The most common cause of failure in small businesses is the inability to generate the cash to repay debt and repay interest costs. Once internal sources, such as working capital, have been considered, either equity or debt finance can be used to satisfy shortfalls in cash. A business owner may inject further cash in the form of equity, and may share the financial risk by inviting other investors to contribute additional equity investment. The equity investors might then consider if any other forms of finance are required to reduce their risk and meet planned expansion.
There is a range of different types of debt agreements.
- Preference shares – these often carry a guaranteed fixed interest rate and rank ahead of ordinary shares in any repayment arising from insolvency.
- Loan stock or debentures – debentures are a special form of contracted loan, usually redeemable at a specific maturity date. They may be issued to raise capital for the purchase of specific assets, and may be secured on those assets.
- Bonds – another form of a contracted loan. Bonds are potentially tradable, although usually unsecured.
- Leasing – specific assets may be acquired using lease finance, which would always be secured on the asset. Leasing saves an upfront, large cash outflow for the purchase of the asset. It can be less risky than borrowing from a bank as the lease is secured on the asset (being leased), rather than the owner’s property or other business assets. A lease contract requires the commitment to regular payments and there may be an early cancellation fee.
- Bank loans – bank loans are usually arranged for a fixed period, carrying a fixed or variable rate of interest. They are often secured on specific assets or on the business as a whole.
- Bank overdraft – an overdraft is offered at the discretion of the bank. It can be cancelled at any time – and not necessarily because of any concerns about the business itself. Sometimes internal bank decisions or concerns about the external economic environment may influence this. An overdraft is suitable for funding short-term cash shortfalls. It is repayable on demand and there will be interest charges and a fee for using this flexible type of borrowing.
- Suppliers or trade payables – suppliers give an interest free loan if they offer credit terms of a month. Suppliers will assess the credit standing of a business before offering generous credit terms.
Next you will consider the potential of business grants.