Raising Capital in the UK Economy
Businesses have several financing options for their capital projects. One of the financing options is bank borrowing. There are several banks in the UK market and a business does its analysis to get the best interest rates in the market. A business may approach a bank loan to purchase assets such as machinery. With this kind of business financing, the company may have to give assets as collateral to the bank to act as security. There are two types of bank loans that offer that is secured loans and unsecured loans. The advantage of secured loans is that the interest rate is lower than for unsecured loans as it is less risky. Banks also offer mortgage loans. This is where a business is engaged in real estate and wants to invest in property. The bank will give the business money to purchase the property. The house in this case is the security or collateral for the loan. The property may be for renting out or selling for commercial or residential purposes. Businesses are also given overdrafts by banks for short-term financing purposes. Banks also offer invoice financing where it agrees to pay a business the amount owed to them by their debtors in exchange for a percentage of the debt usually around 10 percent. This is suitable for small businesses since they need to repay their debtors quickly yet at the same time they need stable cash flows for their day to day activities.
A business may choose equity financing option. The major types of equity financing are business angels and venture capitalist. A business angel is a person or organization willing to invest an agreed amount of money in the company either for a share of ownership or convertible debts. This is through ownership of shares or debentures. This means they are involved in decision making. These business angels invest in any industry as long as it is making a profit. The second type of equity financing option is business venture capitalists. They specialize in firms that are starting out in a new product or industry. They support new technology and new products. These new products will generate higher returns though the risk of business failure is high.
There are various advantages of equity finance. There is no repayment of a loan based on fluctuating interest rates. A company pays dividends based on the company financial performance. There are several disadvantages of this method. On issuance of shares the ownership of the company is spread to more parties diluting control to other shareholders. These additional owners will desire to be involved in the decision making processes. For businesses that wish to retain control it is more advisable to use debt financing option (Momentos Editors). Further more, a business will end up paying dividends for a long time until they purchase back their shares. It is not like a loan where the company will finish paying up and not be obligated anymore.
The advantage of using bank loans as a financing option is that there is no dilution of ownership or control. There are no shareholders to influence bank decisions. For business angels who have debentures in the company, they may enter into restrictive covenants with the business dictating the use of the assets in the company. They may prohibit certain businesses as being too risky. Furthermore they are entitled to future business profits in form of dividends. This is why most businesses prefer banks since the lenders are just entitled to principle and interest repayments unlike shareholders who are entitled to dividends. The company which has taken a bank loan does not have to have meetings with the lenders or send periodic company financial statements. The law requires companies with shareholders to hold annual general meetings and discuss company financial information. The interest on loans is deductible towards calculating tax payable so it offers a tax advantage. The disadvantage in using bank debt is that interest rates keep fluctuating, they are not fixed and depending on the market the company may find itself repaying high interest rates on their loans. In the last quarter of 2010 the loans that had been disbursed to small and medium size enterprises were lower than any other quarter.
The businesses focused on repaying existing bank debts instead of engaging in new projects. Loans with increased interest rates end up reducing a firm’s income and liquidity or working capital that may be used to finance further projects. There are businesses which have issued shares to the public only to use part of those funds to repay existing loans (Bank of England Editors, 2011). Most CFO’s when questioned felt that most companies were over-leveraged. For the last quarter of 2010 most business reduced their debt values in their balance sheets. The method a business uses to fund their businesses is also dependent on the economic conditions at that time. If the company has cash flow problems it cannot take on more debt since it will struggle to repay the loans. There is also a limitation on the amount of loans a company may take. There is also the issue of collateral. A company has to provide security to the banks in order to get loans. Furthermore if a company has a lot of debt is considered risky and lenders and investors are less willing to give more loans or buy equity in the company. With a debt it has to be repaid regularly however with equity financing dividends will only be paid out when a company has performed well. With debt finance the company takes more debt dependent on the existing interest rates. In the fourth quarter of 2010, the interest rates had fallen specifically for large companies only. For medium sized companies the interest rates had remained constant though commissions and fees had fallen. There are businessmen that felt the interest rates, commission and fees had in fact risen for small businesses.(From the fourth quarter of 2010, debt finance and bond finance are now the most attractive financing options(Deloitte publications, 2011).
Currently equity financing is seen as being a less attractive method of financing capital expansion projects than bank borrowing or bond financing. Overall any company in England has several financing options. The option to use is dependent on internal factors and external factors. It depends on the senior management view on ownership, control and debt perception. It also depends on the external factors that are uncontrollable such as the financial economy of the country.
A business will weigh both the advantages and disadvantages of the two types of financing and choose the best method. Both have high risks and several advantages. Debt financing though is preferred as it has more advantages.
References:
Bank of England ( 2011) Credit Conditions Survey: Survey Results 2010 Quarter 4. .
Retrieved from: http://www.bankofengland.co.uk.
Deloitte Publications (2011). The Deloitte CFO Survey: 2011 Outlook, CFO’s planning
for growth. Deloitte. Web. 7th January 2011. Retrieved From:
http://www.deloitte.com/assets/Dcom
Monetos, ( 2010). Smart financing tips for flexible money management. Retrieved from:
http://www.monetos.co.uk.
