What Are The Types Of Business Finance?

Finance What Are The Types Of Business Finance? Share link

Keeping your business running is one of the biggest challenges leaders and entrepreneurs face. There are many day-to-day operational expenses that a leader or entrepreneur has to tackle, for which they need active cash flow in the business. Although businesses have found new and innovative ways to increase their seed capital, few have tapped into creative ways to increase their business finance.

Business finances play a vital role in the smooth functioning of an organization. This article will explore business finance’s different facets, including meaning, types, and benefits. And, towards the end, we will discuss career opportunities in business finance in detail.

What Is Business Finance?

The process of arranging funds for the successful operation of the business enterprise is called Business finance. It is also the process of using finance-related software for record-keeping. Business finance is used as a modern system for organizations to store and access digital records. So, business finance is not limited to arranging funds for business operations, and it extends to accounting and administration of finances incurred by a company. In the current business milieu, where survival is the key, the importance of business finance is substantially increasing. Here are some of the benefits of business finance:

• To stay on track

Many entrepreneurs use business finance to track revenues and expenses. In addition, many entrepreneurs are believed to use cash flow statements to understand the company’s financial position.

• Helps improve daily operations

Organizations need funds to keep the business running, and with the help of an adequate amount of business finances, they can manage to run various functions smoothly. Therefore, borrowing business finance aid daily operations and lets organizations achieve their goals and objectives without hassle.

• Achieve long-term objectives

Borrowing business finance helps organizations achieve their long-term goals and objectives. It also helps businesses achieve their daily target without compromising quality.

• Attracts more business

With adequate funds, organizations can formulate a diversification strategy and attract more businesses to invest in their firm. It is one of the ways of expanding the business and raising capital for it simultaneously.

• Boosts sales

Brands can proliferate to their target audience without hassle since there is a continuous inflow of funds due to business finance. Moreover, business finance helps organizations achieve their sales and profit targets.

Managers and executives often use business finance to control the company’s financial resources. Therefore, business finance is an activity that benefits the managers and executives as much as it does the organization. So, if you are an aspiring manager or executive anxiously searching on the internet- “what is financial management?” then here’s what it means.

Financial management is evaluating, directing, controlling, and planning the company’s funds. It is a business activity performed by the managers and executives to ensure sustainable and proper utilization of the firm’s resources and funds. Now that you are aware of business finance and financial management let’s understand different types of business finance. And later, we will explore how to make a successful career in business finance.

What Are The Types Of Business Finance?

Here are the different types of business finance frequently used by organizations:

1. Equity finance

Equity financing is the process of raising capital by selling the company using its financial tools like shares, bonds, etc. It is also the process of offering a part of a company’s equity or ownership to an external entity for capital requirements. Here are the different types of equity finances designed for different business needs:

Crowdfunding

Venture capital

Family and friends

Investors

2. Debt finance

When companies leverage their fixed or other assets to raise capital, it is called Debt financing. Bank loans and bonds are some of the best examples of debt finance. The debt finance’s fundamental framework works on the promise that the company will be repaying the loan amount in a fixed time. Here are some of the types of debt finance:

Bank loans

Asset finance

Trade finance

Line of credit

What Are The Documents Required To Apply For Business Finance?

Raising capital for businesses can become a tedious task sometimes, especially because it involves a lot of paperwork and documents. Therefore, finance managers or advisors must arrange all the documents required to apply for business finance. Below are the documents required to apply for business finance.

KYC documents: The document is an official proof of identification and authentication issued by the government authority, used while applying for a debt or offering equity.

Bank statements: This document records the bank transactions conducted by the company.

Income statement: This document is used by the debtor to analyze the company’s current financial situation.

In addition, investors or creditors can ask for an array of documents- including address proof, documents to prove the existence of business, etc., while lending capital.

How To Make A Career In Business Finance?

No formal educational degree provides a deep insight into business finance. Therefore, aspiring candidates can take a bachelor’s or Master’s in banking & finance course. It will equip candidates with skills that can be used while operating as a company’s financial advisor or finance executive. Furthermore, these finance courses will also help aspirants gain a deep insight into fundamental concepts of financial management.

Many professionals and executives also undertake certification courses to understand certain aspects of business finance that are not covered in the degree curriculum. Emeritus India offers some of the best finance courses in partnership with renowned Indian and international educational institutes. So, if you want to make a successful career in business finance, take up Emeritus finance courses online.

Small Business Financing: A Resource Guide

Most entrepreneurs use multiple methods to access capital for their small businesses, including personal savings. External sources of financing fall into two main categories: equity financing, which is funding given in exchange for partial ownership and future profits; and debt financing, which is money that must be repaid, usually with interest. Grants and scholarships are funds that do not need to be repaid, and may be offered by government agencies, nonprofit organizations, or for-profit companies.

Funding availability can depend on how established or mature a business is. Financing a brand-new start-up is more difficult since there's no business track record yet. Because of this risk, it may be easier to attract equity financing than debt financing. Funds for a growing business will be much more available because the business already exists and has some financial statements to extrapolate from. For this reason, more mature businesses will find it easier to access debt financing. However, equity financing may be harder for mature businesses to find because the business, or industry, has plateau-ed with little forecast for growth. When creating a financial plan, entrepreneurs may find it useful to compare their business or potential business to industry standards for the same or a related industry or to a public company in the field which has disclosed financial information.

This page provides resources with general overviews on financing. Additional chapters on financing exist in many books on business planning. Subsequent sections of this guide focus on specific types of financing.

Types and Sources of Financing for Start-up Businesses

Types and Sources of Financing for Start-up Businesses

Financing is needed to start a business and ramp it up to profitability. There are several sources to consider when looking for start-up financing. But first you need to consider how much money you need and when you will need it.

The financial needs of a business will vary according to the type and size of the business. For example, processing businesses are usually capital intensive, requiring large amounts of capital. Retail businesses usually require less capital.

Debt and equity are the two major sources of financing. Government grants to finance certain aspects of a business may be an option. Also, incentives may be available to locate in certain communities or encourage activities in particular industries.

Equity Financing

Equity financing means exchanging a portion of the ownership of the business for a financial investment in the business. The ownership stake resulting from an equity investment allows the investor to share in the company’s profits. Equity involves a permanent investment in a company and is not repaid by the company at a later date.

The investment should be properly defined in a formally created business entity. An equity stake in a company can be in the form of membership units, as in the case of a limited liability company or in the form of common or preferred stock as in a corporation.

Companies may establish different classes of stock to control voting rights among shareholders. Similarly, companies may use different types of preferred stock. For example, common stockholders can vote while preferred stockholders generally cannot. But common stockholders are last in line for the company’s assets in case of default or bankruptcy. Preferred stockholders receive a predetermined dividend before common stockholders receive a dividend.

Personal Savings

The first place to look for money is your own savings or equity. Personal resources can include profit-sharing or early retirement funds, real estate equity loans, or cash value insurance policies.

Life insurance policies - A standard feature of many life insurance policies is the owner’s ability to borrow against the cash value of the policy. This does not include term insurance because it has no cash value. The money can be used for business needs. It takes about two years for a policy to accumulate sufficient cash value for borrowing. You may borrow most of the cash value of the policy. The loan will reduce the face value of the policy and, in the case of death, the loan has to be repaid before the beneficiaries of the policy receive any payment.

Home equity loans - A home equity loan is a loan backed by the value of the equity in your home. If your home is paid for, it can be used to generate funds from the entire value of your home. If your home has an existing mortgage, it can provide funds on the difference between the value of the house and the unpaid mortgage amount. For example, if your house is worth $250,000 with an outstanding mortgage of $160,000, you have $90,000 in equity you can use as collateral for a home equity loan or line of credit. Some home equity loans are set up as a revolving credit line from which you can draw the amount needed at any time. The interest on a home equity loan is tax deductible.

Friends and Relatives

Founders of a start-up business may look to private financing sources such as parents or friends. It may be in the form of equity financing in which the friend or relative receives an ownership interest in the business. However, these investments should be made with the same formality that would be used with outside investors.

Venture Capital

Venture capital refers to financing that comes from companies or individuals in the business of investing in young, privately held businesses. They provide capital to young businesses in exchange for an ownership share of the business. Venture capital firms usually don’t want to participate in the initial financing of a business unless the company has management with a proven track record. Generally, they prefer to invest in companies that have received significant equity investments from the founders and are already profitable.

Venture capital investors also prefer businesses that have a competitive advantage or a strong value proposition in the form of a patent, a proven demand for the product, or a very special (and protectable) idea. They often take a hands-on approach to their investments, requiring representation on the board of directors and sometimes the hiring of managers. Venture capital investors can provide valuable guidance and business advice. However, they are looking for substantial returns on their investments and their objectives may be at cross purposes with those of the founders. They are often focused on short-term gain.

Venture capital firms are usually focused on creating an investment portfolio of businesses with high-growth potential resulting in high rates of returns. These businesses are often high-risk investments. They may look for annual returns of 25-30% on their overall investment portfolio.

Because these are usually high-risk business investments, they want investments with expected returns of 50% or more. Assuming that some business investments will return 50% or more while others will fail, it is hoped that the overall portfolio will return 25-30%.

More specifically, many venture capitalists subscribe to the 2-6-2 rule of thumb. This means that typically two investments will yield high returns, six will yield moderate returns (or just return their original investment), and two will fail.

Angel Investors

Angel investors are individuals and businesses that are interested in helping small businesses survive and grow. So their objective may be more than just focusing on economic returns. Although angel investors often have somewhat of a mission focus, they are still interested in profitability and security for their investment. So they may still make many of the same demands as a venture capitalist.

Angel investors may be interested in the economic development of a specific geographic area in which they are located. Angel investors may focus on earlier stage financing and smaller financing amounts than venture capitalists.

Government Grants

Federal and state governments often have financial assistance in the form of grants or tax credits for start-up or expanding businesses.

Equity Offerings

In this situation, the business sells stock directly to the public. Depending on the circumstances, equity offerings can raise substantial amounts of funds. The structure of the offering can take many forms and requires careful oversight by the company’s legal representative.

Initial Public Offerings

Initial Public Offerings (IPOs) are used when companies have profitable operations, management stability, and strong demand for their products or services. This generally doesn’t happen until companies have been in business for several years. To get to this point, they usually will raise funds privately one or more times.

Warrants

Warrants are a special type of instrument used for long-term financing. They are useful for start-up companies to encourage investment by minimizing downside risk while providing upside potential. For example, warrants can be issued to management in a start-up company as part of the reimbursement package.

A warrant is a security that grants the owner of the warrant the right to buy stock in the issuing company at a pre-determined (exercise) price at a future date (before a specified expiration date). Its value is the relationship of the market price of the stock to the purchase price (warrant price) of the stock. If the market price of the stock rises above the warrant price, the holder can exercise the warrant. This involves purchasing the stock at the warrant price. So, in this situation, the warrant provides the opportunity to purchase the stock at a price below current market price.

If the current market price of the stock is below the warrant price, the warrant is worthless because exercising the warrant would be the same as buying the stock at a price higher than the current market price. So, the warrant is left to expire. Generally warrants contain a specific date at which they expire if not exercised by that date.

Debt Financing

Debt financing involves borrowing funds from creditors with the stipulation of repaying the borrowed funds plus interest at a specified future time. For the creditors (those lending the funds to the business), the reward for providing the debt financing is the interest on the amount lent to the borrower.

Debt financing may be secured or unsecured. Secured debt has collateral (a valuable asset which the lender can attach to satisfy the loan in case of default by the borrower). Conversely, unsecured debt does not have collateral and places the lender in a less secure position relative to repayment in case of default.

Debt financing (loans) may be short-term or long-term in their repayment schedules. Generally, short-term debt is used to finance current activities such as operations while long-term debt is used to finance assets such as buildings and equipment.

Friends and Relatives

Founders of start-up businesses may look to private sources such as family and friends when starting a business. This may be in the form of debt capital at a low interest rate. However, if you borrow from relatives or friends, it should be done with the same formality as if it were borrowed from a commercial lender. This means creating and executing a formal loan document that includes the amount borrowed, the interest rate, specific repayment terms (based on the projected cash flow of the start-up business), and collateral in case of default.

Banks and Other Commercial Lenders

Banks and other commercial lenders are popular sources of business financing. Most lenders require a solid business plan, positive track record, and plenty of collateral. These are usually hard to come by for a start-up business. Once the business is underway and profit and loss statements, cash flow budgets, and net worth statements are provided, the company may be able to borrow additional funds.

Commercial Finance Companies

Commercial finance companies may be considered when the business is unable to secure financing from other commercial sources. These companies may be more willing to rely on the quality of the collateral to repay the loan than the track record or profit projections of your business. If the business does not have substantial personal assets or collateral, a commercial finance company may not be the best place to secure financing. Also, the cost of finance company money is usually higher than other commercial lenders.

Government Programs

Federal, state, and local governments have programs designed to assist the financing of new ventures and small businesses. The assistance is often in the form of a government guarantee of the repayment of a loan from a conventional lender. The guarantee provides the lender repayment assurance for a loan to a business that may have limited assets available for collateral. The best known sources are the Small Business Administration and USDA Rural Development.

Bonds

Bonds may be used to raise financing for a specific activity. They are a special type of debt financing because the debt instrument is issued by the company. Bonds are different from other debt financing instruments because the company specifies the interest rate and when the company will pay back the principal (maturity date). Also, the company does not have to make any payments on the principal (and may not make any interest payments) until the specified maturity date. The price paid for the bond at the time it is issued is called its face value.

When a company issues a bond it guarantees to pay back the principal (face value) plus interest. From a financing perspective, issuing a bond offers the company the opportunity to access financing without having to pay it back until it has successfully applied the funds. The risk for the investor is that the company will default or go bankrupt before the maturity date. However, because bonds are a debt instrument, they are ahead of equity holders for company assets.

Lease

A lease is a method of obtaining the use of assets for the business without using debt or equity financing. It is a legal agreement between two parties that specifies the terms and conditions for the rental use of a tangible resource, such as a building or equipment. Lease payments are often due annually. The agreement is usually between the company and a leasing or financing organization and not directly between the company and the organization providing the assets. When the lease ends, the asset is returned to the owner, the lease is renewed, or the asset is purchased.

A lease may have an advantage because it does not tie up funds from purchasing an asset. It is often compared to purchasing an asset with debt financing where the debt repayment is spread over a period of years. However, lease payments often come at the beginning of the year where debt payments come at the end of the year. So, the business may have more time to generate funds for debt payments, although a down payment is usually required at the beginning of the loan period.

For more information on business development, including contracts and agreements, visit the Ag Decision Maker website.

Don Hofstrand, retired extension value added agriculture specialist,