Pecunia, argent, dinero, okane, all of them mean the same: money. Businesses all around the world, profit or non-profit organizations, need money for different purposes: Operations, to increase capacity or to buy capital equipment to increase level of output; Finance, to introduce IT computerized accounting system to increase efficiency; Marketing, to promote the business’s goods or services to the general public via advertisements (through media like TV ads, social media); and Human Resources, to employ the right amount of people with the appropriate skills to help the business achieve its corporate objectives. This blog will be your personal comprehensive guide towards choosing the right external source of finance.
External sources of finance can be categorized in two parts: short term & long term. In short term external finance, there are 3 main sources: Bank overdrafts, trade credit & debt factoring.
What is a bank overdraft?
It is when a bank allows the business to borrow a credit for a specific monetary limit. This can be very beneficial in instances where the business has a very low balance, for example: $1,000, and it has to pay its credit supplier $2,500 for purchase of goods. In this case, the business can ask and arrange an overdraft, where the business can overdraw its account’s balance and pay it to the supplier to reduce its trade payables. Bank overdrafts prove to be an important source for unincorporated businesses, where the business and the owner do not have a separate legal identity (like sole trader/proprietor & partnership); however, there are some drawbacks to this as well. Interest rates are often higher, meaning the business may have to pay higher rates than usual, leading to increased expenses and outflows. In some cases where the bank is not sure about the financial status of a customer to pay back the overdraft, it can just call back the overdraft immediately and force the firm to pay.
What does trade credit mean?
In essence, trade credit means delaying the payments that need to be made to creditors/credit suppliers or trade payables. By doing so a business can save cash and reduce its cash outflows for a particular month, where maybe the closing cash balance is negative in the cash flow statement. Instead of arranging a bank overdraft, which will help overcome the negative closing cash balance, where security will have to be given and interest will have to be paid on a timely basis, simply delaying your payment or asking for a longer credit period would help the business in maintaining a good cash flow. Even though the business can use the goods purchased and pay later, the opportunity cost becomes the cash discount, given by the supplier for prompt payment. The supplier may also look for rival businesses where they pay the suppliers promptly; in turn, suppliers may refuse to offer credit terms and sell only on a cash basis.
Debt Factoring? Never heard of that
For businesses to get immediate cash on selling claims over trade receivables, businesses must sell these claims to a debt factoring agency. This is a better option than insisting on cash payments, and waiting for long periods of time for debtors to settle their accounts. On the contrary, when the businesses sell to the debt factoring agency, it’s not for the full amount of the debt. This is where the debt factoring agency makes its money, they discount the debt and pay less than the actual debt amount. Suppose the debt sold is of $25,000, the agency may only give $18,000 cash to the business and keep $7,000. That $7,000 becomes the opportunity cost for the business, where if it waited for the settlement from the debtor, it might’ve received the full $25,000. But again, it’s not guaranteed that the debtor will pay, sometimes they never pay, leading to irrecoverable/bad debts (the amounts of the debt will not be recovered and are gone).
Now let us look at the long-term sources of external finance: hire purchase, leasing, long-term loans & venture capital.
What is the difference between hire purchase and leasing?
Hire purchase is when a company buys an asset and agrees to pay the amount in fixed installments over a period of time. Once the final payment is made, the asset will belong to the purchasing company. This prevents the company from paying the initial outlay cost as a whole, but the interest rates can be higher than for a bank loan. The partial payments of the purchase cost needs to be made, alongside the payment of interest.
Leasing is obtaining the use of an asset, but it is owned by the leasing company. The leasing charge must be paid over a fixed period, which avoids the need to raise long-term capital to acquire the asset. Leasing helps in reducing the risk of using unreliable or obsolete assets, as the leasing company is responsible to repair and update the asset as part of the agreement, and helps improve cash flow position as compared to an outright purchase of the asset. It can prove to be a high-cost option, but reduces the inconvenience of repairing, maintaining and selling off the asset.
Are loans only long-term?
Loans can be short term or long term, but we will be focusing on the long term aspect of loans. These loans do not have to be repaid for at least one year. Interest rates can be either fixed or variable; fixed interests provide more certainty, but it can be expensive if the loan is arranged during a period of high interest rates. Fixed interest rates can also help in terms of planning for payments, if interest of $200 is to be paid, the business can see if their cash flow position is negative or positive and then plan to pay for the interest accordingly. Additionally, security or collateral has to be given to banks to give them a sense of security, otherwise the loans will not be approved of or arranged. A benefit of loans that shouldn’t be overlooked is that businesses can raise large sums of capital, which could be used for purchasing capital equipment like machinery, and motor vehicles.
What is venture capital?
Venture capital is the risk capital that is invested in startups or small businesses that showcase potential for profit but do not find it easy to raise capital or gain finance from other sources. This risk capital is provided by venture capitalists or business angels. The most famous example of venture capital investments is ‘Shark Tank’, the sharks are business angels that invest the money in highly risky ventures, and expect a share of the future profits or a stake in the business in return for their investment.
In conclusion, choosing the right source of external finance is crucial. Taking factors like duration of finance, interest rates and security into consideration can help streamline your options. It’s best to choose your source according to your want; if you want to get ice-cream please don’t get a long-term loan. Thank you and this has been Hiyansh Khurana. I hope you all learned something new, take care!
Disclaimer: this essay is in no way promoting any types of external sources of finance. The sole purpose of this blog is to inform its readers of the types of sources available.
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