There are several different types of financing that a business can use to operate, each with their own pros and cons. There two main types of financing: equity financing and debt financing.
All businesses have some sort of equity financing. Equity financing is simply funding from the owners of the business. Equity financing always has ownership implications. When considering additional equity financing for your business, other than the initial contribution to start the business, you should consider the ownership structure of your business. You can contribute more money to your business personally or can look to other investors. However, this may involve giving up partial ownership and is something important to consider when seeking outside equity financing. This comes with the benefit of not having to repay the contribution or having to pay interest on the money received. Instead of getting the benefit of interest, the contributing party gets ownership and a share in the profits.
Debt financing is the other form of business financing. There are several forms of debt financing, but they all involve interest and require the debt to be repaid. One type of debt financing is bank financing. This is typically a term loan or line of credit. A term loan is a lump sum that the bank loans to a business. The entire amount is contributed to the business at once. The loan is repaid over a set period of time with a set interest rate. The interest is charged on the principle balance of the loan.
A line of credit, on the other hand, is typically a one year loan that often renews every year. The loan must be repaid at the completion of the term unless it is renewed. These are typically used for short term cash flow purposes to bridge a cash deficit. Interest is charged monthly on the current balance of the line of credit. This allows a business to use it as needed and pay it back once cash balances have improved. With a line of credit, a business risks the fact that the bank can call in the loan should the business fall out of covenant and a lump sum may be required.
The other type of debt financing is asset-backed financing. This is a little riskier type of debt financing, but can be a possible form of financing for businesses that don’t qualify for traditional loans. Asset based financing includes things like factoring, PO financing, hard money loans, and inventory financing. All of these types of financing involve higher interest rates and smaller loan amounts. These types of loans involve using your assets rather than your operations to provide collateral for the financing. While you can use your accounts receivable, POs, or inventory as collateral, these are riskier for the lender and therefore, while include a higher interest rate.
It is important to use the correct financing structure for your specific needs. A poor decision could put assets or even your company at stake unnecessarily. TGG helps many of our clients determine the best financing options for your business. For more information on these types of financing options, call one of our professionals today.Written by: Ashley Peth TGG Accounting