The cost of capital.
Money is a bit like plastic, diesel, cardboard and ingredients. You need just enough of the stuff to run your business. Anymore and it tends to get spilt or wasted. Just like other ingredients you need to watch the price of it. Pay too much and you have a cost on the business that might drag down margins.
Capital comes in various forms. Referred to as debt finance and / or equity finance. Debts being loan that has to be repaid. Equity being a swap for a stake in the business which can be bought back and is rewarded by dividends and share-value growth.
Debt Finance. Of the debt finance the most popular flavour tends to be ‘Working capital’. This is the stuff in the current account, or in the case of many food and drink manufactures, NOT in the current account. This is where overdrafts come in handy as working capital often comes from that short-term debt. Did someone say short-term? Let’s discuss the various flavours on money and how it should be sourced and used.
Working capital: short-term in theory, goes out in exchange for materials with which you make things to sell then comes back in when those things are sold and is repaid with hopefully a small surplus.
Then there are the medium-term requirements; money required to pay for the fixed costs such as people, buildings, and the kit directly required to do business that isn’t directly applied to a product but for general running of the business. Think of this as either the rental payments on an air-compressor, a filling machine, a fork-lift or a pallet wrapper or tray-packer. Difficult to do business without them, but not critical for a particular customer. This money tends to be in the form of asset finance or hire-purchase. It is secured on the piece of kit like the fork-lift or packing machine. It should be ‘cheaper’ money than the short-term working capital, because in-theory, it is secured against a piece of kit.
These tend to be the mortgages on the building and are tied up in the long-term building of the business. ‘Sunk’ costs are literally those costs that are sunk into a business to help get it established. Investing in production lines, buildings, process-plant, boilers and often where there are installation costs, so a big chunk of the costs is never recoverable were the kit to be removed again.
This kind of long-term debt is secured and comes in either asset finance or secured on a building or through debentures and ‘charges’ over the business where other potential lenders can see that there is a priority call on the money in the business should there ever be a problem.
This long-term debt should be the cheapest given it is long-term, lower risk for the lender and asset backed.
This all sounds lovely for those people and businesses that can access a choice of lending. However, we all know that is not the reality. Young, entrepreneurial people do not tend to have piles of assets they can use as security for banks to pick and choose what they can use against a shiny new loan. No, in the real-world people who have ideas, are willing to take risks and have the enthusiasm might not have a home they own, a pot of savings or an existing business with a revenue stream that can afford to finance a new venture.
That is where equity finance comes in. Equity Finance. In exchange for a stake in the business and therefore either a capital growth opportunity and or the promise of future dividends investors will offer capital to finance a business. This money tends to be expansive if later you calculate the value of the share compared to what it might be worth at a later date. However, it is after all risky. What if the plan doesn’t work? What if the growth isn’t competitive compared to putting the same money in a safer investment? The upside is potentially great. The investor can get tax relief, the business can get much needed capital and if everyone is really luck the mix of investor with market knowledge and contacts adds even more value by opening doors, making introductions and supporting their investment. Yes, it is expensive money if a big junk of equity is sold too soon, but then it depends on the growth. More costly than the other forms of finance? Depends. Want to know more? click here https://www.mypackme.com/finance.asp
How might you access these forms of finance? That would be Part III – How much for how much.