What you need to know when choosing the right financing option for your business
Monday, May 2, 2016/
By Brett Isenberg
Access to loan facilities and financing is critical to the ongoing success of any growing Australian business. Whether you’re buying raw materials ahead of a busy season, looking to hire new staff or expanding into a new territory, it will likely require some form of advance funding.
Choosing the right financing option is a complex, time-consuming process. Given the rise of online lending tools in recent years, the number of financing options for any given task means small businesses have a mountain of choices. But such an important and fundamental business decision can’t be taken lightly.
Understanding the options available, the advantages and disadvantages of each, and the context in which you’re taking the financing (whether for receivables or discretionary purchases) are just a few of the considerations to think about before making the leap.
Most of the financing options available can be roughly divided into two core categories: supply chain financing, which relates to any funding methods directly tied to buying and selling goods, and discretionary funding, which lets the business owner spend the money on goods or other means not directly tied to the business.
Supply chain funding
While supply chain funding is a generic term that has many meanings, it effectively refers to any financing methods that deal with the relationship between the buyer and seller. This financing method can only be used to buy or sell goods. However, it’s important to note that some methods largely benefit the business buying the goods, while others are focused wholly on the exporter selling them. Some of these methods include:
This is a form of short-term borrowing used to improve a business’ cash flow position by letting it draw money against its sales invoices before customers have actually paid for a good or service. The business typically borrows a portion of the value of its sales book from a finance company, effectively using the unpaid sales invoices as collateral for the borrowing. It’s often used by fast-growing or seasonal businesses who need a quick injection of funds to prepare for a busy period but the invoice discounting is usually capped at about 60% of revenue and requires businesses to disclose all invoices to the financier.
Reverse factoring is similar to invoice discounting but involves the supplier business or multiple suppliers selling their invoices to the financier. This means the supplier often gets 100 per cent of the value upfront and the business buying the goods then pays the financier directly, becoming responsible for full payment. This is often a simpler funding structure for many businesses but leaves the buyer in the lurch if it has financial difficulties.
Line of credit
A line of credit is a secured or unsecured type of financing that gives businesses the capital they need to purchase items upfront and pay them back on a 60- or 120-day cycle. Though some financiers offer lines of credit for discretionary purchase, others do so purely for supply chain funding, meaning the funds can only be used to purchase goods for the business. By going with this type of funding, a business can pay a supplier upfront and potentially negotiate discounts as a result, while still only being required to pay back the loan at a later stage.
B2B trading card
This is just like a typical consumer or business credit card but is used in a business-to-business platform for the sole purpose of purchasing goods for the business. Both the buyer and supplier sign up to use the same cloud-based platform that tracks and validates all elements of the purchase, from source documentation purchase orders and payment. The process is often entirely online and allows the supplier to get paid quickly, while the buyer business can pay back on typical credit card finance terms of 55 days. Because it’s online, buyers can avoid the international transaction fees often associated with traditional credit cards, while getting access to real-time foreign exchange rates that are better than most of what the market has to offer.
Some other forms of small business financing allow businesses to take funding that isn’t directly tied to their supply chain. While they can of course use this funding to buy and sell goods, it’s also possible to use it for discretionary purchases. However, this often leads to higher interest rates and less favourable credit terms. These forms of lending include:
This is a relatively new practice but is quickly becoming popular for micro and small businesses like cafés and retailers, who need quick funding to fill a short-term cash flow gap, usually of $100,000 or less. The lending format is ‘peer-to-peer’ because the funds themselves come directly from individual investors, instead of a traditional bank or finance institution, often those who are looking for an alternative investment to cash, property or the stock market. The process is often entirely online, meaning lenders can run with lower overheads and offer the service at a lower cost than traditional financial institutions.
Marketplace or balance sheet lending
This method of funding is very similar to peer-to-peer lending — and the two are often confused. However, most online small business lenders are marketplace lenders because they have to lend out of a loan book collated from various sources of debt funding, instead of a direct connection between peers. Some of these lenders are the business equivalent of payday lenders and there are often lots of terms you need to consider, so make sure you understand what you are getting into before making the jump.
Credit cards are of course ubiquitous in consumer life and most business owners have one, but many don’t consider it for everyday business outside of discretionary purchases or travel and entertainment. Credit cards can be a powerful way to extend your finances, offering 30 or 60 day interest-free credit terms so businesses can pay suppliers up front. But don’t forget that if you’re working with overseas suppliers, a credit card by itself will attract transaction fees (something that can be avoided by using a B2B trading card instead).
Small business financing is not a decision to take lightly. It can have huge implications for your business and your ability to grow. So take the time, consider your options and think about what will not only help your business in the short term, but also later down the track.
Brett Isenberg is general manager at Octet Finance, a supply chain finance and management platform for businesses.
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