Financing small businesses.
Managing small businesses is often considered to be an easy job mainly because the owners of such businesses are content with the earnings and consequently do not take risks to better their business. Obviously the returns made by such businesses are small as well. This is to the determinant of business as other stakeholders will take over it by providing better services. Hence it is vital to plan for the expansion of small businesses. But things become tricky if the owner of such a business is a risk-taker and wants to expand his business to garner higher returns.
Let’s have a cursory look at issues faced in this matter and ways to deal with them.
Your decision: Equity financing or debt financing?
The most important part of a business whether small or big is meeting its investment requirements and the first question that comes into the mind is whether to meet the requirement through equity financing or debt financing. Each one has its own advantages and disadvantages.
It is advisable that businesses in early stage of their development avoid debt financing even after break-even is achieved. Debt-financing in such circumstances will earn the business a net loss to meet interest expense and failure to make payments can distort the credit image of the business, in extreme cases rendering the business bankrupt.
Similarly business which has a bad credit history is better off financing through equity. Banks tend to demand a higher return owing to bad credit history, so such businesses tend to be at loss as compared to a similar business with better credit history.
As it is said that debt acts as a lever exacerbating loss in times when business makes losses and augmenting profits when the business is lucrative, it is important to determine how much return the business can make and how much interest rate it will have to pay. If the difference is positive, the business is better off opting for debt-financing.
Just like debt-financing, equity-financing has its own complexities. Financing out of the pocket of the owner is one option but most owners will have already invested their disposable income which leaves them no option but to take cash from third party investors. While managing finances form this source a vital consideration is whether or not you want to indulge them in decision making of the business. If you do you lose the freedom to make decision for the business which may hinder your business growth. For example if you are a risk-taker while your financer is risk-averse he will not let you proceed with your risky plan. On the other hand if you do not want to indulge him in decision-making you will have to give him a higher return. So it is vital to get to know your preferences and the tendencies of investor before you make a deal with him regarding the investment.
In short, the decision to finance your business will be affected by the prevailing circumstances and your preferences. Using equity-financing and debt-financing is a tricky part where due consideration is necessary, as both can be beneficial and harmful to your business.
Some Other tips:
Maintain a good credit policy.
As stated above if you plan to finance your business through a debt, start maintaining a good credit policy. Pay your debtors and collect payments from your customers at the earliest. Many banks will see the current credit history instead of distant past. This will help you get the loan easily and at a lower rate.
Maintain Books.
It is always good to maintain books and even more important if you finance your business through a debt. Keep track of recent expenses, incomes, future income prospects and expected expenditures. Make sure enough cash will be generated prior to the date of payments of your expenses.
Arrange a source of cash.
Many businesses make good profits but default on payments which can render them bankrupt. The main reason for this issue is that they don’t have cash on hand when payments are due. In contrast many businesses keep cash in place well-before the due date which affects the prospects of making a return on the cash stacked. Small businesses can resolve this issue by partnering with retailers or other such businesses which generate enough cash on daily basis. They can give the businesses cash for a week or two and retake them on the day of payment with a return.
Make loans profitable.
It is important not to fear the loans. But do a little research on prospects of making profits on loans. This is really important when taking loan for the expansion of business. Projecting returns expected and arranging for secondary sources for financing the loan is important. Loans you take after you know what they will yield will be profitable.
Look for expansion.
Once a business is established look for insights from the market. Your customers will give you the key insights you need to make profits by entering into different fields. Set aside part of your income to invest in growth opportunities. The credibility of your current business will aid attract the customers to the other business especially if they resemble in some way.
Summary:
Equity-financing and debt-financing are the main sources to finance a small business each beneficial in different contexts dependent on the prevailing conditions and preferences of the owner. Debt financing is beneficial for established businesses which not only make higher returns than the interest rates required to finance the debt but also have a good credit record and ability to generate cash to needed to make interest payments. On the other hand equity-financing can reduce your control on the decision-making. Maintaining books, a good credit record, and cash on hand and making accurate projections increase the likelihood of turning loans into profitable loans while the opposite can give negative returns. So it is vital for small business owners to take all these into consideration while deciding on the way to finance their business.