Sources of business finance

Every business needs money, whether it is about to open or has traded for years. Finance is needed for three broad purposes: covering the costs of getting started, paying the bills of running the business, and funding bigger spending that shapes its future.

Start-up costs

Before a business makes its first sale, money has to go out. A small escape-room business must rent and fit out a unit, build its rooms with locks, hidden doors and props, set up a booking website, buy insurance and advertise before it can take a single booking. These start-up costs arrive as a lump sum at the beginning, so a new owner often has to find a large amount at once.

Day-to-day running costs

Once trading, the business faces regular payments: wages for employees, rent, energy bills and payments to suppliers for stock. The costs that have to be paid whatever the level of sales, such as rent and insurance, are called overheads; wages and supplier payments rise and fall with how busy the business is. A small hardware shop, for example, must pay its supplier for paint and tools well before customers buy them. If the money is not there, the shelves stay empty and sales are lost.

Major investments for the future

Businesses also need larger sums, spent less often, to grow or improve. That could be opening a second workshop, taking on more staff, bringing out a new product or paying for research and development to test and improve designs. A firm making garden planters might spend months testing a weatherproof coating before launching a new range, and none of that spending brings money in straight away.

Short-term finance is money used for immediate or day-to-day needs, such as paying for fuel or materials before customers pay. It is usually cleared within a year. Long-term finance is money used for major investments, such as a building, machinery or expansion, and it is provided over several years.

Short-term does not mean a small amount. A £12,000 overdraft is short-term if it is cleared within a few months, while a £4,000 loan repaid over three years is long-term. What matters is how soon the finance is cleared.

Classifying the sources

Short-term sources are suitable for a temporary cash gap, not for buying a building or funding a long expansion. Using an overdraft for a major investment creates pressure to repay too soon. Long-term sources are suitable for major investments, not for a brief cash shortfall, because the business may pay interest or give away ownership for longer than needed.

For example, a mobile dog-grooming service might use an overdraft to buy shampoo and other consumables in a quiet month, then clear it when the appointments are paid for. To buy a second grooming van that will be used for years, it would be better to use a long-term source such as a loan or retained profit.

Not every source fits every business. A sole trader cannot raise share capital, and a new business may have no retained profit. This classification is about timing, not about how large the sum is.

An overdraft is an arrangement with a bank that lets a business withdraw more money than it has in its current account, up to an agreed limit. If the account holds £300 and the overdraft limit is £500, the business can spend up to £800 in total. Any amount spent beyond the £300 is borrowed and must be paid back, with interest.

It suits a temporary cash gap, when money is due out before customer payments arrive. For example, a mobile bike repair business has £300 in its current account but must pay £520 for parts and insurance before a busy weekend. An overdraft covers the £220 gap so the work can go ahead, then customer payments clear the balance.

Why businesses use one

• Quick to arrange — usually simpler than applying for a loan, especially for an existing bank customer.
• Flexible — the business borrows only what it needs, when it needs it, rather than taking a fixed sum.
• Protects cash flow — it covers short gaps between paying suppliers and receiving sales income.

The costs and risks

An overdraft is not free. Banks charge interest on the amount borrowed and may add arrangement or monthly fees, so the longer the balance stays negative, the more it costs.

The bank can also reduce the limit or ask for repayment at short notice. That makes an overdraft risky for a large, long-term purchase such as machinery or a shop refit, which needs finance that cannot be pulled away. It is best used for short-term needs and cleared as soon as possible.

Trade credit is an agreement with a supplier that lets a business receive goods or services now and pay for them later, within an agreed period. For example, a supplier might offer 30 days to pay. It is a short-term source of finance because the amount owed is normally cleared within a year.

Advantages

Trade credit helps cash flow. The business gets stock without paying straight away, so it can sell the goods and collect cash from customers before the supplier's bill is due, which reduces the risk of a temporary cash shortage. If the business pays within the agreed period it is usually charged no interest, so trade credit can cost less than borrowing the same money from a bank for a few weeks.

How it works in practice

Imagine an independent hardware shop orders £1,200 of paint, brushes and tools from a wholesaler on 30-day terms.

The shop does not need to find £1,200 on day 1. By day 30, sales of the stock should have brought in enough cash to pay the supplier.

Drawbacks

New or small businesses may find trade credit hard to obtain. A supplier may worry that a business with little trading history cannot pay, so it may ask for payment up front or offer a shorter credit period. Trade credit is not a bank loan; it depends on the supplier's trust and on the terms it sets.

Paying late can damage the relationship with the supplier. The supplier may refuse future credit, demand cash on delivery or stop supplying altogether, which could leave the business short of stock.

Personal savings are money that the owner of a business takes from their own savings and puts into the business. The cash comes from the owner rather than from a bank, an investor or a supplier, so there is nobody to repay and nobody new to share the business with.

Personal savings are especially useful for sole traders and partnerships. These businesses are not companies, so they cannot raise money by selling shares, and the owner's own money is often the first finance available when a business starts up.

For example, Ben makes wooden toys and sells them at craft fairs. He needs about £3,000 for a lathe, a sander and materials, but he has £2,000 in a savings account. He uses it to buy the lathe and a second-hand sander, because a new one would not fit his budget.

Advantages of personal savings

• Full control: no lender or investor has a say in decisions, so the owner chooses what to buy and how the business is run.
• No borrowing: there are no loan repayments or interest charges, which keeps costs down when money is tight.
• Careful spending: an owner spending their own money tends to think hard about every purchase, which reduces waste.

Disadvantages of personal savings

• The amount is limited: you can only invest what you have saved, so a bigger idea may have to be made smaller — Ben's second-hand sander is one result of this.
• The owner's money is at risk: if the business does not attract enough customers, the money may never be recovered.
• Lost interest: money left in a savings account would have grown, so the owner gives up that return.
• No safety net: savings are often kept for emergencies, and using them means there is less to fall back on at home.

Venture capital is money put into a business by private investors, usually wealthy individuals or specialist venture capital firms, in return for part ownership or control of the business. It is a long-term external source of finance, used when a business needs a large sum.

How it works

An investor agrees to fund the business, often a start-up with a risky but promising idea, and in exchange receives a share of it. That share gives the investor a say in how the business is run and a claim on a slice of any profits or of the money made if the business is sold. Because they are taking a big risk, they expect a big return if things go well.

For example, Jonah wants to open a chain of indoor climbing centres. He needs £250,000 for climbing walls and fitting out the first centre, but the bank will not lend that much to a business with no trading history. A venture capital firm offers the money for 30% ownership and two seats on the board.

Advantages

• Large sums can be raised, far more than a bank would risk on a new business with little track record.
• Investors often bring business advice and contacts, since they have backed many businesses before, saving the owner costly mistakes.
• There are no fixed monthly loan repayments, so a slow month does not force the business to find interest it cannot afford.

Disadvantages

• The owner loses some control. Jonah now has to persuade his investors before changing membership prices or hiring a centre manager.
• Investors expect a say in major decisions and may disagree about how fast to grow or where to sell, which can slow decisions down.
• The investor takes a share of the returns. If the business is later sold, 30% of the value goes to the firm, not to Jonah.

Venture capital is not free money: it suits a business with strong growth potential that can afford to hand over part of itself.

Crowdfunding raises finance by collecting small amounts of money from a large number of people, often through an online platform. Each backer gives a little, and together the amounts can reach the target. The money is not a loan from a single investor: the business usually offers a reward, such as a first version of the product, rather than repaying the money as it would a bank loan.

For example, a small business selling recycled stationery kits might ask for £5,000 on a crowdfunding platform. It offers backers a notebook set at a reduced price, and the platform takes a fee from the money raised.

Benefits

A campaign can be set up online quickly and shared widely, so it can reach a large number of people. It can also help with marketing, as the campaign page tells people about the product and may be shared on social media. It lets the business test public reaction: lots of backers suggest strong demand, while a weak response warns the owner before they spend more. It also raises finance without adding debt, which suits an owner who cannot get a bank loan or does not want one.

Drawbacks

It takes work to attract backers. The owner must build interest with a clear description, updates and messages, and may still fail to reach the target; many platforms release no money if the target is missed. A public campaign can also let another business see the idea and copy it. Finally, platform fees and the cost of making and sending rewards reduce how much of the money the business keeps.