Raising finance - an overview

Author: Jim Riley Last updated: Sunday 23 September, 2012

When a company is growing rapidly, for example when contemplating investment in capital
equipment or an acquisition, its current financial resources may be inadequate. Few growing
companies are able to finance their expansion plans from cash flow alone. They will therefore
need to consider raising finance from other external sources. In addition, managers who are
looking to buy-in to a business ("management buy-in" or "MBI") or buy-out (management buy-
out" or "MBO") a business from its owners, may not have the resources to acquire the company.
They will need to raise finance to achieve their objectives.

There are a number of potential sources of finance to meet the needs of a growing business or to
finance an MBI or MBO:

- Existing shareholders and directors funds

- Family and friends
- Business angels
- Clearing banks (overdrafts, short or medium term loans)
- Factoring and invoice discounting
- Hire purchase and leasing
- Merchant banks (medium to longer term loans)
- Venture capital

A key consideration in choosing the source of new business finance is to strike a balance
between equity and debt to ensure the funding structure suits the business.

The main differences between borrowed money (debt) and equity are that bankers request
interest payments and capital repayments, and the borrowed money is usually secured on
business assets or the personal assets of shareholders and/or directors. A bank also has the power
to place a business into administration or bankruptcy if it defaults on debt interest or repayments
or its prospects decline.

In contrast, equity investors take the risk of failure like other shareholders, whilst they will
benefit through participation in increasing levels of profits and on the eventual sale of their stake.
However in most circumstances venture capitalists will also require more complex investments
(such as preference shares or loan stock) in additional to their equity stake.

The overall objective in raising finance for a company is to avoid exposing the business to
excessive high borrowings, but without unnecessarily diluting the share capital. This will ensure
that the financial risk of the company is kept at an optimal level.

Business Plan
Once a need to raise finance has been identified it is then necessary to prepare a business plan. If
management intend to turn around a business or start a new phase of growth, a business plan is
an important tool to articulate their ideas while convincing investors and other people to support
it. The business plan should be updated regularly to assist in forward planning.

There are many potential contents of a business plan. The European Venture Capital Association
suggest the following:

- Profiles of company founders directors and other key managers;

- Statistics relating to sales and markets;
- Names of potential customers and anticipated demand;
- Names of, information about and assessment of competitors;
- Financial information required to support specific projects (for example, major capital
investment or new product development);
- Research and development information;
- Production process and sources of supply;
- Information on requirements for factory and plant;
- Magazine and newspaper articles about the business and industry;
- Regulations and laws that could affect the business product and process protection
(patents, copyrights, trademarks).

The challenge for management in preparing a business plan is to communicate their ideas clearly
and succinctly. The very process of researching and writing the business plan should help clarify
ideas and identify gaps in management information about their business, competitors and the
market.

Types of Finance - Introduction

A brief description of the key features of the main sources of business finance is provided below.

Venture Capital

Venture capital is a general term to describe a range of ordinary and preference shares where the
investing institution acquires a share in the business. Venture capital is intended for higher risks
such as start up situations and development capital for more mature investments. Replacement
capital brings in an institution in place of one of the original shareholders of a business who
wishes to realise their personal equity before the other shareholders. There are over 100 different
venture capital funds in the UK and some have geographical or industry preferences. There are
also certain large industrial companies which have funds available to invest in growing
businesses and this 'corporate venturing' is an additional source of equity finance.

Grants and Soft Loans

Government, local authorities, local development agencies and the European Union are the major
sources of grants and soft loans. Grants are normally made to facilitate the purchase of assets and
either the generation of jobs or the training of employees. Soft loans are normally subsidised by a
third party so that the terms of interest and security levels are less than the market rate. There are
over 350 initiatives from the Department of Trade and Industry alone so it is a matter of
identifying which sources will be appropriate in each case.

Invoice Discounting and Invoice Factoring

Finance can be raised against debts due from customers via invoice discounting or invoice
factoring, thus improving cash flow. Debtors are used as the prime security for the lender and the
borrower may obtain up to about 80 per cent of approved debts. In addition, a number of these
sources of finance will now lend against stock and other assets and may be more suitable then
bank lending. Invoice discounting is normally confidential (the customer is not aware that their
payments are essentially insured) whereas factoring extends the simple discounting principle by
also dealing with the administration of the sales ledger and debtor collection.

Hire Purchase and Leasing

Hire purchase agreements and leasing provide finance for the acquisition of specific assets such
as cars, equipment and machinery involving a deposit and repayments over, typically, three to ten
years. Technically, ownership of the asset remains with the lessor whereas title to the goods is
eventually transferred to the hirer in a hire purchase agreement.

Loans

Medium term loans (up to seven years) and long term loans (including commercial mortgages)
are provided for specific purposes such as acquiring an asset, business or shares. The loan is
normally secured on the asset or assets and the interest rate may be variable or fixed. The Small
Firms Loan Guarantee Scheme can provide up to £250,000 of borrowing supported by a
government guarantee where all other sources of finance have been exhausted.

Mezzanine Debt

This is a loan finance where there is little or no security left after the senior debt has been
secured. To reflect the higher risk of mezzanine funds, the lender will charge a rate of interest of
perhaps four to eight per cent over bank base rate, may take an option to acquire some equity and
may require repayment over a shorter term.

Bank Overdraft

An overdraft is an agreed sum by which a customer can overdraw their current account. It is
normally secured on current assets, repayable on demand and used for short term working capital
fluctuations. The interest cost is normally variable and linked to bank base rate.

Completing the finance-raising

Raising finance is often a complex process. Business management need to assess several
alternatives and then negotiate terms which are acceptable to the finance provider. The main
negotiating points are often as follows:

- Whether equity investors take a seat on the board

- Votes ascribed to equity investors
- Level of warranties and indemnities provided by the directors
- Financier's fees and costs
- Who bears costs of due diligence.

During the finance-raising process, accountants are often called to review the financial aspects of
the plan. Their report may be formal or informal, an overview or an extensive review of the
company's management information system, forecasting methods and their accuracy, review of
latest management accounts including working capital, pension funding and employee contracts
etc. This due diligence process is used to highlight any fundamental problems that may exist.

Sources of finance for startups and SMEs

Author: Jim Riley Last updated: Sunday 23 September, 2012

Sources of finance for a start-up business

Introduction

Often the hardest part of starting a business is raising the money to get going. The entrepreneur
might have a great idea and clear idea of how to turn it into a successful business. However, if
sufficient finance can’t be raised, it is unlikely that the business will get off the ground.

Raising finance for start-up requires careful planning. The entrepreneur needs to decide:

 How much finance is required?

 When and how long the finance is needed for?

 What security (if any) can be provided?

 Whether the entrepreneur is prepared to give up some control (ownership) of the start-up in
return for investment?

The finance needs of a start-up should take account of these key areas:
  Set-up costs (the costs that are incurred before the business starts to trade)
 Starting investment in capacity (the fixed assets that the business needs before it can begin to
trade)

 Working capital (the stocks needed by the business –e.g. r raw materials + allowance for
amounts that will be owed by customers once sales begin)

 Growth and development (e.g. extra investment in capacity)

One way of categorising the sources of finance for a start-up is to divide them into sources which
are from within the business (internal) and from outside providers (external).

Internal sources

The main internal sources of finance for a start-up are as follows:

Personal sources
These are the most important sources of finance for a start-up, and we deal with them in more
detail in a later section.

Retained profits
This is the cash that is generated by the business when it trades profitably – another important
source of finance for any business, large or small.
Note that retained profits can generate cash the moment trading has begun. For example, a
start-up sells the first batch of stock for £5,000 cash which it had bought for £2,000. That means
that retained profits are £3,000 which can be used to finance further expansion or to pay for other
trading costs and expenses.

Share capital – invested by the founder

The founding entrepreneur (/s) may decide to invest in the share capital of a company, founded
for the purpose of forming the start-up. This is a common method of financing a start-up. The
founder provides all the share capital of the company, retaining 100% control over the business.

The advantages of investing in share capital are covered in the section on business structure. The
key point to note here is that the entrepreneur may be using a variety of personal sources to
invest in the shares. Once the investment has been made, it is the company that owns the money
provided. The shareholder obtains a return on this investment through dividends (payments out
of profits) and/or the value of the business when it is eventually sold.

A start-up company can also raise finance by selling shares to external investors – this is
covered further below.

External sources

Loan capital
This can take several forms, but the most common are a bank loan or bank overdraft.
A bank loan provides a longer-term kind of finance for a start-up, with the bank stating the
fixed period over which the loan is provided (e.g. 5 years), the rate of interest and the timing and
amount of repayments. The bank will usually require that the start-up provide some security for
the loan, although this security normally comes in the form of personal guarantees provided by
the entrepreneur. Bank loans are good for financing investment in fixed assets and are generally
at a lower rate of interest that a bank overdraft. However, they don’t provide much flexibility.

A bank overdraft is a more short-term kind of finance which is also widely used by start-ups
and small businesses. An overdraft is really a loan facility – the bank lets the business “owe it
money” when the bank balance goes below zero, in return for charging a high rate of interest. As
a result, an overdraft is a flexible source of finance, in the sense that it is only used when needed.
Bank overdrafts are excellent for helping a business handle seasonal fluctuations in cash flow or
when the business runs into short-term cash flow problems (e.g. a major customer fails to pay on
time).
Two further loan-related sources of finance are worth knowing about:

Share capital – outside investors

For a start-up, the main source of outside (external) investor in the share capital of a company is
friends and family of the entrepreneur. Opinions differ on whether friends and family should be
encouraged to invest in a start-up company. They may be prepared to invest substantial amounts
for a longer period of time; they may not want to get too involved in the day-to-day operation of
the business. Both of these are positives for the entrepreneur. However, there are pitfalls.
Almost inevitably, tensions develop with family and friends as fellow shareholders.

Business angels are the other main kind of external investor in a start-up company. Business
angels are professional investors who typically invest £10k - £750k. They prefer to invest in
businesses with high growth prospects. Angels tend to have made their money by setting up and
selling their own business – in other words they have proven entrepreneurial expertise. In
addition to their money, Angels often make their own skills, experience and contacts available to
the company. Getting the backing of an Angel can be a significant advantage to a start-up,
although the entrepreneur needs to accept a loss of control over the business.

You will also see Venture Capital mentioned as a source of finance for start-ups. You need to
be careful here. Venture capital is a specific kind of share investment that is made by funds
managed by professional investors. Venture capitalists rarely invest in genuine start-ups or
small businesses (their minimum investment is usually over £1m, often much more). They
prefer to invest in businesses which have established themselves. Another term you may here is
“private equity” – this is just another term for venture capital.

A start-up is much more likely to receive investment from a business angel than a venture
capitalist.

Personal sources

As mentioned earlier, most start-ups make use of the personal financial arrangements of the
founder. This can be personal savings or other cash balances that have been accumulated. It can
be personal debt facilities which are made available to the business. It can also simply be the
found working for nothing! The following notes explain these in a little more detail.

Savings and other “nest-eggs”

An entrepreneur will often invest personal cash balances into a start-up. This is a cheap form of
finance and it is readily available. Often the decision to start a business is prompted by a change
in the personal circumstances of the entrepreneur – e.g. redundancy or an inheritance. Investing
personal savings maximises the control the entrepreneur keeps over the business. It is also a
strong signal of commitment to outside investors or providers of finance.
Re-mortgaging is the most popular way of raising loan-related capital for a start-up. The way
this works is simple. The entrepreneur takes out a second or larger mortgage on a private
property and then invests some or all of this money into the business. The use of mortgaging like
this provides access to relatively low-cost finance, although the risk is that, if the business fails,
then the property will be lost too. .

Borrowing from friends and family

This is also common. Friends and family who are supportive of the business idea provide money
either directly to the entrepreneur or into the business. This can be quicker and cheaper to
arrange (certainly compared with a standard bank loan) and the interest and repayment terms
may be more flexible than a bank loan. However, borrowing in this way can add to the stress
faced by an entrepreneur, particularly if the business gets into difficulties.

Credit cards
This is a surprisingly popular way of financing a start-up. In fact, the use of credit cards is the
most common source of finance amongst small businesses. It works like this. Each month, the
entrepreneur pays for various business-related expenses on a credit card. 15 days later the credit
card statement is sent in the post and the balance is paid by the business within the credit-free
period. The effect is that the business gets access to a free credit period of aroudn30-45 days!

Overdraft financing is provided when businesses make payments from their business current
account exceeding the available cash balance. An overdraft facility enables businesses to obtain
short-term funding - although in theory the amount loaned is repayable on demand by the bank.

There are several important factors to consider when assessing the appropriateness of an
overdraft as a source of funding for SME's:

- The amount borrowed should not exceed the agreed limit ("facility"). The amount of the
facility made available is a matter for negotiation with the bank;

- Interest is charged on the amount overdrawn - at a rate that is above the Bank Base Rate. The
bank may also charge an overdraft facility fee;

- Overdrafts are generally meant to cover short-term financing requirements - they are not
generally meant to provide a permanent source of finance
- Depending on the size of the overdraft facility, the bank may require the SME to provide some
security - for example by securing the overdraft against tangible fixed assets, or against personal
guarantees provided by the directors

The amount of an overdraft at any one time will depend on the cash flows of the business, the
timing of receipts and payments, seasonal trends in the sales and so on. This can be illustrated
using the data below. In the example cash flow statement given below, the SME generates a
positive overall cash flow in a full year. However, due to the timing of sales receipts compared
with supplier payments, the business needs to fund a temporary overdraft during the year:

In the example above, the business requires a maximum overdraft facility of £75,000 in July.
Thereafter, the overdraft balance reduces as sales receipts exceed cash payments.

If the business finds that an overdraft facility appears to be becoming a long-term feature of the
business, the bank may suggest converting the overdraft into a medium-term loan.

Comparison of Bank Overdrafts and Bank Loans

The key advantages of overdrafts and loans in certain business situations:

Advantages of an overdraft over a loan

Customer only pays interest when overdrawn

Bank has flexibility to review and adjust the level of the overdraft facility, perhaps on a short-
term basis

Overdraft can be effectively be used as a medium-term loan – the facility is simply renewed each
time the bank comes to review it

Being part of short-term debt, the overdraft balance is not normally included in calculations of
the business’ financial gearing

Advantages of a loan over an overdraft

Business and bank know precisely what the repayments of the loan will be and how much
interest is payable and when. This makes cash flow planning more predictable

The loan is committed – the business does not have to worry about the loan being withdrawn
whilst it complies with the terms of the loan

Venture capital
Author: Jim Riley Last updated: Sunday 23 September, 2012

Venture Capital is a form of "risk capital". In other words, capital that is invested in a project (in
this case - a business) where there is a substantial element of risk relating to the future creation of
profits and cash flows. Risk capital is invested as shares (equity) rather than as a loan and the
investor requires a higher"rate of return" to compensate him for his risk.

The main sources of venture capital in the UK are venture capital firms and "business angels" -
private investors. Separate Tutor2u revision notes cover the operation of business angels. In these
notes, we principally focus on venture capital firms. However, it should be pointed out the
attributes that both venture capital firms and business angels look for in potential investments are
often very similar.

What is venture capital?

Venture capital provides long-term, committed share capital, to help unquoted companies grow
and succeed. If an entrepreneur is looking to start-up, expand, buy-into a business, buy-out a
business in which he works, turnaround or revitalise a company, venture capital could help do
this. Obtaining venture capital is substantially different from raising debt or a loan from a lender.
Lenders have a legal right to interest on a loan and repayment of the capital, irrespective of the
success or failure of a business . Venture capital is invested in exchange for an equity stake in the
business. As a shareholder, the venture capitalist's return is dependent on the growth and
profitability of the business. This return is generally earned when the venture capitalist "exits" by
selling its shareholding when the business is sold to another owner.

Venture capital in the UK originated in the late 18th century, when entrepreneurs found wealthy
individuals to back their projects on an ad hoc basis. This informal method of financing became
an industry in the late 1970s and early 1980s when a number of venture capital firms were
founded. There are now over 100 active venture capital firms in the UK, which provide several
billion pounds each year to unquoted companies mostly located in the UK.

What kind of businesses are attractive to venture capitalists?

Venture capitalist prefer to invest in "entrepreneurial businesses". This does not necessarily mean
small or new businesses. Rather, it is more about the investment's aspirations and potential for
growth, rather than by current size. Such businesses are aiming to grow rapidly to a significant
size. As a rule of thumb, unless a business can offer the prospect of significant turnover growth
within five years, it is unlikely to be of interest to a venture capital firm. Venture capital investors
are only interested in companies with high growth prospects, which are managed by experienced
and ambitious teams who are capable of turning their business plan into reality.

For how long do venture capitalists invest in a business?

Venture capital firms usually look to retain their investment for between three and seven years or
more. The term of the investment is often linked to the growth profile of the business.
Investments in more mature businesses, where the business performance can be improved
quicker and easier, are often sold sooner than investments in early-stage or technology
companies where it takes time to develop the business model.

Where do venture capital firms obtain their money?

Just as management teams compete for finance, so do venture capital firms. They raise their
funds from several sources. To obtain their funds, venture capital firms have to demonstrate a
good track record and the prospect of producing returns greater than can be achieved through
fixed interest or quoted equity investments. Most UK venture capital firms raise their funds for
investment from external sources, mainly institutional investors, such as pension funds and
insurance companies.

Venture capital firms' investment preferences may be affected by the source of their funds. Many
funds raised from external sources are structured as Limited Partnerships and usually have a
fixed life of 10 years. Within this period the funds invest the money committed to them and by
the end of the 10 years they will have had to return the investors' original money, plus any
additional returns made. This generally requires the investments to be sold, or to be in the form
of quoted shares, before the end of the fund.

Venture Capital Trusts (VCT's) are quoted vehicles that aim to encourage investment in smaller
unlisted (unquoted and AIM quoted companies) UK companies by offering private investors tax
incentives in return for a five-year investment commitment. The first were launched in Autumn
1995 and are mainly managed by UK venture capital firms. If funds are obtained from a VCT,
there may be some restrictions regarding the company's future development within the first few
years.

What is involved in the investment process?

The investment process, from reviewing the business plan to actually investing in a proposition,
can take a venture capitalist anything from one month to one year but typically it takes between 3
and 6 months. There are always exceptions to the rule and deals can be done in extremely short
time frames. Much depends on the quality of information provided and made available.

The key stage of the investment process is the initial evaluation of a business plan. Most
approaches to venture capitalists are rejected at this stage. In considering the business plan, the
venture capitalist will consider several principal aspects:

- Is the product or service commercially viable?

- Does the company have potential for sustained growth?
- Does management have the ability to exploit this potential and control the company through the
growth phases?
- Does the possible reward justify the risk?
- Does the potential financial return on the investment meet their investment criteria?

In structuring its investment, the venture capitalist may use one or more of the following types of
share capital:

Ordinary shares
These are equity shares that are entitled to all income and capital after the rights of all other
classes of capital and creditors have been satisfied. Ordinary shares have votes. In a venture
capital deal these are the shares typically held by the management and family shareholders rather
than the venture capital firm.

Preferred ordinary shares

These are equity shares with special rights.For example, they may be entitled to a fixed dividend
or share of the profits. Preferred ordinary shares have votes.

Preference shares
These are non-equity shares. They rank ahead of all classes of ordinary shares for both income
and capital. Their income rights are defined and they are usually entitled to a fixed dividend (eg.
10% fixed). The shares may be redeemable on fixed dates or they may be irredeemable.
Sometimes they may be redeemable at a fixed premium (eg. at 120% of cost). They may be
convertible into a class of ordinary shares.

Loan capital
Venture capital loans typically are entitled to interest and are usually, though not necessarily
repayable. Loans may be secured on the company's assets or may be unsecured. A secured loan
will rank ahead of unsecured loans and certain other creditors of the company. A loan may be
convertible into equity shares. Alternatively, it may have a warrant attached which gives the loan
holder the option to subscribe for new equity shares on terms fixed in the warrant. They typically
carry a higher rate of interest than bank term loans and rank behind the bank for payment of
interest and repayment of capital.

Venture capital investments are often accompanied by additional financing at the point of
investment. This is nearly always the case where the business in which the investment is being
made is relatively mature or well-established. In this case, it is appropriate for a business to have
a financing structure that includes both equity and debt.

Other forms of finance provided in addition to venture capitalist equity include:

- Clearing banks - principally provide overdrafts and short to medium-term loans at fixed or,
more usually, variable rates of interest.

- Merchant banks - organise the provision of medium to longer-term loans, usually for larger
amounts than clearing banks. Later they can play an important role in the process of "going
public" by advising on the terms and price of public issues and by arranging underwriting when
necessary.

- Finance houses - provide various forms of installment credit, ranging from hire purchase to
leasing, often asset based and usually for a fixed term and at fixed interest rates.

Factoring companies - provide finance by buying trade debts at a discount, either on a recourse
basis (you retain the credit risk on the debts) or on a non-recourse basis (the factoring company
takes over the credit risk).

Government and European Commission sources - provide financial aid to UK companies,

ranging from project grants (related to jobs created and safeguarded) to enterprise loans in
selective areas.

Mezzanine firms - provide loan finance that is halfway between equity and secured debt. These
facilities require either a second charge on the company's assets or are unsecured. Because the
risk is consequently higher than senior debt, the interest charged by the mezzanine debt provider
will be higher than that from the principal lenders and sometimes a modest equity "up-side" will
be required through options or warrants. It is generally most appropriate for larger transactions.

Making the Investment - Due Diligence

To support an initial positive assessment of your business proposition, the venture capitalist will
want to assess the technical and financial feasibility in detail.

External consultants are often used to assess market prospects and the technical feasibility of the
proposition, unless the venture capital firm has the appropriately qualified people in-house.
Chartered accountants are often called on to do much of the due diligence, such as to report on
the financial projections and other financial aspects of the plan. These reports often follow a
detailed study, or a one or two day overview may be all that is required by the venture capital
firm. They will assess and review the following points concerning the company and its
management:

- Management information systems

- Forecasting techniques and accuracy of past forecasting
- Assumptions on which financial assumptions are based
- The latest available management accounts, including the company's cash/debtor positions
- Bank facilities and leasing agreements
- Pensions funding
- Employee contracts, etc.

The due diligence review aims to support or contradict the venture capital firm's own initial
impressions of the business plan formed during the initial stage. References may also be taken up
on the company (eg. with suppliers, customers, and bankers).

Other Business Study Res

inance using leasing - introduction

Author: Jim Riley Last updated: Sunday 23 September, 2012

Introduction to hire purchase and leasing

Introduction

The acquisition of assets - particularly expensive capital equipment - is a major commitment for
many businesses. How that acquisition is funded requires careful planning.

Rather than pay for the asset outright using cash, it can often make sense for businesses to look
for ways of spreading the cost of acquiring an asset, to coincide with the timing of the revenue
generated by the business.The most common sources of medium term finance for investment in
capital assets are Hire Purchase and Leasing.

Leasing and hire purchase are financial facilities which allow a business to use an asset over a
fixed period, in return for regular payments. The business customer chooses the equipment it
requires and the finance company buys it on behalf of the business.

Many kinds of business asset are suitable for financing using hire purchase or leasing, including:
- Plant and machinery
- Business cars
- Commercial vehicles
- Agricultural equipment
- Hotel equipment
- Medical and dental equipment
- Computers, including software packages
-Office equipment

Hire purchase

With a hire purchase agreement, after all the payments have been made, the business customer
becomes the owner of the equipment. This ownership transfer either automatically or on payment
of an option to purchase fee.

For tax purposes, from the beginning of the agreement the business customer is treated as the
owner of the equipment and so can claim capital allowances. Capital allowances can be a
significant tax incentive for businesses to invest in new plant and machinery or to upgrade
information systems.

Under a hire purchase agreement, the business customer is normally responsible for maintenance
of the equipment.

Leasing

The fundamental characteristic of a lease is that ownership never passes to the business
customer.

Instead, the leasing company claims the capital allowances and passes some of the benefit on to
the business customer, by way of reduced rental charges.

The business customer can generally deduct the full cost of lease rentals from taxable income, as
a trading expense.

As with hire purchase, the business customer will normally be responsible for maintenance of the
equipment.

There are a variety of types of leasing arrangement:

Finance Leasing

The finance lease or 'full payout lease' is closest to the hire purchase alternative. The leasing
company recovers the full cost of the equipment, plus charges, over the period of the lease.
Although the business customer does not own the equipment, they have most of the 'risks and
rewards' associated with ownership. They are responsible for maintaining and insuring the asset
and must show the leased asset on their balance sheet as a capital item.

When the lease period ends, the leasing company will usually agree to a secondary lease period
at significantly reduced payments. Alternatively, if the business wishes to stop using the
equipment, it may be sold second-hand to an unrelated third party. The business arranges the sale
on behalf of the leasing company and obtains the bulk of the sale proceeds.

Operating Leasing

If a business needs a piece of equipment for a shorter time, then operating leasing may be the
answer. The leasing company will lease the equipment, expecting to sell it secondhand at the end
of the lease, or to lease it again to someone else. It will, therefore, not need to recover the full
cost of the equipment through the lease rentals.

This type of leasing is common for equipment where there is a well-established secondhand
market (e.g. cars and construction equipment). The lease period will usually be for two to three
years, although it may be much longer, but is always less than the working life of the machine.

Assets financed under operating leases are not shown as assets on the balance sheet. Instead, the
entire operating lease cost is treated as a cost in the profit and loss account.

Contract Hire

Contract hire is a form of operating lease and it is often used for vehicles.

The leasing company undertakes some responsibility for the management and maintenance of the
vehicles. Services can include regular maintenance and repair costs, replacement of tyres and
batteries, providing replacement vehicles, roadside assistance and recovery services and payment
of the vehicle licences.

Finance using leasing - advantages?

Author: Jim Riley Last updated: Sunday 23 September, 2012

Advantages of using leasing & HP as a source of finance

Introduction

As we discussed in our introduction to asset finance, the use of hire purchase or leasing is a
popular method of funding the acquisition of capital assets. However, these methods are not
necessarily suitable for every business or for every asset purchase. There are a number of
considerations to be made, as described below:

Certainty

One important advantage is that a hire purchase or leasing agreement is a medium term funding
facility, which cannot be withdrawn, provided the business makes the payments as they fall due.

The uncertainty that may be associated with alternative funding facilities such as overdrafts,
which are repayable on demand, is removed.

However, it should be borne in mind that both hire purchase and leasing agreements are long
term commitments. It may not be possible, or could prove costly, to terminate them early.

Budgeting

The regular nature of the hire purchase or lease payments (which are also usually of fixed
amounts as well) helps a business to forecast cash flow. The business is able to compare the
payments with the expected revenue and profits generated by the use of the asset.

Fixed Rate Finance

In most cases the payments are fixed throughout the hire purchase or lease agreement, so a
business will know at the beginning of the agreement what their repayments will be. This can be
beneficial in times of low, stable or rising interest rates but may appear expensive if interest rates
are falling.

On some agreements, such as those for a longer term, the finance company may offer the option
of variable rate agreements. In such cases, rentals or installments will vary with current interest
rates; hence it may be more difficult to budget for the level of payment.

The Effect Of Security

Under both hire purchase and leasing, the finance company retains legal ownership of the
equipment, at least until the end of the agreement. This normally gives the finance company
better security than lenders of other types of loan or overdraft facilities. The finance company
may therefore be able to offer better terms.

The decision to provide finance to a small or medium sized business depends on that business'
credit standing and potential. Because the finance company has security in the equipment, it
could tip the balance in favour of a positive credit decision.

Maximum Finance

Hire purchase and leasing could provide finance for the entire cost of the equipment. There may
however, be a need to put down a deposit for hire purchase or to make one or more payments in
advance under a lease. It may be possible for the business to 'trade-in' other assets which they
own, as a means of raising the deposit.

Tax Advantages

Hire purchase and leasing give the business the choice of how to take advantage of capital
allowances.

If the business is profitable, it can claim its own capital allowances through hire purchase or
outright purchase.

If it is not in a tax paying position or pays corporation tax at the small companies rate, then a
lease could be more beneficial to the business. The leasing company will claim the capital
allowances and pass the benefits on to the business by way of reduced rentals.