Is Your Business Short of Cash?
February 23, 2017
Small businesses and SMEs frequently find themselves in the situation of being short on cash. Sometimes, this is just a temporary or seasonal situation while at other times cash is needed for long-term projects. When presented with a cash shortfall, owners must decide what is the best source of securing needed funds for their business.
The reason for financing – startup, working capital, or expansion – makes a difference which particular form of financing a business should undertake. Various options must be reviewed and considered carefully before making a final decision. The choice made today will have implications in the future. Once made, many financial decisions cannot easily be reversed, so it is prudent to study all options to understand current and future effects for both owners and their business.
It is important to first understand the difference between equity and debt financing. Each has advantages and disadvantages.
Equity financing (also referred to as equity capital) is an investment from owners or investors. This is sometimes referred to as risk capital since the investment is at risk of being lost if the business is not successful. Investors (owners) lose money if the business fails but if the business is successful, they share in the rewards through the payment of distributions or dividends and an increase in the value of their investment.
When a business borrows money, it is referred to as debt financing. The business is creating a debt, and that debt must be repaid. The repayment and interest terms will be specified in the debt instrument. Small business/SME loans can be difficult to obtain and are based on many factors such as length of time in operation, cash flow, collateral, profits/losses, experience of owners and management, credit history and credit score of owners and the business, industry outlook, equity investment, business risk, and outstanding debt.
Sources of Equity Financing
Equity financing can come from the original owner or owners as additional contributions to the business or might come from outside investors willing to make an investment in the business for partial ownership. When a business accepts outside investors, questions must be answered regarding percentage of ownership and if the new investors will have input regarding business decisions.
Sources of Debt Financing
There are numerous sources of debt financing that a small business or SME can investigate for cash needs. The source of financing will depend on many factors, such as the business structure, size, earnings history, and collateral available to secure the loan. Some types are better suited for certain situations than others such as:
• Friends and family
• Commercial banks
• Non-traditional or alternative forms of debt financing
A small business or SME can also seek additional funding options by financing with receivables, vendor financing, leasing, credit cards, refinancing homes, or second mortgages.
Given that there is a greater risk for a small business or SME to fail, lenders will normally charge a higher interest rate compared to interest rates charged to larger, established companies. Lenders will carefully scrutinize a business before making a loan. They will consider the amount of risk to determine the interest rate to be charged – a direct relationship between risk and reward.
Be Prepared for Questions with the Right Answers
Regardless of the reason for owners seeking additional funding, or whether the money is going to be secured from equity financing or debt financing, the person or entity investing or loaning money will ask a number of basic questions and expect informative and complete answers before finalizing a transaction. Rather than being caught by surprise or tongue-tied with answers, owners should be prepared with appropriate responses before seeking funding.
Typical questions are likely to be:
• How much equity and debt is there in your business and the percentage of each?
• What will the investment or loan be used for?
• If the business is not cash flow positive, how much cash is being burned monthly and when will the negative cash flow become positive?
• What are the gross profit margins or expected gross profit margins on your various products or services?
• How are you marketing your product or service now, and do you foresee any changes in the future? Why?
• Who is your competition, and why are you different and better?
All questions are on the table when an owner seeks additional funding. He or she must know the details of the business' financial statements (regardless of who prepared them) and various trends, business or strategic plans, budgets, and different marketing campaigns and goals. All of these items demonstrate to investors and lenders the overall understanding an owner has of his or her business.
It is important to be optimistic about the future when trying to secure a new investor or be approved for a loan, but it is equally important to be honest, knowledgeable, and realistic about your business.