In its early stages, a business may take out small loans, apply for government grants, or receive investment from venture capital firms/business angels. As a business grows and matures, it may use its cash resources to fund day-to-day operations and increasingly use debt (where the investors are lenders) or issuances of equity (where the investors become part-owners). Large businesses may combine multiple forms of financing, for instance issuing shares (equity) whilst also taking on multiple layers of debt from different sources (for instance taking loans or issuing bonds). Note that businesses may borrow money even if they have cash available. For instance, a business may choose to invest available cash in a new venture and borrow money to fund day-to-day operations (or use available cash to fund day-to-day operations and use money borrowed to invest in a new venture) in the hope that the profits generated by that new venture will exceed the cost of borrowing money to use in place of the available cash.
If a business becomes insolvent, the ways in which the repayment of different creditors is organised and prioritised can depend on the type of financing they have provided (debt or equity) and the nature of the contractual agreements made between the parties. The repayment of senior debt holders is prioritised over the repayment of other creditors if a company becomes insolvent. They generally receive lower interest payments, as they are more likely to be repaid and often take security over a company’s assets. Junior (subordinated) debt holders are ranked below senior debt holders and therefore will only be repaid once senior creditors have been repaid in full (if any money remains). Subordinated creditors may charge more interest to compensate for this additional risk.
Financing operations using existing cash resources (for instance, retained profit).
- Control: the owners retain full ownership and control of the business and its assets.
- Cost Savings: no interest payments or dividends will need to be paid.
- Arranging Finance: businesses can access their own capital immediately and without incurring hefty administration fees.
- Effectiveness: some firms may not have enough cash to finance investment and maintain sufficient cash flow.
Bank Loan / Overdraft
Firms can borrow from banks and then pay back the loans in instalments, plus interest. The interest rate can be fixed (making it easier for a business to predict its costs) or floating, in which case the rate may be linked to the fluctuation of a benchmark interest rate (for instance LIBOR), which could in turn end up costing less than fixed rate repayments if interest rates happen to fall or, contrary to expectations, remain static. A bank may be persuaded to issue a loan on the strength of a well-prepared business plan, a strong previous relationship with the borrower, a financial guarantee from another party, or a company’s ability to provide collateral.
Where multiple banks (the ‘syndicate’) work together to contribute funds in order to provide the required capital. The banks share interest payments from the borrower and risk. Syndicated loans are more viable where borrowers require a large amount of capital, as these loans can be complicated and expensive to administer.
- Control: the owners generally retain full ownership and control of the business so long as repayments are met. Note however that lenders may be able to exert some control over a borrower’s business through taking security over assets on terms that restrict the ability of the borrower to sell those assets.
- Cost Savings: money can be borrowed as and when it is required, meaning that the borrower may only have to make interest payments that reflect the actual capital in use (i.e. the money drawn out of the bank account). In addition, interest payments made are tax deductible.
- Effectiveness: banks are generally more suited to complicated lending structures as they have extensive experience of evaluating risk. They may thus be more inclined to approve financing and once a loan is approved, a business is generally guaranteed to receive the full amount immediately. Banks may however decide to hedge risk through releasing funds in instalments. This could prevent borrowers from using capital recklessly or for purposes not previously agreed. Under such circumstances, borrowers may only qualify for new instalments once certain targets have been met.
- Arranging Finance: small loans are quicker and cheaper to arrange than bond or share issues. However, as mentioned, large, syndicated loans may be incredibly costly and complicated to arrange.
- Security: collateral may be required in return for a loan, typically in the form of an asset. If repayments are not met, lenders may seize and sell any secured assets in order to retrieve their money. In addition, companies lacking valuable assets may struggle to secure loans due to their inability to offer sufficient collateral.
- Costs: interest payments may be substantial, depending on a borrower’s credit rating and the economy.
- Repayable On Demand: certain loans (notably overdrafts) are repayable on demand, which could cause cash-flow issues if repayment is demanded earlier than expected.
By Jake Schogger - City Career Series