Types of capital
Capital can be thought of as the money invested in a business when it is first opened. That money is used to buy whatever machinery, equipment or other items used to operate the business. These items become part of the assets (items of value that a business OWNS) of the business.
There are 3 types of capital a business might need:
__1. START UP CAPITAL – __Capital a business needs to ‘get off the ground’. For example, the owner of any new business must be able to buy or rent premises, buy necessary equipment and to buy stock to trade.
2. ADDITIONAL CAPITAL – Required at some stage. This type of capital is used to expand a successful business into a new market or to buy a new piece of machinery. Another reason maybe the rebuilding or refurbishment of premises.
3. WORKING CAPITAL – Used to pay for the day-to-day running expenses of the business and to pay urgent bills such as electric and telephone. Working capital comes from money in the bank and sales. A lack of working capital will result in cash-flow problems which could cause a businesses downfall. A lack of working capital would mean that the business could not pay its short term bills and eventually its creditors (people to whom it owes money) would have to take legal action. In extreme cases, the court would have the business wound up and assets sold in order to raise money to pay the creditors.
Sources of finance
Businesses need to find sources of finance to start up and run their operations. One way is to attract capital from others in return for a share of ownership. Or if the business is going strong, it can put back into the business a share of the profits made (I.E. RETAINED PROFITS). The business needs to decide which is the best option. For instance, should a sole trader put in his own savings? If a partner or sole trader is brought in, what will be his/her share of the profit and control of business affairs?
The time for which the finance is needed may be:
Short term - up to 1 year
Medium term - 1 to 5 years
Long term - over 5 years
Sources of finance can be:
Internal - retain profits, reduce stock levels, sell assets
External - lease, borrow from friends/family, grants, bank loan, equity investments
Internal sources of finance are usually a cheaper way to raise working capital – though it is a slow way. Obtaining finance externally is usually the last option as interest has to be paid increasing the cost, or control diluted – though it is a fast way.
Internal and External Sources
Internal sources of finance come from inside the business, the business’ assets or activities.
1. OWNER’S OWN CAPITAL
Description - The owner(s) invest more of their private money into the business.
Time period - Used if the money was required long term.
__Advantages: __Does not have to be repaid
__Disadvantages: __Not all business owners have that additional capital to call on
2. RETAINED PROFITS
‘Plough back in’ profits from previous years instead of taking them out of the business to keep for the owner(s) own use. Used if the money was required for medium/long term purposes.
__Advantages: __Does not have to be repaid (no interest or time limit)
Not diluting ownership or control of the business
__Disadvantages: __If small profit margins not a lot to reinvest (none if loss is made)
Less money to keep for you!
Risking own cash (quit while you are ahead)
3. SALE OF FIXED ASSETS
Businesses have large sums of money invested in their fixed assets and sometimes choose to sell some surplus assets (perhaps a machine, property, fixtures & fittings, vehicles etc.) in order to raise funds. Used if the money were required in the medium term.
[If a business wants to use its assets, it may consider sale and lease-back where it may sell its assets and then rent or hire them back. It may mean paying more money in the long run but it can provide cash in the short term to avoid a crisis.]
Advantages: Don’t lose control of business/share profits.
If you don’t need the asset, may as well sell them
Disadvantages: Reduces production output
Don’t get their worth back in money (depreciation)
It may take a long time to sell the product – slow
New/small businesses are unlikely to have surplus assets to sell
4. SALE OF STOCKS
Every manufacturing/retail business has surplus stock that has never been sold. The business could raise finance quickly by holding a sale and offering the goods to the public at a discount. This is unlikely to raise a large amount of capital. (E.g. January sales used to raise money and create space for the new spring stock). Selling stock would be done if the money were required in the short term.
__Advantages: __Fast way of raising cash
Disadvantages: Unlikely to raise a large amount of capital
Mightn’t get the full value for items if selling price is reduced
If the stock is stockpiled due to a lack of demand, very little
stock maybe sold despite any vast reduction in selling price
5. DEBT COLLECTION
The business might have a lot of money owed to it from customers (debtors who purchase goods on credit). The business may make a greater effort to ‘chase the customers’ for the outstanding money if the firm requires capital.
Advantages: Immediate money upfront
Disadvantages: Customers might shop elsewhere in future if they think that the firm is pressurising them unfairly for payment.
If it is not possible to raise the required capital internally, businesses will look towards external sources.
External finance comes from outside the business, involving the business owing money to outside individuals or institutions.
1. BANK OVERDRAFT
An overdraft allows a business to withdraw more money from its current bank account than it contains, up to a certain limit agreed previously with the bank manager.
Interest is paid on the amount actually overdrawn each day and therefore getting a bank overdraft is usually cheaper than a bank loan which has a fixed rate of interest. It is a short term source of finance. It is probably the most important source of funds for a lot of businesses.
2. BANK LOAN
a medium to long-term source of finance. The bank agrees to lend the business a set sum of money for an agreed period of time. It is paid back in regular instalments. Compared with a bank overdraft, the interest charged is slightly higher. For this reason a bank loan can be an expensive source of finance.
The bank requires security for its loans. This means that the bank has the right to sell an asset belonging to the business if repayments are not kept up.
Example: Student loan
£16,000 x 3.2/100 = £512 p.a.
With a loan, the business will pay back more than its value in the long run. E.g. if a business borrowed £3,000 for a year, it may pay it back in monthly instalments of £300 each – meaning that £600 of interest is paid. If the firm has a bad year, the bank will still insist that it receives payment. If the capital was raised by selling shares you could persuade the shareholders not to take a dividend because the business has had a bad year. An advantage of loans however is that you do not lose or have to share control/profits of the business.
Therefore plcs and ltds prefer loans, more capital for them in the long run.
E.g. Require £10,000 in extra funds. Have £10,000 in profit.
40,000 £1 shares in total: 30,000 – £7,500 10,000 new - £2,500
loan at 10% p.a.:£10,000 - £1,000 = £9,000 to keep
Businesses use mortgages to buy property in the same way as a private individual obtains a mortgage to buy a home. A mortgage is a very long-term source of finance, and the money has to be paid back over a fixed number of years (usually 20 to 25). The premises purchased act as collateral (i.e. mortgage is secured on the premises) which could be sold by the bank if it fails to keep up payments on the mortgage.
INTEREST HAS TO BE PAID ON OVERDRAFTS, LOANS AND MORTGAES.
4. ADDITIONAL PARTNERS
If a partnership requires extra finance, the partners can agree to invite an additional partner to join the partnership (or a sole trader can take on a partner and become a partnership). A long-term source.
Advantage: Further capital as well as sharing out costs/unlimited liability. Drawbacks: Sharing profit and control.
5. SHARE ISSUE
In the case of a limited company, extra finance maybe raised by issuing new shares for shareholders. This is a long-term source for a company and no interest is payable although shareholders are entitled to a share of the profits (dividend) and control is diluted.
6. LEASING ASSETS
If an expensive new piece of machinery is needed the firm could decide to lease it out (i.e. hire it) rather than buy it. The lease is arranged by a finance company and the business makes regular payments to it for the use of the asset. The business will never own the asset; it is simply paying for its use. It is a medium-method.
Pros: You don’t need to find so much money immediately
Convenient if you only need the machine for a short period of time
Better to lease computers as software and hardware might go out-
of-date in 2-3 years.
Cons: In long-term more expensive (end up paying far more in rent than
cost of machine)
Can’t resell it for quick money or secure a loan on it
7. HIRE PURCHASE
Hire purchase is a mixture of purchasing the asset as well as leasing it. The business pays a deposit on the asset and agrees to pay off the balance in equal instalments over an agreed period of time.
The difference between hire purchase and leasing is that the business eventually becomes the owner of the asset once it has paid off all the instalments.
It is a popular method of finance as the business can have modern equipment (though it maybe dated in the end-up) without having to part with a large sum of money at the outset, and it will eventually own the asset.
The major disadvantage is that the total cost of the asset is much higher than if it were bought for cash. A medium-term source of finance.
If a machine costs £10,000, the firm might pay £2000 of a down payment and then pay £200 a month for 4 years. In the long run, the firm will pay:
£2000 + (12 x 4 x £200) = £11,600 for the same £10,000 machine.
8. TRADE CREDIT
A short-term means of finance. Another way of getting money is to put off paying your suppliers, i.e. instead of paying for materials immediately you take one month to pay, or even longer. Helps the working capital of a small shop, for example, buy the goods on credit then sell them to raise money to pay the supplier. Added advantage of being free (no interest charged). This might be a good idea if you require short-term money, but it has its disadvantages:
- You miss out on discounts available for immediate payment
- If your suppliers are unhappy they may refuse to let you have supplies in the future
- You still have to pay the money at some point
A business will sell its debt (outstanding money owed by customers (debtors)) to a Factor. The Factor collects all the payments due and pays the firm the amount owed, less charges for the factoring service. Although these factoring services can be high, the firm saves money by not having to employ its own staff/time for debt collection and it also benefits by getting the money faster. However customers may resent being chased up for their debt and do their business elsewhere in the future.
A firm is owed £20,000 by its debtors but does not have the time to phone up its customers and chase the debt. So it approaches a factoring firm who takes over the debt. They take a 5% commission (so the firm receives £19,000 immediately) and then the firm tries to get £20,000 from the debtors. Anything
> £19,000 is a profit to them. The original firm gets most (but not all) of its money immediately.
10. GOVERNMENT GRANTS
Official bodies such as Invest NI provide grants to assist businesses setting up, expanding or exporting. The European Union also provides grants for businesses and councils in areas of high unemployment. The government also supports companies, both British and foreign, that creates jobs in these areas by opening new factories. Grants usually do not have to be repaid but they do have conditions, e.g. locating on a specific site.
11. ONLINE COLLABORATIVE FUNDING/VENTURE CAPITALISTS
Description – AKA ‘crowd funding’. An online way to get an array of venture capitalists with the idea of a lot of people investing a little collaboratively accumulating to be a lot of money! An example is ‘Collaborative Fund’ which runs ‘AngelList’ – check it out! This form of peer-to-peer lending platforms function like marketplaces where lenders can connect with borrowers. In 2014 it raised 1.2 bill in loans for UK businesses. The gov created one such platform called ‘Funding Circle’ which reckons it gets investors a rate of return of 7%. Investors give you their money in return for a share in the business and annual dividends….with hope of selling on the share when the business turns big for big bucks!
Time period – LONG-TERM
Advantages: Popular way for start-ups to get additional capital.
Disadvantages: Success of return rate is bad, off-putting.