The question in the chapter title probably appears simplistic. The answer is obviously to pay for things: suppliers for stock, staff for their wages, utilities for services, the bank for the mortgage on the premises or the landlord, the taxman, the photocopier rental people, the leases on the equipment. And so on, right down to yourself as a business owner since you need a salary, dividends or drawings for the time and effort you put in to running the business, otherwise what is the point?

Yet it’s a good question to start with, since it helps to start to illustrate the different uses for cash in your business and how it impacts on the types of finance you need.

INVESTMENT AND WORKING CAPITAL

It is when you start to think about what you need cash for in your business that you can see it divides into two different areas.

The first is what you could see as the long-term investment in the business. This can take many forms. It could be investment in physical assets such as machinery, or in buying the business’s factory or offices, or in less tangible things such as research and development in order to produce intellectual property, or in long-term marketing to develop a brand, or even in training in order to develop staff skills and resources.

These can all be seen as long-term investments in the business’s future, which require a long-term commitment of funds to achieve results and where a payback is going to come over many years.

These are in contrast to the shorter-term requirement to finance the day-to-day trading of the business, the buying in of stock and the meeting of the day-to-day running costs of the business, including the cost of staff wages in order to be able to sell goods or services on to customers.

The working capital cycle

This shorter term activity and requirement to make payments actually forms part of a larger cycle of activities in the business which accountants refer to as the working capital cycle. This concept is illustrated in the diagram in Figure 1 of a cash pump which shows how a business’s working capital cycle is like a person’s heart, pumping the business’s lifeblood of cash around its system in a virtuous circle.

Imagine for a moment a business which only undertakes a single transaction at a time, buying in goods and selling them on, and which operates on credit. You can see that starting at the top of the circle the business will buy goods from a supplier (a purchase) at a cost of £75 and in doing so it creates somebody who is owed money, known in accounting terminology as a creditor (it may help you in thinking this through to use the American term of ‘payable’ as this is more descriptive).

The goods that the business has bought then form the business’s stock (at a value of £75, being the price the business has bought them at) until it sells them.

When the business then sells these goods to a customer at £100 it creates somebody who then owes the business money (a debtor in English accounting terminology, a ‘receivable’ in American).

In due course you would expect the debtor to pay the business in order to clear their debt of £100 and this means that the business is then holding cash. As the business has sold the goods for a higher price than it has bought them for from the supplier, the cash received in from the sale is then sufficient to both pay off the supplier (the creditor or payable) and generate a surplus or contribution of £25 which can go firstly towards the costs of running the business known as its overheads, and then once these have all been paid represents profit.

Of course very few businesses only deal in a single transaction at a time. So if you imagine many transactions happening over a period, all at different stages in the cycle, it may be easier to think of this cycle as actually being a pump, spinning round and sucking in cash from your customers as they pay their debts.

Management of the working capital cycle

Looking at Figure 1 you can see that some of this flow stays in the pipe to go back round to the start of the cycle to pay the suppliers.

You can also see that the surpluses generated by this process are then pouring out of this system, each drop making a contribution towards filling a bucket that represents the total cost of your overheads. And once this first bucket is filled so that your overheads are covered, the overflow from this into the second bucket represents your profits which can be used to invest in the business or to pay off borrowings.

In this simplified example, the business is able to obtain credit terms from its supplier that are long enough to allow it to both sell the goods in question and receive the cash in time to pay the supplier. As a result the business in this example has no need of funding to support its working capital cycle. Of course in practice few businesses are in such a fortunate position and the degree to which a business requires financing in order to trade is determined by its actual terms of trade with its suppliers and customers.

This is, however, an important concept. Management of the working capital cycle, and the degree to which there is a funding gap that needs to be covered by other sources of finance, is critical in determining how much cash your business needs and this will be looked at in more detail in Chapters 3 and 4.

Long-term investment and short-term working capital

Of course in practice the distinction between long-term investment and short-term working capital can be more difficult to make. For example is your advertising a long-term investment in building your brand? Or is it a shorter-term requirement in order to ensure your working capital cycle is rolling around day-to-day?

Similarly the cost of your machinery and your premises, while clearly long-term investments, are also a necessary cost in the short-term in order to manufacture your goods and to be able to operate.

Nevertheless, it is a useful distinction to try to keep in mind, since one of the first principles of financing a business is that the nature of the finance used needs to match the characteristics of what the finance is required for.

So, for example, if you have a long-term asset such as a machine that is going to cost £100,000, where the business is going to obtain the benefits of that machine in terms of a cash profit it can generate over many years at say £50,000 a year, for say a useful life of ten years, then the business has a choice about its approach to funding this asset.

• It could look to pay £100,000 immediately in cash. This has the advantage that the business does not have an outstanding payable of £100,000 and so it has eliminated any risk that it might not be able to pay for the machine at a future date. But it also means that the business will be out of pocket for two years until the machine has made sufficient profits to reimburse this expenditure (or in fact it is likely to be more since it may take time for the sales to actually turn into the cash).
• It could look to pay the machine off in, say, just over two years, allowing for some interest costs by using all the profit that it generates to cover its costs until it’s completely paid for. However, this means that the business will not be seeing a return in the form of increased profits for at least the first two years. Agreeing these terms also means that the business is taking a risk, since what happens if for some unknown reason the machine does not generate a cash profit of £50,000 a year in the first few years? The business will then be committed to making up the difference from some other source of funds.
• Perhaps the more appropriate way of funding the asset is by way of long-term funding over, say, five to eight of the ten years of the machine’s useful life so that the payments for that funding can be made broadly over the useful life of the asset. This in turn means that the profits that can be made from the machine can be relied on to generate cash with which to make the payments in respect of investment in it.

Funding for investment tends to be long term and relatively stable in that payment dates are set on a monthly or quarterly basis, while interest rates may vary up and down with the underlying bank base rate. It is, however, relatively easy for the business to project forward the payments it is going to need to make over the foreseeable future to fund this asset that it’s going to use during this period.

This can be contrasted with the financing that might be needed to support the company’s working capital cycle. As the level of the company’s business changes from day-to-day and week-to-week the funding it may need is also likely to vary, since if turnover is growing the company may need to acquire more stock from suppliers and may have more money tied up in debtors who have not yet paid. Working capital funding therefore needs to be flexible and capable of changing over relatively short periods of time to meet the trading needs of the business.

For businesses in the UK this has typically in the past meant using a bank overdraft facility where the company’s current account is expected to swing into overdraft as funding is required, returning into credit again as the profitable transactions turn into surplus cash. In this way the overdraft provides a very short-term facility which can be increased as the business’s demand for funding requires. Indeed overdrafts are actually much more short-term funding than many businesses realise; bank overdrafts are actually repayable on demand by the bank.

This general approach to financing is referred to as matching, since it looks to match the type of finance to the useful life of the asset or length of the requirement so that the following are possible.

• Long-term assets or funding requirements are financed with funding that is structured on a longer-term basis providing longer-term security and stability for the business. It does not make much sense, for example, to finance the purchase of a building that may have a useful life of, say, 50 years out of an overdraft that is theoretically repayable tomorrow.
• Short-term assets or funding requirements should be met with short-term flexible funding that can be ‘retired’ when not required so that you are not paying for what you do not use. It would not make much sense, for example, to fund a temporary requirement for working capital that may only last a month or so by taking out a mortgage on the business’s premises that ties you into repaying a loan over ten, 15 or even 25 years, long after the need for the cash has gone.

WHO NEEDS THE MONEY? YOUR BUSINESS’S LEGAL STATUS

Before considering finance in much more detail, it is probably worth thinking first about who or what your business is that is going to need finance, since the form that you choose can have a significant impact on how the business’s finance works.

This is not the place for a lengthy discussion on the various forms of corporate structure available to the business owner, but it is necessary to understand just who is the business.

In business on your own

You – You can obviously set up in business on your own and begin trading in your own right, buying in goods and selling them on (having notified the Inland Revenue that you are starting up). If you do so you are said to be acting as a sole trader in that you, the proprietor, are trading in your own name (and even if you use a business name, ‘Southern Widgets’, you will actually need to open bank accounts and enter into transactions as ‘Joe Smith, trading as Southern Widgets’). This is because from a legal point of view, you and the business are one and the same.

On the upside you own all the business’s assets personally, including whatever cash it may hold, and when the business makes a profit, this forms part of your personal income on which you will need to account to the Inland Revenue. On the downside, you are also personally responsible for all the business’s liabilities, including any money it has borrowed and if the business does not pay its bills or make its repayments, the supplier or lender involved will sue you personally to recover their money as you are the business.

The advantages of this approach to you when looking at financing a business is that since you are the business, all of your resources can be used to raise money for the business and lenders do not have to worry, for example, about distinguishing between assets owned by you and those owned by the business.

The disadvantage of this approach to you as an individual is that since you are the business, you have no protection if things go wrong, as you have unlimited personal liability for the company’s debts, including any borrowings. You obviously also cannot attract investment into the business from outsiders as there is no vehicle separate from you as an individual for an investor to invest in.

In business with others

Sometimes of course you may not go into business on your own, but may do so with one or more colleagues in which case you may form a partnership.

A partnership does have a certain status as an entity distinct from the individual partners that make it up (it has, for example, to file a partnership tax return), but for the purposes of financing, being a partner is very similar to being a sole trader in that you have unlimited personal liability for the partnership’s debts including repayment of any borrowings. The difference here is ‘joint and several liability’ where each partner is liable to an unlimited degree for the whole of the partnership’s debts while your ownership of the assets is restricted to your share of the partnership’s capital (see Chapter 2).

As with an individual, when it comes to raising finance, a partnership is not an appropriate structure through which to try to raise most forms of investment, as there is no separate entity outside the individual partners in which an investor can obtain a stake in return for their investment.

The fact that a partnership is actually a collection of individuals, rather than a legal entity in its own right, can make raising finance from lenders more difficult than for an individual. A lender has to deal with all the partners and assets will have to be held in the names of all the partners. The position is then complicated as new partners may be admitted to the partnership, or existing partners may retire or leave, and these entries and exits will have to be dealt with by way of the partnership deed which is its constitution. If the partnership has not agreed such a deed then the partnership will be governed by the provisions of the Partnership Act 1890 which will, for example, mean that in the event of the death or departure of one of the partners, the partnership formally comes to an end, which obviously if you were acting as a lender to a partnership could cause you a certain amount of concern.

Since neither sole traders nor partnerships have to file public or audited accounts showing how the business is doing in the way that companies do, this can also make lenders more cautious in dealing with them.

Limited Liability Partnership

A recent variation of the partnership which has come in over the last few years is the limited liability partnership (LLP). This is something of a cross between a partnership (since it is constituted and taxed as a partnership), and a limited liability company (since it has to file annual accounts at Companies House).

The advantage of this form of partnership for the participants is that your liability for the business’s debts can be limited to a specified amount, thus separating for the first time your personal assets and liabilities from those of the business.

The disadvantage when it comes to raising finance is that the lenders can no longer take automatic comfort from your personal abilities to repay any borrowings from resources outside the business, and can therefore be expected to take a more critical and cautious view of lending to the business.

In business as someone else

The final form a business can take is a limited liability company identified by the words:

• limited (or Ltd) after its name, the basic form of company also known as a ‘private company’; or
• public limited company (or PLC), which is essentially a special type of limited liability company which has chosen to comply with a number of rules concerning the size of its share capital and how it is governed, which then entitle it to offer its shares for sale on a stock market (to be listed) assuming that it fulfils the stock market’s criteria for entry (see Chapter 12).

A company is owned by shareholders who may either have subscribed for the initial shares offered when it was formed, or may have bought shares subsequently.

In contrast with a sole trader or a partnership, a limited liability company is regarded by the law as a legal person, separate from the shareholders who own it. It may therefore enter into contracts in its own right, can hold assets and incur liabilities, sue and be sued, all in its own name. The limitation of liability means that the liability of the owners of the business (its shareholders) for the company’s debts is limited to the amount of any unpaid parts of the share capital that they own. This difference is illustrated in Figure 2.

There are some companies that are limited by guarantee, but these are rare, and are not normally used for commercial trading. Instead they are used to form trade associations or other bodies that may need to have a corporate personality.

To decide which is the best form of business organisation for you, you should talk to your accountant as, for example, the effect of tax can be very different. However, my view in general would be that the ability to separate your personal position from the business and its risks means that you should always strongly consider trading through a limited liability company.

Pros and cons for raising finance

From the point of view of raising finance this distinction between the owners and the company has both advantages and disadvantages.

• Since the company shares can be sold, or more shares issued, this provides a mechanism whereby other people can invest money into the business in a way that is impossible for a sole trader and difficult for a partnership.
• Because the company has a legal life of its own, independent of those of the shareholders, it can survive them and pass on from generation to generation, so the party with which a lender or investor is dealing is potentially immortal.
• As the price for allowing shareholders to limit their liability in this way, a company has to file public accounts on a regular basis so that third parties dealing with it, such as suppliers or lenders, can assess its financial performance and position.

The separation of personal and business assets can also be advantageous since through the publicly filed accounts, lenders and investors can obtain a clear picture of what assets and liabilities the company has. But on the other hand, this also restricts the assets available with which to repay lenders if difficulties arise, as the owner’s assets are now separated from those of the business. This may also lead lenders and investors to feel that the owner has less commitment to the business.

This separation is known as the veil of incorporation as it screens the business owner from the liabilities of the business. If the company as a separate legal person gets into difficulties, and is not able to pay its bills or can’t repay its borrowings, then this is the company’s problem, and in general the business owner will not be personally liable. There are some exceptions to this.

• The first is that the protection which the limitation of liability gives is obviously one that is potentially open to abuse. So insolvency legislation provides mechanisms whereby if a company fails insolvently, the directors may potentially be held liable for the liabilities run up by a company they have been controlling.
• The second is where the directors or shareholders have personally guaranteed a liability of the company. This situation arises where a lender (who will be well aware of this issue), or sometimes another supplier such as a landlord or equipment hire company, insists on the directors or shareholders providing a personal guarantee (PG) in order to provide the loan or equipment. They do so in order to be able to try to claim against the guarantors in the event that they suffer a shortfall in payment by the company.

The issues surrounding personal guarantees are discussed in more detail in Chapter 7.

Making the shareholders liable for the liabilities of a company in this way is known as piercing the veil of incorporation (or corporate veil).

TWO SPECIAL CASES

Having drawn the distinction between the normal uses of finance in a business, there are two special cases which it is worth discussing at this stage.

Funding losses

In Figure 1 the working capital cycle is spinning out cash from the completion of each of its trading transactions, to contribute towards first covering the business’s overheads and then towards its eventual profits.

However, if the working capital cycle is not generating enough flow with which to fill the first bucket in the cash pump diagram representing the business’s total overhead costs, then at the end of the trading period the gap between the level of funds generated and the top of the bucket will represent a loss suffered by the business.

However, if the overheads have to be paid then cash has to come into the business from somewhere with which to make up the gap and fill the bucket. The business will be demanding funds with which to cover these losses.

Even worse, in some cases the working capital cycle can be running so badly that actually there is not enough cash to go back round to the start of the cycle.

And if you’ve ever had an airlock build up in pipes in your house you’ll know that it starts by restricting the flow around the system and eventually causes it to dry up altogether. The same process will affect the cashflows in your business and once the cash, which is the lifeblood of your business, ceases to flow, your business will die from a business heart attack.

As will be covered in Chapters 3 and 4, managing your working capital cycle is vital for the financial health of your business.

Defined benefit or final salary pension schemes

A specific issue has arisen at the time of writing, due to changes in the law in relation to the types of pension schemes that provide a pension based on levels of earnings and periods of service, so known as defined benefit or final salary pension schemes.

This change has come about following situations where pension schemes have been unable to cover the liabilities due to a business’s employees following the failure of the employer, together with the significant deficits that some schemes are believed to have, due in part to poor performance of their investments over the past few years.

If your business operates a defined benefit or final salary pension scheme the likelihood is that your business will need to raise cash to invest in the scheme and to pay increased running costs.

Within the next three years, the trustees of every scheme will be required to have reviewed the scheme’s funding requirement, which is to say the money that you as an employer need to put into it. This is likely to go up because the basis on which it has to be calculated is changing from what was known as the minimum funding requirement (MFR) introduced after the Maxwell scandal, to the pension protection fund (PPF) measure which is significantly higher.

To give you an idea of the scale of this problem, in one case being quoted by professionals involved in the area, the deficit to be made up under the MFR basis was £3 million. The deficit under the PPF measure, however, was approximately £600 million (and in this case the deficit for buy out basis, probably the most expensive measure of pension scheme liability, was estimated at £1.6 billion). As you can see, the impact of changing the measure of the scheme’s liabilities can suddenly produce a significant increase in the deficit that will need to be covered.

The legislation goes on to say that the pension scheme will be allowed only ten years in which to achieve funding of the PPF level required.

The likelihood is, therefore, that as an employer who will be required to ensure the scheme is properly funded, you are likely to receive a cash call over the next ten years from any such scheme.

At the same time, the new pension protection fund has been set up to act as a safety net for schemes where the employer fails while the scheme still has a deficit. This fund is to be financed by way of a levy on all defined benefit pension schemes which do not meet the PPF funding level. This levy will be calculated on the basis of the size of your scheme and its deficit multiplied by a risk factor which will be based on your business’s credit rating as at March 2006. The worse your credit rating, the higher the risk factor and the higher the bill the scheme may expect to receive when the first invoices arrive in August 2007.

So if your scheme has a deficit on the PPF measure you will be faced with the prospect of:

• paying in funds to bring it up to this level, over at most the next ten years; while
• paying a levy to the PPF.

The good news, however, is that this problem only applies to defined benefit pension schemes. It does not apply to defined contribution (also known as money purchase) schemes. So one strategy may be to attempt to cease to provide a final salary pension scheme. You can in theory buy out the scheme members’ benefits (a Section 75 buy out), but in practice the cost of this will usually be more than the funding required to meet the PPF criteria. You may, however, be able to incentivise members to voluntarily transfer their benefits out of a final salary scheme and into a money purchase scheme at a lower cost than bringing an existing scheme into line with the funding required. This will of course still take cash.

If your business has a defined benefit or final salary pension scheme, as a matter of urgency I would suggest you should:

• take advice on the impact of these changes in legislation on your business’s position; and
• consider how you’re going to fund the cost of whatever action you may need to take.

For advice you will need to speak to an appropriately qualified Independent Financial Adviser. If you would like a referral to an adviser please contact me at mark@theoss.freeserve.co.uk.