Chapter 7 of the Business finance basics section in the 'Achieving financial success' series

Chapter 7 of the Business finance basics section in the 'Achieving financial success' series
Chapter 7: Financing your business - debt, equity or internal funds?

By David Jenkins*

Financing your business - debt, equity or internal funds?

Just as cash flow and profit are important to the business, ensuring the business is financed appropriately is essential to achieving financial success.

Financing comes in many different forms. In this section we will discuss funding a business with debt or equity, and the different types of loan products that can be considered.

In addition, we will look at the types of transactional banking available and at specific types of finance for importers and exporters.

Comparing debt finance, equity investment and internal funds

All businesses need finance to start up operations and in order to grow.

Finance can be provided from the following sources:

• debt - financing provided from an external source, such as a bank

• equity - financing provided from an internal source, such as an owner or investor

• internal funds - profits and cash generated by the business are used to fund the ongoing operations and expansion of the business.

Many people running small businesses face the dilemma of determining which type of funding is the right option for them. Most small businesses look to raise debt finance or obtain funding support from a family member in order to establish themselves. This is because it is often difficult to get an external investor interested in taking the risk of a start-up business.

Debt finance or using existing funds also enables the owner to maintain control over their business rather than having to give a percentage of ownership to an investor.

Internally generated equity is the original funding provided by the owner. It may include any profits on the sale of an asset owned by the business or profits generated through business trading each year that have not been drawn out (through dividends or drawings) by the owner. It could also include any additional equity funds contributed by you as the owner.

The assets of the business can also be funded from an investor who wishes to put permanent equity capital into the business. If the business is a company, then either new shares are issued by the company or the investor purchases some of the shares from the original owner. Seek advice from your accountant regarding the tax and cash flow implications of each of these choices in relation to your specific circumstances.

Utilising internal funds generated from the business is, in most circumstances, one of the more favourable alternatives.

Most small businesses do not adequately assess the potential of generating increased cash flow through good management of working capital.

Chapter 5 provides details on how this can be achieved. Sourcing excess cash through good management of working capital can provide many advantages over sourcing funding through debt or equity.

The table below outlines the key areas to consider when comparing debt and equity. It shows the differences between those who have an interest in the ownership of the business (an equity party), such as yourself or a shareholder, and a party that has a debt finance relationship with your business (a bank).

The comparison looks at:

• definitions and examples of each

• level of risk for each financier/investor

• the type of security required

• how each funding party receives income on their funds

• repayment of debt finance/investment capital

• impact of the alternatives on the financial statements of the business

• advantages and disadvantages of the alternatives.

Financing your business is an important part of good financial management practice. Not only having access to finance, but also being able to choose the most appropriate method of finance for your business, will result in continued growth and profitability.

A key requirement for ensuring you choose the right funding is to make certain you fully understand the differences between debt and equity, and to consider the implications of each for your business.

Deciding between debt and equity

In uncertain economic times, you may wish to reduce the financial risk of taking on significant debt funding (it may also be difficult for you to raise debt finance), so you may need to be prepared to share the ownership of your business to increase funding to the business.

You may also consider a combination of debt and equity funding to meet the business requirements. An investor may be prepared to provide both equity and debt finance.

HINT
In deciding whether to seek an equity party, you need to consider both the financial and non-financial outcomes.

Considerations in selecting equity investment as your finance option may include:

• the ability to recognise an external investor’s interests in operating the business

• your attitude to losing full control and power to make all decisions without consulting other owners

• identification of skills of potential investors that would be advantageous to the growth of the business

• the need to reduce the risk associated with the gearing level of the business through lower interest and principal repayment commitments

• long-term plans for succession and, if a family business, the impact on other family members

• willingness to identify an appropriate exit strategy and its impact on you

• the opportunities equity funding will bring that could not be achieved with existing debt available to the business

• whether your business is attractive to an investor

• whether you have prepared the necessary financial statements and forecasts that a potential investor will want to see

TIP
Generally, a business would aim to maximise the use of debt finance to fund its operations, as long as the business can service the level of debt and has enough security to support the funding. The business owner would retain the benefits of ownership in respect of growth and profitability of their business.

• how quickly you need the funding.

The choice between debt and equity is therefore a combination of:

• assessing the limitations that debt finance may bring

• determining if your business has the growth potential to be attractive to an equity investor

• evaluating your willingness and/or preparedness for the changes equity investment will require.

Many small business owners find that the retention of majority control over their business is important to them, and that their objectives are based on both lifestyle and family priorities. In these circumstances, debt will be their primary alternative for funding their business, as they are unlikely to meet an investor’s objectives.

TIP
You may find the ability to raise debt improves with equity investment.

Understanding debt financing options — long term vs short term

If you select debt as a financing option, you have to consider which debt product (as there are many) will meet the needs of your business.

In making this assessment, you will need to:

• understand the nature of alternative debt products in the market to make an informed decision

• identify the alternative features available for each product

• compare debt products by reference to a common basis

• match the right debt product/features with your business circumstances and requirements

• understand the tax implications of alternative products.

In a competitive market, lenders will package finance products under different names and introduce a range of features to differentiate themselves.

A list of the most common debt finance products lenders use, and an overview of each, is provided on the following page.

Evaluating your own circumstances

In matching a debt product and selecting the appropriate features to suit your business requirements, you need to determine the following about your business:

• what the funds are going to be required for and how long you need them

• whether they are for short-term funding of working capital or long-term funding, to fund a building extension or export market entry costs

• how much finance you need. (Be realistic about the amount of funds you require; don’t be cut short.)

• what level of security you can offer and how the lender will view the value of the security. (Real property security, compared with business assets, is likely to result in a lower interest rate margin being charged.)

• how the lender will assess “risk” for your business.

This evaluation will help you better match your requirements and limitations to the “guidelines” for particular alternative debt funding.

It is important to consider the impact of the above features as well as the nature of the product.

In some circumstances, borrowers can structure their loan with a mix of fixed/variable/capped and other variations of interest charges. If specific features are important to you based on your circumstances, you may need to compare alternative debt providers until you find the right finance for you. You may find, however, that your circumstances limit the debt products available for your business.

It can often be difficult for small business owners to evaluate debt product options. Lenders can use different names for similar products and structure the terms, conditions and fees differently.

TIP
Ensure the type of financing chosen matches the reason for seeking finance. A general rule of thumb is to match the term of the loan with the length of the life of the asset you are funding.

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The full Guide is available in the .pdf attachment, or here »

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David Jenkins is the New Zealand-based manager of the global professional accounting body, CPA Australia. You can contact him directly here »

You can read the Introduction to this series here »  The related Glossary is an important resource. And readers are encouraged to read this page first »

Chapter 1 is about Understanding financial statements and you can read it here »
Chapter 2 is about Assessing your busines's financial health and you can read it here »
Chapter 3 is about the Importance of Budgeting and you can read it here »
Chapter 4 is about the Maintaining Profitability and you can read it here »
Chapter 5 is about the Improving Cashflow and you can read it here »
Chapter 6 is about the Managing Cashflow and you can read it here »

Chapter 8 is about Transactional banking and will follow next week.

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