Reasons why small businesses need finance

Small businesses often require additional funds to start up, operate smoothly, or grow.

The main reasons small businesses need finance:

• Starting a new business - Funds are essential for initial capital, which includes money or assets required to establish the business.
• Managing poor cash flow - New or small firms may struggle to cover expenses early on, so extra finance helps bridge this gap.
• Dealing with delayed customer payments - When customers take time to pay, businesses face temporary cash shortages and need finance to continue operations.
• Covering day-to-day costs during difficulties - If a business is struggling, additional funds may be needed to meet regular running expenses.
• Supporting expansion - Growth activities, such as purchasing larger premises, often require significant investment.

Short-term sources of finance for small businesses

Short-term finance provides funds for a limited time, typically less than a year.

Trade credit

Trade credit allows businesses to buy goods or services and pay later, often within one or two months.

Key features:

• This gives small firms time to generate revenue from sales to cover the payment.
• However, late payments can lead to high fees, increasing overall costs.
• Firms must ensure they can afford these repayments.

Overdrafts

Overdrafts enable a business to withdraw more money from its bank account than is available, helping to make timely payments during cash shortages.

Key features:

• They offer flexibility for unexpected expenses.
• Drawbacks include higher interest rates compared to other loans and the risk of the bank cancelling the facility suddenly.
• If not repaid, the bank may seize business assets.

Long-term sources of finance for small businesses

Long-term finance is available for extended periods, often more than a year, and some types do not need repayment at all.

Loans

Loans, such as those from banks, provide funds that are repaid over time with interest, usually in monthly instalments.

Key features:

• They are straightforward to arrange and often have lower interest rates than overdrafts.
• Repayments increase fixed costs, so businesses should check they can still break even.
• Failure to repay allows the lender to take assets.

Share capital

Share capital is raised by selling shares to individuals, giving them partial ownership in the business. The funds received can be used without repayment obligations.

Venture capital

Venture capital involves selling shares to specialised investors who fund high-risk, high-potential small or expanding firms.

Key features:

• It targets businesses with rapid growth prospects.
• Investors take a stake and often demand quicker returns than typical shareholders.

Personal savings

Business owners can invest their own savings to start or support the firm, especially during cash flow problems.

Key features:

• This avoids interest payments or external interference.
• It carries high personal risk, as the owner could lose their money if the business fails.

Retained profit

Retained profit refers to earnings kept in the business after owners take dividends, rather than distributing all profits. It provides internal funding for reinvestment without debt.

Crowd funding

Crowd funding collects small contributions from many people, often online, to launch a business or idea, commonly for creative projects.

Key features:

• It spreads the funding burden and can build early customer interest.
• Contributors may receive rewards, but the approach relies on public appeal.