Understanding Business Financing Basics

Capital is arguably one of the foremost needs to start and then run a business. At some point in the journey of your business, you will need access to capital through business financing. Businesses just starting out may require capital infusion to give the initial form to an idea and to take off. At the same time, even already established businesses may require business financing for growth, expansion or operational needs.

Business financing can be in many different ways. They all come with unique features in terms of security, repayment, or other terms. Depending on the need, duration, amount or size of the capital needed, and terms of repayment, etc. different types of business finance can be availed at different stages of business. Choosing the wrong business finance may deal a heavy blow to your business’s finances in the long run, sometimes even to the extent of losing control over one’s company.

Finance refers to the study, management, creation, and application of money. Finance impacts every part of a business operation and every operation of a business impacts finance.

Most decisions taken in the life of a business, from day-to-day operational needs to mergers and acquisitions are backed by strategic financial decisions based on financial data and inputs. In other words, finance is a broad term encompassing the management, creation, and study of money, banking, credit, investments, funding, assets, and liabilities that constitute a financial system.

In this article, we will look at the basics of business financing, different types of business finance, and factors to consider for each.

Key Takeaways

• Finance is related to banking, funding, leverage or debt, credit, capital markets, money, investments, and even accounting, taxation, and compliance. 
• Microeconomics and Macroeconomics have contributed to the development of basic concepts of finance. 
• The finance domain can be categorised into three broad branches: personal finance, corporate/business finance, and public finance.

Finance, from planning, budgeting and cash flow management, to capital structure, risk management, risk mitigation and cost management is crucial for any business decision. While finance has personal, corporate, and public branches, we will focus on corporate or business finance in this discussion. First, let’s have a look at the different aspects of business financing:

Different Aspects of Business Financing

Setting the Course: Planning and Budgeting

Planning is about laying down the goals of the business, and the direction and roadmap to achieve those goals. Budgeting is only one part of strategic planning. 

Budgeting is the process of forecasting revenue, expenses, and expected profit of a business for a specified period, typically one financial year. The combined effect of planning and budgeting addresses the business’s aspirations, determines the objectives and goals, and helps figure out how much money will be required to attain them.

Fund Raising

The plan and budget act like a blueprint, revealing how much money is needed to steer business operations and strategic initiatives.  They also provide guidance on the optimal capital structure, informing decisions about how to fund those needs.  Financial expertise is crucial here, helping businesses choose the best sources of funding,  whether equity, debt or a mix of both.

Cash Flow Management

Cash flow management is the process of tracking, controlling, and managing the money that is coming into and going out of a business. This helps understand how much money will be available to the business and how much money the business will need in the short-term and long term.

Cash flow management helps businesses understand their financial health, both present and future. Effective cash flow management involves overseeing working capital components – receivables, payables, inventory, and cash balance.  It also explores opportunities for investments and additional funding sources.

Profit Planning and Controls

Famous management consultant, Peter Drucker rightly said, "Profit is the condition of business survival." Businesses need to manage profit effectively for its optimum spending.  An ideal profit planning process creates a roadmap for future income, considering the business's capabilities, resources, and market conditions. This process might involve analyzing the profitability of individual products, identifying areas for improvement, or finding cost-saving measures.  Regularly reviewing financial statements to compare performance against budgets and past years allows for course corrections and ensures business success.

Navigating Uncertainities: Managing Risks

Risk can be defined as the uncertain probability of an event and its consequences. Risk management is identifying, assessing and controlling the risks to a business's capital, earnings, growth, and survival. A business risk can emanate from financial uncertainties, statutory obligations, technology issues, management mistakes, accidents, or even natural disasters.

Financial uncertainties, such as interest rates, currency fluctuations, volatile commodity prices, and customer payment delays, pose significant challenges.  Financial management plays a vital role here, continuously analyzing risks in markets, monitoring customer creditworthiness, reviewing loan and investment terms, and keeping the business informed of potential dangers, can go a long way in minimizing the cost of uncertainities.

Key Types Of Business Financing

Debt Financing

Debt financing refers to the process of raising money for a business through debt instruments like loans or issuing of bonds and debentures. Usually debt financing is availed from financial institutions like banks.

The most significant advantage of debt financing for businesses is that you do not have to dilute your equity to take a loan. Lenders do not become the owners of the business, and as such do not have a say in how the company is run. Besides, interest paid on debt can be deducted as an expense in calculation of income tax.

On the other hand, debt financing imposes a regular financial burden in the nature of periodic repayments. This can become an headache for businesses that are just starting out and may not have a stable cash inflow, or for businesses that are involved in seasonal industries.

Equity Financing

Equity financing for a business comes from investors who invest in the capital of the company in exchange for a proportional share of ownership rights, including a right to a share in the company’s profits and voting rights.

At an early stage, these investors can be venture capitalists, or angel investors. As the business grows different types of investors can become shareholders including the public investors when the company gets its shares listed on the stock market.

The biggest advantage of equity financing is that there is no obligation of repayment. Since investors are not creditors they do not have a priority claim over the company’s assets when it goes bankrupt. Besides, for companies that our just starting out, banks may not be willing to lend without a track record, and equity financing can give you the required kickstart.

Equity financing involves giving up of ownership stake, and accordingly investors become entitled to proportionate share in the dividend. Investors also have a say in the operation and management of the company pursuant to their voting rights.

Mezzanine Financing

Mezzanine financing sits somewhere between debt and equity financing. It offers lenders a higher interest rate than traditional loans, often with the option to convert debt into equity if the company defaults on the loan.  This can be attractive to businesses needing capital but wanting to avoid diluting ownership. However, mezzanine debt comes with steeper interest rates than regular loans.

Off–Balance Sheet Financing

Off-balance sheet financing can be used to raise capital without impacting the company’s balance sheet. This can be achieved through methods like lease agreements or joint ventures. While it improves debt ratios and potentially makes the company more attractive to investors, it can also mask true liabilities and create a less transparent financial picture. Additionally, off-balance sheet financing often comes with hidden costs or ongoing commitments that may not be fully captured in traditional financial statements.  This can make budgeting and future financial planning more complex.

Conclusion

Business financing and proper financial management are key determinants of business’s success right from the start of the business. Taking care of planning and budgeting, risk management, cash flow management, profit control, etc. can ensure smooth running of operations, and fuel long-term aspirations of a business. At the same time, it is important to choose the right type of funding. While debt offers more liberty in terms of running the business, it can become a financial burden. Equity, on the other hand gives investors a say in the running of the business, and share in the profit for as long as they remain invested. As a business owner you should weigh your factors before deciding on a funding source.

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