One basic rule of financing is to know the difference and uses of different types of financing that is available to the business owner. For example, not knowing when to use short-term financing or long term financing could easily cause you to end up with a financial imbalance. If you purchase equipment with a one year bank loan, you might find yourself short of cash to purchase inventory, carry receivables, pay your payables or even be short of cash to pay back the one year loan. In such a situation you could be forced into liquidation or bankruptcy.

SHORT-TERM FINANCING

In most businesses the greatest need is for short-term financing, generally considered to be funding required for a period of less than a year. In short-term financing the lender will tend to place greater emphasis on your balance sheet in order to see if, in case of your businesses liquidation, current assets would provide sufficient funds to repay the debt. Some of the various methods of short-term financing are as follows.

1) Trade Credit. Surprisingly, the most common means of short-term financing is trade credit or financial assistance from suppliers with whom you do business. The reason for this is that most suppliers do not demand cash on delivery after a business relationship has been established except if you have developed a reputation for delinquency in payment of accounts.

Inventory purchased at the beginning of the month usually are not billed or invoice until the end of the month. A 30 day payment period for such items means that you use the inventory received without cost for anywhere up to 60 days. This type of trade credit is an important source of cash for a business. Even if you had the cash to pay the bill at the time it was received, it may be wise not to do so. As long as there is no penalty imposed, you are free to let your cash sit in the bank and collect interest until the invoice has to be paid. This is also another source of profit to you.

2) Open Credit. This finance source can be useful in financing the inventory of a new business. For example, if you purchase $3,000 worth of inventory, you might be asked to put up $1,000 cash and owe the supplier the balance to be paid in 30 days. During that 30 days, most if not all of that inventory will be sold at a profit and you will have cash to pay off the $2,000 owed. This cycle can be repeated ad infinitum with each of your suppliers.

For a new business, unfortunately cash is generally (but not always) required on delivery (COD) at least for the first order. This means that you do not receive any trade credit. However, by paying cash on delivery for orders from suppliers you should be able to establish and maintain a solid credit base. You should also be ready to provide a supplier with credit references. Most larger suppliers will have a credit department, or will employ an agency to check on your credit status if you are a new customer.

3) Cash Discounts. Sometimes a supplier may offer both a credit period and a cash discount. One common type is 2/10, net 30. This means that you are offered a 2% discount off the invoice price if the bill is paid within 10 days. If the bill is not paid within the 10 day period, it must be paid within 30 days of the invoice date, but without discount. With a 2/10, net 30 arrangement, you must seriously consider the cost of not taking the discount. For example, if you make a $1,000 purchase and pay within 10 days, the amount to be paid is $980. If the discount is not taken you, in effect, have the use of the $980 for a further 20 days. However, the cost would be:

 

$20	×	365	=	37.2%
$980		20

 

This is an expensive form of financing. Even if you are short of cash, it might be wise to borrow $980 from the bank to pay within the discount period, since the bank interest would be considerably less than 37%.

4) Seasonal credit. If the nature of your business is seasonal, you may find it difficult to pay all bills in the off-season when they are due. In such cases, it might be wise to prearrange for a longer payment period with suppliers whose financial resources allow them to extend longer credit, instead of risking the loss of your credit. Alternative arrangements could be made with a lending institution to borrow funds for the interim to pay bills within the normal payment period.

You should also recognize that trade credit is not absolutely ’free’. The supplier who extends credit also has financing costs, which must be paid out of revenues from the products sold. In another words, the cost is included in the selling price. However, where competition exists among suppliers, this hidden cost could be much smaller than any other short term financing.

5) Working capital. These loans are typically for financing inventory and accounts receivable and other items requiring working capital during peak periods. Typical sources of working capital are commercial banks or similar financial institutions. This way may be a good way to establish credit with a bank. A lender who is considering a short term loan will be interested in your businesses liquidity. Liquidity is the ability to convert an asset into cash or cash equivalent without significant loss in the value of the asset. Liquidity is the capability to pay all the bills due during a given time period. The current ratio is used to measure whether or not a business has enough current assets to pay off its current debts, plus a little extra to handle any emergencies that might happen.

 

Current Ratio =	Current assets
	Current liabilities

 

A good ratio is 2 to 1, i.e. the assets are double the liabilities. However, the ratio by itself says nothing. It really depends on the type of business. For businesses with little inventory and with accounts receivable that are easy to collect, a current ratio lower than those businesses with less steady cash flow can nevertheless be considered good. If needed, ways of increasing the ratio can be accomplished by paying off some debts, increasing current assets with loans having maturities of a year or greater, securing new equity contributions, or put profits earned back in to the business.

Another form of liquidity test is known as the Acid_Test Ratio, or ‘quick ratio’.

 

Acid_Test Ratio =	Cash + marketable securities + accounts receivable
	Current Liabilities

 

The advantage of the acid-test ratio over the current ratio is that the acid-test ratio does not include inventories so it focuses on a company’s assets that are truly liquid. It gives a good sense of whether or not a business could pay off all its current debts using the easily liquidated funds available. An acid test of 1 to 1 is plausible if your accounts receivable collections keep pace with your payment of current liabilities (and you take advantage of early payment discounts), and there is little chance that anything will thwart your ability to collect accounts receivable. If your business is unable to meet these conditions, it would be wise to maintain an acid-test ratio higher than 1 to 1.

While lenders might want to see a business maintain a high acid-test ratio as a sign that the company is being run conservatively and safely, it is not usually a good idea to have a lot of cash or accounts receivables and inventories in relation to what you need for sales. You want to be careful with your resources, but you also want to be able to transform cash and other resources into more sales for your business. In another words, you do not want a lot of excess cash sitting around if you are in desperate need of more modern equipment or if your sales could be improved by a better stocked inventory. You want to get the most bang for your buck. You want your dollars placed where they do the most to make your business run smoothly. They might be most helpful in cash, but putting them into a better stocked inventory, more efficient operation, or adding a new staff member might be better.

Working capital loans are usually negotiated for specific periods of time, and may be repayable in a lump sum, or in periodic installments such as monthly. If you have adequate liquidity, loans of up to one year can sometimes be negotiated. Each loan is usually covered by a promissory note spelling out the interest rate and terms. A personal guarantee by you and/or your spouse may be required.

The interest rate on term loans is usually a stated annual rate. The stated rate may differ from the effective (or true) rate if the loan is discounted. By discounting the interest on the loan is deducted in advance. For example if you take out a $1,000 loan at the beginning of the year, to be repaid at the end of the year at a discount rate of 15%, you would receive $850, and repay $1,000 at the end of the year. Since you only received $850, the effective interest rate is,

 

$150	× 100 = 17.6%
$850

 

6) Line of credit. A line of credit is an agreement between you and a lender specifying the maximum amount of credit (overdraft) the bank will allow you to have at any one time. Credit lines are usually established for one year periods, subject to annual re-negotiation and renewals with the lender taking your accounts receivable and inventory as security. This type of loan is sometimes called a demand loan since the lender can demand that it be repaid immediately without notice. However, this should not happen under normal circumstances. A business with a line of credit is generally required to keep a deposit balance with the lender. Since the deposit amount is generally in an account that pays little or no interest it favors the bank and increases the effective interest rate you are paying on any money used from your line of credit. Some lenders may require fees or higher interest rate if the deposit balance is not high enough.

7) Other loans. Other types of short term loans that a lender might offer are collateral loans, character loans, chattel mortgages, and floating charge debentures. Each one of these loans has its own unique characteristics and restrictions.

Intermediate-Term Financing

Lending companies typically rely on indications of your businesses profitability and ability to repay. These indications are provided by income statements and cash flow forecasts for the next several years as long as these forecasts are reasonable and not made on the basis of overestimated sales and underestimated expenses.

1) Term loans. These loans are usually arranged to cover the purchase of leasehold improvements, and assets such as furniture, fixtures and equipment. Generally 60% to 75% of the cost of these can be obtained through term loans. Term loans are usually paid in regular installments of principal and interest over the life of the loan, which is usually less than the life of the assets for which financing is required. Term loans can vary in length from one to five years. The interest rate is usually a percentage point or more higher than that for a short-term loan made to the same borrower.

The periodic payments on term loans can be geared to your businesses cash flow. In some cases only the interest portion of such loans is payable in the first year or two. Payments could be monthly, quarterly, semi-annually, or annually. Payments are calculated so that the debt is repaid (amortized) by a specific date. If the periodic payments do not completely amortize the debt by the maturity date, the final payment will be larger than the previous periodic payments. This larger, final payment is sometimes referred to as a ‘balloon’ payment. Term loans sometimes allow early repayment without penalty.

Interest rates may also be negotiated. As long as you adhere to the terms of the loan, you can generally be assured that no payment other than the regular installment ones will be required before the due date of the loan.

Most term loans are only offered to companies with profitable histories whose current or projected financial statements demonstrate an ability to repay. For that reason a term loan may not be easy to find for a new business.

2) Installment Financing. As an alternative to a term loan, installment financing could be used to finance the purchase of equipment of various kinds. By using an equipment loan you can retain precious working capital. Lenders will generally finance from 60% to 80% of the asset’s value. The balance is your down payment. Since the assets being financed generally have a life of 5 to 10 years, and since the financing agency runs a relatively high risk because of the very low value of the now secondhand equipment. The length of the life of such financing is usually 3 to 7 years with payments of principal and interest made monthly. The interest rate is generally much higher than with term loans. It could run as much as 5 or 6 points over prime.

Installment loans are generally secured by a chattel mortgage (a lien on the assets financed), which can be registered and which permits the seller or lender to sell the liened assets if the installment payments are in default. Alternatively, the lender’s security could be a conditional sales contract whereby the seller or lender retains title to the assets until you have satisfied all the terms of the contract.

The installment loan agreement usually binds you to maintaining working capital at an agreed level and to obtaining lender approval before making any capital expenditure over a specific limit. It might also limit the amount that can be paid in salaries and bonuses, and require that assets be kept free of encumbrances.

Finally, the agreement might require that a portion of profits be applied to loan repayments above and beyond the amount stipulated in your note payable securing the installment loan.

Long Term Financing

Long term financing is generally required to purchase land or to build or purchase a building. It will probably be in the form of a mortgage.

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