The purpose of this assignment is to provide Alex with advice prior to his meeting with the bank. It requires a consideration of the issues, that a small business may encounter due to unplanned financing. It also requires an assesment of three short term finance options.
This report is divided into findings, conclusion and recommendations. The findings outline the importance of understanding working capital and the possible reasons why Alex has cash flow difficulties. The short term finance options are discussed referring to the advantages and disadvantages of each. A brief summary is provided, followed by the recommendations formulated for Alex.
Working capital is the money needed for a business to finance its day to day trading activities (Skinner, 2017). It is important that the business can meet its short term needs while being able to pay short term debts. Financial health describes your financial situation and it includes factors such as savings, income, spending and emergency funds. A financial plan is required to manage these factors, to help the business to meet it's targets and to reduce taking financial risks (Ward, 2017).
As it states in the scenario, “Alex underappreciated the importance of financial planning”.
Alex did not understand the concept of working capital or the difference between the business' current assets and current liabilities (Skinner, 2017). The current assets are something that may already be cash or is expected to turn into cash within the year. Current liabilities are amounts owed by the business to external parties which are repayable within one year (Gish, 2017). The current assets need to be greater than the currents liabilities. The working capital ratio is dividing current assets by current liabilities, therefore this information is used as an indicator to assess the short term liquidity of the business (Wohlner, 2017).
There is a difference between cash flow and income. A business can have a positive cash flow, but that does not mean it is making a profit. This is relevant in Alex's financial situation. The two types of cash flow are, inflow, which is the sale of goods and services; and outflow, which is payments to suppliers, employees, revenue and basic expenses (Nordmeyer, 2017). Accurate cash-flow statements are necessary to assess the amount, timing and predictability of this (Business dictionary, 2017).
Three possible reasons why Alex's cash flow is not as healthy as forecasted
1. In the beginning, Alex used his savings on high tech equipment and the set up of the business. This was a financial risk, as he could have used other options, such as getting a loan or leasing the equipment. This would have enabled him to keep his liquid cash available for day to day running costs and not end up in a cash crisis.
2. Before starting his business, Alex did not evaluate his day-to-day running cost and what they would amount to. Alex should also have projected cash flow statements, which would have shown what his short term running cost would be. A financial plan would have been beneficial to prevent unhealthy cash flow.
3. Alex may be owed money from debtors and may owe creditors. This relates to the current assets and current liabilities of the business. In this instance, these problems would suggest short-term liquidity.
This service allows businesses to withdraw funds from their account in excess of the balance (Finance Management, 2017). This service is an un-secured loan; this is why the interest rates are higher than normal fixed rate loans.
This service is effective for a business that is experiencing short term cash flow problems. Alex needs 7,500 pounds in the near future, this would be a good solution to shore up his cash flow difficulties.
Keeping a good track record for business
This would provide Alex with sufficient funds to manage his day to day expenditure. By maintaining timely payments, Alex will have positive relations with his suppliers and avoid any late payment penalties. According to Bank of Ireland, unpaid direct debits or standing orders will cost €12.70 each time (Bank of Ireland, 2017).
An overdraft is more flexible as funds can be used at any time and repaid according to an agreed plan (Finance Management, 2017). This would benefit Alex as he requires an overdraft urgently for a short amount of time.
Interest is calculated on the amount of money used per day. The interest and arrangement fees Alex would pay is tax deductible, which will lower his tax liabilities (Skinner, 2017).
Annual Percentage Rate (APR) is how much borrowing this money is going to cost Alex (The Guardian, 2009). Alex may choose BOI and avail of a €10,000 overdraft facility; He may then become overdrawn by €7,500 for a period of 5 days. This calculation would be €7,500 at 15.9% per annum, divided by 365 days and multiplied by the 5 days that the facility was active (Table 1).
Bank of Ireland (BOI) 15.9%
Permanent TSB 16.3%
Ulster Bank 15.55%
Table 1. Rates calculated on 26/10/2017.
Exceeding limit costs
If Alex exceeds the limit or the repayment plan this will add cost penalties to his account, therefore a financial plan is required. When a customer exceeds the limit, it is called unarranged borrowing which will cost €4.44 (Ulster Bank, 2017).
The risk of reduction in overdraft Limit
An overdraft undergoes regular revision by the bank, if Alex's repayments are poor; the bank has the right to withdraw or decrease the limit on the overdraft at any time (Finance Management, 2017).
Risk of seizing
In some cases, an overdraft may need to be secured against personal investments, life insurance or other shares. This presents the risk of personal assets being seized if Alex fails to repay the overdraft (Finance Management, 2017).
Slow debtor's collection
The security of an overdraft can cause some business owners to become slow in collecting their debts. Alex must ensure that a priority in his financial plan is to collect his debts without delay (Finance Management, 2017).
Invoice financing is borrowing money based on the amount owed from debtors. There are two types; Invoice factoring is where the financer is responsible for collecting debts; and invoice discounting is where the business owner collects debts as normal (Trade Finance Global, 2016).
Quick access to cash
Alex needs access to cash quickly to resolve his cash flow problems. This option does not take as long as a business loan, which can take time to process (Finance Management, 2017).
Invoice discounting can ensure that Alex's customers or suppliers do not know about his financial help. This could help with customer relations, as they will not receive a bill from an outside agency (Finance Management, 2017).
Offer better terms with customers
The cash received from the financier will help Alex to manage the day-to-day running of his business. The steady flow of cash could allow Alex to give customers more time to pay back their debt (Rose, 2015).
Decrease in profit margin
This service will entail charges. The financier may total Alex's invoices and give him 80-90% up front and the remainder when his customers have paid. On average the financier will take a 3% fee. Although Alex is getting paid up front, the fees will affect his profit margin (Trade Finance Global, 2017).
Alex must pay for the services of the invoice-financing provider. He will be liable to pay these fees regardless of his customer's repayments. The provider may retain the invoices collected until their service fees are paid. These costs may be too expensive for a small business (Invoice Financing, 2017).
Loss of control
This service allows the financer to control whom Alex can do business with. If the financer perceives a customer at risk of not paying, then Alex cannot do business with that person. This could in the future hinder a business from growth (Invoice Financing, 2017).
The finance company will contact Alex's customers to ensure they pay what is owed. This could frighten customers and stop them from doing business with him in the future. Customers might also see that your business is in trouble and decide not to pay back what they owe (Invoice Financing, 2017; Richardson, J. 2016).
Business Credit Card
Credit cards are money made available to you by the bank, in the form of a card. This money needs to be repaid within a set amount of time.
Alex has a good personal credit score, so receiving a business credit card will be quick and easy. If Alex keeps timely payments, this will develop a good business credit history (Miller, 2016).
A good credit history will allow Alex to receive a business loan, which would enable him to expand his business in the future. The interest rates are based on his business credit history and not personal credit history (Miller, 2016).
Separation from personal and business expenses
A business bank account and credit card will separate Alex's business and personal transactions. Alex can use his business credit card for purchasing products and his business bank account can be used to pay bills. This avoids any confusion (Miller, 2016).
Personal credit problems
If Alex was late or unable to pay back the balance on his business credit card, this will affect his personal credit rating. Any defaulting on your debts is reported to the Irish credit bureau (Miller, 2016; More Business, 2010).
High cost fees
Credit cards are expensive due to the high interest rates, late payment and annual fees (More Business, 2010). A cash advance fee will also be charged.
Banks Annual Fee Cash advance fee
BOI €31 1.5%
AIB €19.05 1.75%
Ulster Bank €30 1.75%
Table 2. (AIB, 2017; BOI, 2017; Ulster Bank, 2017).
Interest rates are applied when the money is not repaid by the end of the month. BOI have an interest rate of 17.39% variable (BOI, 2017); If Alex does not pay off the bill after the 37 days interest free period, he will pay interest incrementally on the amount outstanding and the period that the account has a balance outstanding (BOI, 2017).
Government stamp duty
Every year, there will be a charge of €30 billed to the credit card account (BOI, 2017).
The main finding within task one showed that Alex did not acknowledge the importance of his working capital and financial planning before developing his business. The three possible reasons for Alex's unhealthy cash flow are:
- Taking a financial risk
- Having no financial plan
- Developing short term liquidity problems
The findings of task two discussed over-draft, invoice financing and business credit cards.
Overdrafts provide short-term cash flow in a flexible manner, allowing Alex to maintain timely payments under favorable interest rates. However, they come with a limit cost and Alex may need collateral as a guarantor.
Invoice financing is a quick cash option that can remain confidential and maintain positive customer relations. However, they come with additional costs that may be too costly for a small business.
Business credit cards are useful to build credit history, obtain loans to help expand future business. However, they can affect personal credit history and have high cost and interest rates.
From the findings, it is recommended that Alex apply for an overdraft.
This would be most suitable as it is instant access to cash that Alex requires for his day-to-day trading. Secondly, as Alex foresees long-term profitability in his business, it can be assumed that he would repay the overdraft in a timely manner. This would avoid any limit or late payment penalty costs. Due to the flexibility of an overdraft, Alex could learn to use the service efficiently to reduce the interest rates that may be applied.
According to the scenario provided, Alex had spent his working capital and savings on developing his swing studio. Therefore, invoice financing would not be suitable as it is based on the money Alex is owed from debtors.
A business credit card would not be suitable in this scenario, as the interest rates are significantly higher. Also, a credit card payment must be made at the end of every month to avoid penalty charges, whereas, overdraft repayments are more flexible.
To conclude, an overdraft would be best suited to Alex to ensure that his business stays afloat during the predicted cash flow difficulties.
To apply for a business overdraft, Alex should first consult with his bank about the necessary documentation required. An audited annual account is needed to display the businesses balance sheet and profit and loss account (Gov.uk, 2017). A cash flow statement for 12 months is required to have record of the operating, cash and capital transactions of the business (Skinner, 2017; Accounting Explained, 2017). A business plan should be developed to outline the business description and management, target market, marketing plan, employment and financial plans (Ulster Bank, 2017). A list of debtors and creditors is required for the bank to assess your credit worthiness (Citizen Information, 2017). Alex may need to propose collateral to secure his overdraft (AIB, 2017). Some banks require property valuation to calculate the overdraft limit, as Alex is not the property owner, he cannot use it as security (Home loan experts, 2017). A comprehensive tax evaluation is required to show Alex is running an honest business (Berry, 2017).
The bank needs to understand the business and it's owner. Alex must provide his personal and salary details to help the bank to meet his current needs. Every detail about the business must be disclosed, including previous loan and borrowing history to ensure credibility. Alex must disclose to the bank the reasoning for his unhealthy cash flow, why he regards overdraft as the preferred source of short-term finance and agree the specific repayment details (AIB, 2017).
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