating payment and receiving cash

float due to:

transmission delay - time from payer to payee

lodgement delay - delay in banking any payments received

clearance delay - time for bank to clear and pass on payment

Stock management

consider optimum amount of stock

depending on industry or needs mange in different ways

just in time - don’t hold inventory but produce stock to be used just in time (no storage costs or cost of deterioration from quality loss or opportunity cost from cash tied up)

OR hold lots of extra storage to account for demand surges

NOTE: Conflicting needs: financial incentives want to hold less stock for less costs, marketing may want to hold more to offer quantity discount promotions (BOGOF)

Cash conversion cycle

time between spending cash on raw materials and inflow from sale of finished goods = number of days financing is needed for (to cover time before receiving cash)

longer cycle = greater investment needed

length depends on:

• inventory conversion period (stock to product)

• trader receivables collection period (customers buying on credit - time to actually pay) -→ debtor turnover = how quickly collect money owed

• trade payables period (how long suppliers let you use stock unpaid for) → linked is creditor turnover = how quickly you pay off suppliers (quicker shows good cash management)

Ways to improve cash flow (may be in response to a cash flow forecast

• can increase forecasted sales with discounts and promotions BOGOF

• negotiate costs of goods sold with suppliers

• negotiate creditor payment (how long till pay back)

• cut costs e.g. salaries (but be wary is this feasible considering employee motivation)

• lease equipment instead of outright buy

• invest more of own money/retained profits over borrowing