What kind of financing would suit me best?
If you’re starting or expanding your business, you have four main choices of funding: debt (funds borrowed from a lending institution), equity (your money or other investors’ money), reserves (profits reinvested into the business) or government grants.
Financing your business requires extensive consideration because it will impact on the overall profitability of your business. Financing decisions will have implications for your cash flow, tax obligations and overall risk profile.
If you’ve decided to raise funds by borrowing money, you need to consider what source and type of finance will suit your needs. You’ll need to consider how much you need to borrow, the level of equity or security you are able to offer and the ability of your business to meet the repayments based on its historical performance.
The higher the proportion of debt to equity used in your business, the greater its financial leverage. This can translate into a higher return on investment, but it also means higher risk. Leverage enhances a company’s profits and losses so it should be treated carefully.
Types of Debt
Short-term finance: This is often referred to as working capital and is used to finance the day-to-day running of a business. It can be used to buy assets such as trading stock. It is usually repaid within 12 months and should not be used for long term projects because it’s more expensive. The main sources of short-term finance include:
· bank overdraft
· commercial bill
· bridging finance
· accounts receivable financing
· trade credit
· import-export finance.
Long-term finance: This is used to finance fixed assets such as vehicles, plant and equipment, buildings or property. It can also be used to buy another business or set up a new one. The asset being bought must be able to generate sufficient cash flow to meet the interest and principal repayments. The main types of long-term finance include:
· term loans
· hire purchase.
Sources of debt
You can either borrow funds privately (from friends or family) or from a financial institution. The latter will require you to make regular interest and principal repayments. You’ll also need to lodge some form of security such as a personal guarantee or mortgage on your home. Note that if the business fails, the debt provider will get the first repayment as debt ranks ahead of equity.
Advantages of debt
· Debt is cheaper than equity because it’s tax deductible.
· You retain control of your business as there is no dilution of equity to external investors.
It is important that you match the method of funding and term of the loan to the purpose for which the finance is being used. For example, if you operate a business with very lumpy cash flows and you don’t get paid regularly, then you’ll need to assess the company’s capacity to service monthly interest repayments.
Equity capital is the money that owners invest in a business. It can be sourced from individual savings or from personal loans. Retained earnings, which are profits generated from the company can also be used as business equity.
When sourcing external equity, an investor provides capital in exchange for a portion of ownership in your business. However, there are two main disadvantages with this approach. Firstly, shareholder returns are diluted as profits must be split between more shareholders. Secondly, with more owners in the business, your control is weakened as the new investors now have a greater say in the business’s operations.
Small businesses can also access funding from venture capital firms or business angels who can provide capital and expertise to help your business grow.
Published: 10 December 2007