Getting The Right Mix of Financing For Your Small Business
Every business needs a robust financing plan. For small businesses, any decision on financing is probably one of the most critical turning points for the short and long term. It is essential part of the financial management scheme that every business should have, which I have covered in my previous article.
In order to create a business financing plan, or BFP in short, there are two very important questions to answer:
First question is — “What are the long-term and short-term funding requirements of the business?”
Long-term funding is linked to the nature of your business and the investment required in fixed assets to meet the current & expected demand. For example, the machines that you will need to operate your business for the next few years.
Short-term funding is linked to the entire working capital cycle, payment terms with buyers and suppliers, employee payroll and the inventory holding patterns.
The second question is — “What is the mix between Equity & Debt?”
Equity and Debt can also be considered as long term & short term financings.
We will answer the second question in this article.
Long Term: Equity Capital
In the simplest form, equity capital is the most stable and long-term finance available to the business. Key advantages of equity financing are longevity, stability and the lack of interest payable on an ongoing basis.
Providers of equity capital are, in fact, owners of the company and will expect a high rate of return in the long run. Raising equity capital from third parties is essentially offering part ownership to them and diluting the founders’ stake.
There are now multiple sources to explore equity raising for a business. These include Private Sources, Private Equity, Venture Capital and Angel Investors.
Long Term: Debt Financing
Debt is the second source of funding for any business. There are also various forms of long and short-term debt options available that you can explore.
For small businesses, the banks and government agencies are the main sources for long-term debt. Most governments have special schemes that support provision of long-term debt for specific purposes. You can find more details of schemes in Singapore here.
A robust BFP will ensure that all the long-term requirements of the business are met through equity and long-term debt options. Any mismatch will result in chronic liquidity shortage and could lead to severe challenges on a day to day basis for the small business.
Short Term Financing
Short-term debt options are Working Capital loans, Overdrafts, Hire-Purchase loans, and Receivable Financing.
Banks are also the principal providers of short-term debt to small businesses. In addition, there are Non-Banking Financial Companies active in the market who offer one or multiple short-term debt products. With the growth in fintech sector, there are now emerging platforms offering online short-term debt solutions.
The cost of debt here is paid in the form of interest payments, which varies based on i)the source, ii)tenor of the debt iii) and the collateral offered. The interest cost has to be serviced on a regular basis and it is a key outflow of the business. Interest cover is the ability of the business to cover its interest payments from its revenue after meeting other expenses.
A robust BFP aims for a healthy Debt-Equity ratio (DER) and a comfortable interest coverage ratio(ICR). These ratios are linked to the nature of the business and the underlying industry so those benchmarks are important.
As a broad principle, too much debt is unhealthy and will reflect in unhealthy level for the above two ratios. Equally, every business can afford an optimal level of debt and should aim to achieve the same. These optimal levels change with the growth of the business, its underlying profitability and the industry benchmarks.
A robust BFP is, therefore, a dynamic ongoing exercise.
