For business owners there are many considerations and alternatives available to the most appropriate sources of business funding, their cost and risk.
Approaching financiers can be daunting, jargon filled and risky and to know what type of funding would best suit your business is difficult. Also it is important to know whether a financier is doing what is best for the business or themselves? Many midmarket companies will have internal book keepers and external accountants who may not necessary be aware of all financial products available or the necessary expertise and time to find and evaluate and select the most appropriate.
Sources of business funding, their cost and associated risk to the company is summarised in the figure above. A key “cost” of debt is the ongoing obligation to pay interest regularly (monthly) and in some instances repayment of principle on a regular basis. The “cost” of shares, which are generally unsecured, is in the form of commitment to pay dividends and for the share value to grow overtime. Dividend payments are dependent on decisions made by the directors associated with the performance of the business. Share value growth is dependent on the performance of the business but the value is determined by the market.
The greater the security on the funds the lower the cost hence bank loans are typically fully secured and have the lowest interest rates. The less the security, the greater the risk for the lender and hence the greater is the cost of the funds. As there is higher risk with unsecured shares, the “cost” and return to shareholders is higher than secured bank debt.
The most frequently used bank and lending institution funding require a form of security with the most common forms including:
- Debtor finance (often referred to as invoice finance or factoring) – up to 80% of approved invoices for approved debtors.
- Trade finance – generally related to imported stock and fund up to 80% of the value of stock on the water
- Asset and Equipment finance – plant and equipment. Removable equipment such as vehicles and earth moving equipment is preferred and where there is a ready market to sell the asset. Special purpose machines have low loan to value ratios due to the cost of removing them and the difficulty of finding buyers (at a reasonable price) and often the loan for these machines is provided at the value which would be recovered at an auction.
- Inventory Finance – generally difficult to secure with valuation by banks or lenders at approximately 25% of cost for general merchandise and materials. Floor Plan financing is widely used to fund finished goods on retail show room floors from cars to boats and white goods with funding up to 80%. Floor plan finance is for limited duration and associated with a specific item and is often tracked by serial number.
- EFIC (Export Finance & Insurance Corporation) is an Australian government funding scheme to lend working capital in support of export growth for small and midmarket companies with revenue up to $150m. EFIC is very useful to overcome a gap in funding or need for extra working capital where you have a major export contract or contracts.
The funding ratio between equity and debt (gearing), is a measure that lending institutions monitor as a risk indicator. Essentially banks like to share the risk with shareholders and may, where additional bank funding has been requested, ask the company to commit more shareholder funds to reduce their exposure and manage the risk.
Speak to your advisor to ensure you have an appropriate cost-effective funding structure and sources of business funding.