Choosing an appropriate source of business finance can be a difficult and time-consuming task. This is due to the sheer amount of funding options available. Financing can come in the form of debt or investment, and finance terms can vary significantly.
The criteria and implications of each source require critical analysis before proceeding, and it is essential to weight the cost versus benefits of each source before making a decision.
Below are some of the factors that we should consider before deciding on a source that most suits our business needs.
Risk is an important element to consider. We must consider what will happen if we are unable to meet the financial commitments relating to that particular source of finance. If we borrow from friends and family, for example, we will need to take into account what would happen to our relationship with them should the business fail and we are unable to repay them.
What will happen if we are unable to meet the financial commitments of a bank loan if our business succumbs to financial difficulty? When it comes to choosing suitable funding, we must strive to minimise the overall risk.
When it comes to choosing suitable funding, we must strive to minimise the overall risk.
If we are a startup, we must bear in mind that certain suppliers of funding will perceive us as having a higher risk of failure than an existing business. As a result, funding may prove more difficult to obtain. Despite the economic downturn, banks are still lending. However, they are more cautious about where the money is going. Especially when considering a loan to new businesses with no track record. Therefore, guarantors or a letter of guarantee are often required on startup loans.
If we are perceived as risky, then the financier will require a higher return as compensation for that risk, thereby increasing the cost of capital for us. Financiers, whether a bank or investor, will look at the performance of the industry in which we operate. Buying patterns and customer spending will all be taken into account when determining the level of risk.
The higher the level of risk, the higher the return required.
If we decide to rely heavily on borrowing as our main source of funding, then we will need to consider the effects of a high level of gearing on our future borrowing capacity. High levels of gearing can increase our financial risk and also affect the earnings per share (EPS).
Deciding the appropriate balance of equity and debt will be an important decision when deciding the appropriate funding or capital structure for our business. Our overall aim will be to find the mix of finance that minimises our overall capital structure, thereby increasing the net present value of future cash inflows.
The cost of finance and its effect on income will play a fundamental role in our financing decision. Our overall aim is to minimise the cost of finance and maximise owners wealth. Therefore, it is essential to consider the implications of choosing one source of funding over another.
For example, if we increase our borrowing, will this increase our cost of equity? What this means is that if we increase our borrowing, will our existing shareholders perceive this increase in borrowing as having an effect on their risk?
If they consider that the additional borrowing increases the risk of bankruptcy then they may require an additional return as compensation for this risk. Therefore, this compensation will represent an increase in the cost of equity. We also need to consider the other costs of borrowing which include interest rates, origination fees, and brokers’ fees.
Financing through issuing new shares can lead to a change in management and a shifting in strategic focus. In addition, the costs associated with issuing new shares can be substantial and there is also uncertainty with regards to the success of the issue.
Furthermore, shareholders will expect appreciation for their investment in the form of a dividend or increased share value. The payment of dividends is not tax deductible whereas interest payments on borrowing are tax deductible.
On the other hand, receiving a grant for our business may mean that we won’t incur additional debt. However, grants will often come with certain criteria that must be met such as employing a certain number of people over a period of time or using the funds for research and development etc.
If these conditions are not satisfied the grant may become repayable.
As you can see each type of financing offers certain benefits and pitfalls. It is essential to add up all of the costs associated with each source of finance before making a decision.
Control is another factor that plays an important role when choosing a source of finance. Issuing additional shares (equity) will result in a dilution of control among existing shareholders/owners. You are effectively giving each investor a piece of ownership in your business and thereby are accountable to those shareholders.
Investors will require input into the operations such as sitting on the board of directors and receiving performance and operation reports. You will have to provide them with information that you may have wished to keep hidden from your competition, as well as detailed explanations for your business decisions.
Owners who do not want to lose control of their business, preferring to keep major decision-making in their own hands, will only consider equity financing up to a certain level or may prefer loan capital.
Once the loan is paid back, your relationship with the lender ceases, whereas investors continue to have a say in the company until they are bought out, the company is sold, or goes public. As a result, how we choose to finance our company will have an impact on our independence as management.
4) Long term versus short term borrowing
When sourcing finance, we also need to consider whether we should obtain long term or short term funding. In many cases, it may be appropriate to match the type of funding to the nature of the asset.
If we are obtaining a noncurrent asset, for example, a piece of machinery that will form a permanent part of our operating base, then we would consider using a long term source of finance to fund this asset.
Long term finance will be repaid over a longer period and include bank loans, hire purchase, debentures and retained profits for example.
On the other hand, if we were obtaining an asset that was more flexible in nature and could be paid at short notice, such as an asset obtained to meet seasonal demand or money to cover the day-to-day operations of our business, then we would finance this using a short term source of finance.
This kind of finance is intended to be paid back in a matter of months rather than years. As a result, there is less risk involved for the lender. Overdrafts and supplier credit would be an example of short term finance.
However, it can be difficult to make this distinction at times, due to the difficulty in predicting the life of an asset.
Flexibility will also have an important bearing when choosing an appropriate source of funding. If interest rates are high but are forecasted to lower in the future, we may choose a short-term source of funding to delay a commitment to long-term sources until a future debt.
Short-term financing can often appeal more as they often come with no additional penalty for early payment, which is not the case with some sources of long-term finance.
Despite lower interest rates and no penalty for earlier repayment of short-term funding, it does come with disadvantages. These can become apparent with refunding risks. Short term finances will have to be reviewed more regularly than their long-term counterpart and as a result, can prove a problem if our business is in financial difficulty or there is a shortage of funding available. As a result, long-term funding may be more desirable.
As a result, long-term funding may be more desirable.
Finally, interest rates will play a fundamental role when we are deciding our financing options. Due to the increased risks associated with long-term borrowing, lenders will require extra as compensation for this increased risk as their funds are tied up longer. This will be reflected in higher interest rates.
Lenders often require additional security to safeguard against you defaulting on a loan. For example, if you obtain a mortgage you are using your house as security so if you don’t repay the loan amount, your property may be repossessed by the lender and sold to recoup the money owed.
While this may make short-term funding more desirable, it is critical to consider the other costs as short-term financing will need to be reviewed more regularly thereby increasing costs.
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