Banks are the key suppliers of external finance to the business world, helping businesses to turn future sales into ready cash. For this reason, one of the traditional ways in which finance can be raised is by establishing financial relationships with the banking system.
A bank loan is money advanced and borrowed for a given period with an agreed schedule for repayment. The lender (the bank) and the borrower (either an organisation or an individual) also agree on the repayment amount and the rate of interest (i.e. the cost for the lending service).
Even though it is quite a simple instrument, lenders generally seek a low exposure to risk, so they will evaluate the creditworthiness of the loanee. As a result, bank loans may not be accessible to all business organisations; rather, they are suitable mainly for well-established businesses with a solid track record of an ‘ability to repay’.
The lender usually tends to protect itself from the risk of not receiving loan repayments by asking for collateral. Businesses lacking collateral could find it quite difficult to borrow funds from banks. In addition to this, arranging a loan with a lender can sometimes be a rather lengthy process.
Interest rates on bank loans tend to be low, although the borrower will have to pay the interest rate calculated on all the outstanding debt. As you gradually pay off your loan, interest will be paid on a smaller amount of the principal. Conversely, the share of principal payments increases gradually as you repay the loan.
Another way in which a business can use the banking system to fund its short-term activities is through bank overdrafts. Overdraft facility schemes can be arranged with a bank in order to obtain short-term funding within an agreed limit. As in the case of bank loans, there will be a cost for this service (the interest plus a fee) and a period within which the repayment must be made. Owners of smaller businesses may be required to provide security (collateral) against these overdraft agreements, usually in the form of property, although this is not a requirement for all overdraft facilities.
For businesses searching for some flexibility in funding, for example due to seasonal fluctuations in sales that might result in cash shortages, a bank overdraft would be preferable to a bank loan, as the latter is fixed both in terms of time and size. Moreover, in the case of bank overdrafts, the interest is calculated and paid only on the amounts borrowed (or overdrawn) each time because there is no outstanding principal.
Using an overdraft as a form of financing can be risky. The lender can demand that the overdraft is repaid or reduce the overdraft limit at any time. It could also be expensive for a business as a higher rate is charged by the lender to compensate for making funds available ‘on tap’ and, as a result, the business could lose other investment opportunities.
Table 4 summarises the main advantages and disadvantages of bank loans and bank overdrafts.
Financial lease and hire purchase agreements
Financial leases are another common way for business organisations to raise long-term debt finance. A lease is a relationship, or a contract, between a lessor (the provider) and the lessee (the receiver). The lessee agrees to a series of payments to the lessor for the right to use an asset (e.g. a portion of land, a building, or a vehicle) for a fixed period, or lease term. The agreement is usually mediated by a leasing or financing company. At the end of the lease, the asset either returns to the lessor or the lease is renewed.
The key advantages of financial leases are flexibility, and the fact that the business can avoid a large outflow of cash and smooth the expenditure over a longer period (i.e. the asset’s life). Leasing is a form of financing used across all sectors and represents a consolidated source of finance, particularly in transportation and manufacturing. Leasing, though, comes with some disadvantages. For example, in the case of missed payments, the assets may be repossessed, and the business’ credit rating can be compromised.
Cases where the agreement stipulates that the asset will be purchased at the end of the period are referred to as hire purchase agreements. In such arrangements, at the end of the lease term the lessee becomes the legal owner of the hired assets. This is a form of credit used to buy an asset, which is usually mediated by a financial institution.
Box 1 Financing Flash Trucks’ expansion
The financial management at Flash Trucks is facing a challenge. The company is exploring an opportunity to expand its delivery business into France, which will require an expansion of the current fleet. However, given uncertainty about future trade relations between the countries, and the viability of the new contract, buying three new lorries could be risky. Moreover, Flash Trucks does not currently have enough internal funds to sustain this expense.
A finance lease could be a solution. In fact, Flash Trucks will not be required to pay the full price for the three new lorries and can agree on a short period for the rentals (say one year). This will provide a good degree of flexibility to explore the new business opportunity. At the end of the lease period, Flash Trucks can also decide to sell the vehicles to a third party.
So far you have learned about the traditional ways in which organisations can fund their activities. The next section provides and overview about alternative ways of financing, such as Crowdfunding and Peer-to-Peer lending.