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Cash Flow Learning Trail
Sources of Funds or Capital
So how do we solve a cash flow problem?
In the real world businesses can use a wide range of sources of funds to help finance their trading activities. Not all of them are in cash; some take the form of assets that the business can use. These can be used to improve cash flow in both the long and short term.
Below are the main sources of funds or capital, available to businesses to improve and manage cash flow. The links will take you to some other information on the web about that particular source.
- Owner's Capital - As you probably know, this is often the only source of capital available for the sole trader starting in business. The same often applies with partnerships, but in this case there are more people involved, so there should be more capital available. This type of capital though, when invested is often quickly turned into long term, fixed
assets, which cannot be readily converted into cash. If there is a shortfall on a Cash Flow Forecast, the business owners could invest more money in the business. For many small businesses the owner may already have all his or her capital invested, or may not be willing to risk further investment, so this may not be the most likely source of funding for cash flow problems.
- Shareholders' Capital - Shareholders are of course the owners of a Limited Company, they invest money in the hope of capital growth, (that is the business makes profits, grows, makes more profits, so as the business becomes bigger their investment will be worth), and dividend (the shareholders share of the companies profits). It is quite
normal for limited companies to issue new shares (a Rights Issue) (http://www.yahoo.com/Business_and_Economy/
Finance_and_Investment/Initial_Public_Offerings/Online_Stock_Offerings), in an attempt to raise capital, but this is normally for investment, funding expansion or restructuring, not for solving a cash flow problem!
- Retained Profit - At the end of the trading year a business will work out its profit. All of this profit can be taken by the owners, (this would be a dividend in limited company), or alternatively some or all of it could be reinvested in the company, to help the business grow and therefore make even more profit in the future. Retained profit is shown as reserves
on a Balance Sheet, but can take the form of any business asset, so it may not be cash, or money in bank. Normally when preparing a cash flow any Retained Profit will be allowed for and shown in opening balance, if it is held as cash.
- Overdraft - This is a form of loan from a bank. A business becomes overdrawn when it withdraws more money out of its account than there is in it, this leaves a negative balance on the account. This is often a cheap way of borrowing money as once an overdraft has been agreed with the bank the business can use as much as it needs at any time, up to the agreed
overdraft limit. But, the bank will of course, charge interest on the amount overdrawn, and will only allow an overdraft if they believe the business is credit worthy i.e. is very likely to pay the money back. A bank can demand the repayment of an overdraft at any time. Many businesses have been forced to cease trading because of the withdrawal of overdraft facilities by a bank. Even
so for short term borrowing, an overdraft is often the ideal solution, and many businesses often have a rolling (on going) overdraft agreement with the bank. This then is often the ideal solution for overcoming short term cash flow problems, e.g. funding purchase of raw materials, whilst waiting payment on goods produced.
- Bank Loan - This is lending by a bank to a business. A fixed amount is lent e.g. £10,000 for a fixed period of time, e.g. 3 years. The bank will charge interest on this, and the interest plus part of the capital, (the amount borrowed), will have to be paid back each month. Again the bank will only lend if the business is credit worthy, and it may require security. If security is required, this means the loan (http://www.mortgagesforbusiness.co.uk) is secured against an asset of the borrower, e.g. his House
if a Sole Trader, or an asset of the business. If the loan is not repaid, then the bank can take possession of the asset and sell the asset to get its money back! Loans are normally made for capital investment, so they are unlikely to be used to solve short-term cash flow problems. But if a loan is obtained, then this frees up other capital held by the business, which can then be used
for other purposes.
- Leasing - With leasing a business has the use of an asset, but pays a monthly fee for its use and will never own it. Think, of, someone setting up business as a Parcel Delivery Service, he could lease the van he needs from a leasing company. He will have to pay a monthly leasing fee, say £250, which is very useful if he does not wish to spend £8,000 on buying a
van. This will free up capital, which can now be used for other purposes. A business looking to purchase equipment may decide to lease if it wishes to improve its immediate cash flow. In the example above, if the van had been purchased, the flow of cash out of the business would have been £8,000, but by leasing the flow out of the business over the first year would be £3,000, leaving
a possible £5,000 for other assets and investment in the business. Leasing also allows equipment to be updated on a regular basis, but it does cost more than outright purchase in the long run.
- Hire Purchase - This is similar to leasing, but at the end of the hire period the asset belongs to the company that hires it. E.g. a farmer could Hire Purchase (http://www.bplans.com) a tractor.
- Buying on Credit - This creates Creditors. If a business, which sells shoes, buys on credit from Clark's shoes, it may not have to pay Clark's for a month after delivery. This means it could sell the shoes at a profit, and have
the money at the end of the month to pay its bill to Clark's. Extending a credit period will help short term cash flow, this could be done by delaying paying bills for an extra 14 days, meaning there will be more cash in the bank for this period. Unfortunately this type of action may upset a businesses suppliers, after all they have their own cash flows to think of! The next time
the business wanted credit from a supplier they had been very slow in paying in the past, they may be turned down! Slow payment by debtors is a problem for many businesses, and in fact the government has tried to take action against this type of behavior in several budgets.
- Selling Assets - A business can sell assets it owns to raise capital! This is often a last gasp measure as assets are usually vitally necessary to business activity. In some cases the business may lease back the asset, so that it still retains its use. But this often the preserve of big business e.g. the sale and lease back of office blocks. Selling assets, and
leasing the asset back improves cash flow in the short term. If the cash raised from the sale of the asset is used effectively by the business, cash flow and profitability can also increase in the long term.
- Debtors - If a firm is in immediate need of cash it could chase its debtors for repayment. This may involve giving discounts for early repayment. Chasing debtors for early repayment may lead to long term loss of trade, as the debtors may buy from another business next time, but it can be an effective method of solving short-term cash flow problems.
- Factoring - For larger firms, with a turnover (sales) of £100,000 or more a year, it is possible to let a Factor manage your debts for you. The factor (a type of finance company) will pay 80% of the value of an invoice at the time of sale, and will take responsibility for receiving payment from the debtor. The balance of the debt will be passed on when the money
is received by the factor. There is of course a charge for this and the amount of charge will depend upon several issues such as, number of debtors, size of debts, past bad debt history. But factoring (http://www.alexlawrie.com) does improve a businesses' cash flow and it popularity amongst small to medium size businesses proves many
managers and owners regard this service as good value for money.
Remember to use the Hypertext links above to increase your understanding of sources of funds.
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