As world leaders and investors are trying hard to get a grip on the coronavirus pandemic, the global economy is starting to see a ray of light with the introduction of stimulus packages around the world. However, businesses in the tourism and F&B sectors, especially the Small and Medium Enterprises (SMEs), are still greatly affected, leaving many in a vulnerable state.
In such difficult times, sound planning and management are essential for SMEs to weather this financial storm. Among the pandemic-proof strategies, proper funding is the most crucial as it offers immediate relief to possible financial burdens SMEs may face during the economic downturn.
While there are many ways for a firm to raise funds, the most common and effective option during an economic crisis would be debt financing. Funding a business through the use of debt financing is critical for startups, but also beneficial towards companies wishing to expand their businesses.
What is Debt Financing?
Debt financing is a process where an individual or institutional investor lends a specific capital or fund to a firm for its business needs by buying the company’s fixed income products, such as bonds, bills, or notes.
A key reason why debt financing is attractive to businesses who expect to perform well is the lower effective cost compared to equity financing. Debt financing allows firms to retain full ownership over running of the business as investors are considered as lenders and not partial owners of the company. Moreover, debt interest costs incurred from the financing could potentially be fully tax-deductible as a business expense. In the case of long-term financing, the repayment period can be extended over many years, reducing the monthly expenses of the SMEs. Such flexibility, coupled with the fixed loan repayment rate, provide SMEs with certainty as well as opportunities in their business expansion plans.
Debt Financing Options for SMEs
Besides the benefits mentioned above, debt financing is more preferred as it is easily accessible and less risky as compared to other fund-raising options. Additionally, debt financing can be tailored according to the different needs and requirements of the firm.
However, companies must be realistic and careful in selecting their debt financing options as it would potentially affect the future of their business. Among the different variation of debt financing, the most common types of debt financing options for SMEs are as follows:
- Working Capital Loans
- Invoice Factoring Loans
- Business Overdraft Loans
- Hire-purchase Loans
Working Capital Loans
Firstly, a working capital loan is a funding option where a firm can use the capital to cover its daily expenses , such as utility fees, payroll, rental fees and supplies. Such financial loans are especially helpful during the current economic crisis as it offers SMEs with an immediate influx of cash to cover their business expenses.
Yet, this form of business funding is not recommendable for long-term investment, but rather useful as a reserve for a short-term financial goal until a more permanent solution is proposed to solve the cash flow problem.
Invoice Factoring Loans
Similar to a bank line of credit, an invoice factoring loan is a type of funding granted to companies in exchange for their account receivables or outstanding invoices. However, unlike bank financing, invoice factoring loans provide more flexibility in terms of fund approval by considering the credit quality of applying business’s customers rather than the business age or credit history. Such funding option is suitable for SMEs as most startups have difficulties in securing funds from banks due to the lack of a proven track record in investment credibility.
Business Overdraft Loans
Essentially, a business overdraft is a line of credit that is attached to the bank account of a firm which allows the firm to access capital beyond their credit limit. Companies can potentially get the funds on the same day of application and will only have to pay interest on the overdrawn amount. Moreover, it also has a flexible term limit where firms have the liberty to extend or terminate the loan within the agreement from both the firm and the lender. Such a funding option is suitable for SMEs, as it provides firms with a flexible safety net, coupled with cash flow that would potentially alleviate the financial burden that a firm has to bear due to this prolonged pandemic.
Hire-Purchase Loans
Lastly, a hire-purchase loan is a type of financing that allows a company to acquire or manage an asset by making an initial down payment and paying the balance on instalment basis. However, the ownership of the purchased asset can only be transferred when paid in full, including the interest. This debt financing option enables SMEs with low cash flow to deploy expensive assets that are essential to the business, though they can be more expensive in the long run due to the high interest rate as compared to purchasing over full payment.
Finding the Right Debt Financing Solution
Undoubtedly, there are a plethora of debt financing solutions for SMEs. However, not all the available options are compatible with the needs of the firm. To ensure that your business receives the most suitable financing solution, you need to first consider these factors:
- Long term goals
- Risk assessment
- Debt vs equity financing
Long Term Goals
It is no doubt that funds and capitals are critical for a startup’s business growth. However, a firm first needs to have a clear long term plan as these goals will determine its business structure and in turn decide the purpose of acquiring funds. This is essential, especially in determining the financial purpose as different purposes will require different debt financing solutions.
Risk Assessment
Besides identifying the purpose of acquiring funds, SMEs will also need to have a thorough understanding and risk analysis of their business. Although business structures will change in the long run, there is no doubt that the pre-existing structure will have a major impact on short-term financing decisions. Thus, investors will only be able to make wise decisions on the options of acquiring funds with a clear grasp of the current business structure.
Risk assessment is essential as it helps a firm plan its financing strategy in advance. Such assessment will ensure a smooth process for startups during the acquisition of corporate finance as most financial institutions review factors, such as overall business plan, business maturity and potential, revenue and credit histories, which can be easily highlighted after a risk assessment. Although there is an alternative where lending companies offer a “no-credit-check background” financing opportunity, the interest rates coupled with this option will be too high and risky for a startup to bear, especially during an economic crisis.
Debt vs Equity Financing?
The debate between debt financing and equity financing has been going on for a long time. While debt financing may be a good option for a startup business, equity financing should not be thrown out of the consideration.
Unlike debt financing which essentially works like a loan, equity financing is a type of funding where a percentage or share of a business is sold to an investor in exchange for an investment. The advantage of such financing options is that it will help to amplify the potential of the venture-backed business with the addition of wisdom and experience. Whereas, debt financing is appropriate for business when their need for funding is sudden and short-term. To determine which financing solution is more preferred, the company will need to take its financial plan and business goals into consideration.
Pandemic-Proof with Debt Financing Now
Raising funds for your business should be a springboard to success and a saviour in the current volatile economic environment. In whichever scenario, debt financing is an excellent place to start. Although most of the debt transactions are subjected to a deal-by-deal basis, many factors regarding a firm still need to be taken into consideration.
Consultants at Desfran can offer you guidance in finding the right debt financing options to alleviate the financial burden and fuel the growth of your business. With our large network of professionals and local experts, we offer a wide array of corporate advisory solutions for business startups. Talk to Desfran today.
References
A Founder’s Guideline to Debt Financing, Medium.com
Debt Financing for Companies in Singapore, Opencompanysingapore.com
What Are Working Capital Loans and How Do You Get One?, Nav.com
Invoice Factoring 101: Picking the Best Factoring Company, Joinharper.com
Pros and cons of business overdrafts, Mozo.com
Hire Purchase Agreements, Investopedia.com
7 Factors to Consider When Choosing Between Debt and Equity Financing for Your Young Business, Capitalwithstartegy.com
How to Choose the Best Financing Option for Your Business, Foundershield.com
