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Sources of finance Paper

The recent financial crisis was a combination of bad financial risk management by the banks and poor government intervention on activities such as bank mortgages. This resulted in a global recession and the collapse of the financial and housing market. There have been recent signs of recovery from the recession such as the announcement by the BBC of 0.3% economic growth in the UK (BBC online, 2010). However, the banking sector feels small British firms are still at risk of being hit by the economic downturn in 2010. The aim of this essay is to discuss the further consequences small businesses face as a result of the economic downturn in 2010, the possible changes a small firm could make to their working capital in preparation for a period of falling demand. In addition, the advantages and disadvantages of reducing stocks in times of economic downturn.

A recession is defined as ‘a downturn in sales and production that occurs across most parts of the economy perhaps leading to six months of continuous economic decline’ (I.Marcous�, 2008). In summary, the recent economic downturn was to an extent, caused by the collapse of the US housing and global financial market. Previous to the recession banks loaned money to individuals and businesses who were interested in purchasing property in the belief that value of the property will rise and in some reported cases lent more money than requested. However, the prediction of the banks was proven to be wrong as the value of housing rapidly dropped as demand decreased due to the high prices. As demand declined house value became lower than the mortgages resulting in a large amount of foreclosure. This crisis continued inevitably affecting the stock market as financial institution reported large losses. Financial institution became unable to lend, thus slowing down economic activity resulting in a steady decrease in demand for goods and services and the bankruptcy of large corporation such as Lehman brothers and General Motors. As a response employees were made redundant in order to manage cost causing a rise in unemployment and leading to further fall in demand for goods and services.

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The decrease in demand for goods and services as resulted in the closure of many small businesses in the UK. ‘During the first 5 months of 2009, there was a 52% rise in the number of small businesses filing for commercial bankruptcy. According to the Automated Access to Court Electronic Records (ACER), there were 36,103 filings compared to 23,829 this time last year'(AsaGhaffar,2010). As I stated earlier the economy has begun to show signs of a recovery but Banks remain sceptical of the future of small firms. In order to maintain the current state of growth, further business activity is needed this will require banks to loan more money to firms. However, this has not been the case. A recent article states ‘In a survey of 1,045 directors, the Institution of Directors found that 60% of businesses are being turned down for credit by the banks despite repeated claims made by UK lenders that they are fulfilling demand for loans’ (Lucy McCann, 2010). In addition, an increasing amount of firms have been refused overdrafts. This may be a result of the increase in loan guarantees and securities required by the Banks and the reason why banks are sceptical about the future of small businesses.

Working Capital can be defined as ‘the day to day finances needed to run a business- generally seen as the difference between the values of a firm’s current assets and its current liabilities’.(I.Marcous�, 2008). Efficient working capital management involves ensuring there is sufficient cash available to meet the cash requirement at any one time. In a business operation working capital is highly important. Irrespective of the firm’s size ‘insufficient working capital is the commonest cause of business failure’ (I.Marcous�, 2008). In preparation for a fall in demand effective working capital becomes even more important for small firms. During a period of falling demand consumer will save more and buy less goods and services this will result in a decrease in sales revenue for many small businesses such local restaurants, pubs and small shop owner. In time small firms will begin to experience a shortage of cash or working capital due to falling revenue and may not be able to purchase as much stock or pay bills on time. In such a situation like falling demand and revenue small firms will have to make drastic changes to their working capital and reconsider their source of finance.

During an economic downturn many small firms are likely to experience rapidly decreasing revenue and problems with their working capital. In addition, the more conventional source of finance such as a bank loan or an extension on the firm’s banks overdraft may become difficult to attain as banks will be aware of the dilemma facing firms and may require more guarantee for their money. Therefore small firms will have to consider alternative sources of finance. Trade credit is a possible alternative source of finance for a small firm. Defined as ‘when suppliers agree to accept cash payment at a given date in the future’ (I.Marcous�, 2008).This is possibly the cheapest finance option available as it cost the business nothing to arrange such an agreement. Trade credit will allow the firm spend their already declining capital on other aspects of the business operation in order to accommodate for the falling demand. For example a local restaurant will be able to pay their electrical and water bill allowing them to continue operation. However, during a period of falling demand the future of a small firm may not be certain an as a result there is a risk the firm will not be able to pay suppliers when the time comes and this could damage the relationship between the firm and supplier and mitigate chances of attaining trade credit in the future. In addition, the chances of obtaining trade credit will be low considering the possibility that falling demand will also affect competitors and as a result they may also try to attain trade credit thereby creating heavy competition. A small firm may consider debt factoring as an alternative source of finance. Debt factoring is when ‘A business sells its outstanding customer accounts (those who have not paid their debts to the business) to a debt factoring company’ (tutor2u). The possible advantages are; the firm will be able to raise cash quickly and will no longer have to continue chasing there debtors this will save them time and resources. However, firms will have to sell their debt at a loss. This will negatively affect the profit of a firm. Furthermore, in a period of falling demand debtors are likely to default and this will make it difficult for firms to sell their debts.

‘Stocks are the organisation’s assets in the form raw material, work in progress and finished goods, in order to make best use of warehousing facilities and stockholding costs’ (J. Sutherland and Diane .Canwell, 1995). There are 3 different types of stock. Raw materials and components are stocks purchased by the business from outside suppliers. Work in progress, these are stocks which are incomplete as they are still in the production progress, for example a car chassis on a convey belt in a factory. Finally, finished goods are stocks which are held by the firm for a period of time until they are sold. This may be due to numerous reasons such as; the products are seasonal or the firm only sell products in batches ( I.Marcous�, 2008). In an economic downturn a small firm will likely experience falling demand and at this point consider the possible advantages and disadvantages of reducing stock. If a small firm is to reduce their stock they will require less storage space and as a result save money allowing them to spend it on other aspects of the operation. Furthermore, a smaller stock increases the liquidity of the firm. Less stock increases the chances of the firm selling all their products thus making them more liquid, thus enabling the firm to gain short term cash quickly which is highly important in an economic downturn as demand falls and revenue drops. In addition, the cost security will be less. The less space consumed will require less security personal to monitor. Conversely, by reducing stock a small firms risk losing their competitive advantage. If the economy was to suddenly recover and demand begins to rise for goods and services the firms may not be able to meet the sudden demand. In such a circumstance a firm may lose future customers to competitors who will be able to meet demand. In the long term this will have a negative impact on sales and could eventually lead to bankruptcy.

Reducing stock may be beneficial in a period of economic downturn but the ability for a firm to reduce the stock may depend on the type of business. For example, in comparing a local store to a small building firm the difference in reducing stock can be seen. In order to reduce stock a local store could simply offer discounts to customers which will increase the demand for the goods and thereby allow the shop to get rid stock quicker. In addition, most of the stock are finished goods and as a result are ready to sell as soon as they arrived. On the other hand a, building firm hold stock such as sand and cement and tools which are mostly raw materials and work in progress and vital to their operation and as a result cannot be sold to the customers in a period of falling demand.

It can be argued; depending on your business reducing stock will be beneficial for a small firm as it reduces cost in terms of storage space and security, also allows the firm to accommodate for the falling demand resulting from the economic downturn. However, from my perspective debt factoring will be the best course of action for a small business during a time of falling demand. In an economic downturn there is likely to be high unemployment and as a result falling demand thus reducing the circulation flow of income. Consumers will have less cash available and this means there is a greater chance of individuals not paying their debts on time or even defaulting. For this reason, assuming the firm has debtors, firms which require a short term form of finance will want to consider debt factoring. Seeing as it is likely debtors will not pay on time or at all it will be greatly beneficial for the firm to sell off their debts. Although a firm are selling at a loss and may face difficulty selling the debts in an economic downturn as debt factoring company will also be aware of problems facing debtors, if possible it will provide the small firm the capital they need to finance their operation, thereby giving the firm a better chance of surviving the economic downturn. In addition, survival should be the likely objective for any small firm in such a period.

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