Let’s say you have an innovative business idea and plan, but not, unfortunately, all the funds necessary to finance it. What can you do? You have two basic choices:
- a) You can find investors (partners) with whom to share the eventual business profits (and losses), or
- b) You can borrow the money.
This chapter is about borrowing money – in other words, financing with debt. Borrowing money is a straightforward process: someone transfers funds to you, you use them to finance your project, and repay what you borrowed plus interest.
Let’s take a look at the kinds of “debt products” available out there – their general characteristics and their maturities. I put “debt products” in quotes because that’s how they’re commonly referred to these days. I use the term, but I am frankly suspicious of the people who started calling loans “products.”
The lenders (a financial institution in most cases) benefit from lending because of the interest received. They develop products (types of loans) targeted to meet different borrowers’ operational or investment needs.
SHORT-TERM FINANCING
is designed to meet operational needs – such as purchasing inventory, getting a business’s receivables upfront, or just financing more personal expenses such as education, a vacation, etc.
Credit card: a convenient financial product that allows you to make purchases, up to a pre-set limit. Credit cards are designed to finance relatively small purchases; that is why they are used for such things as personal purchases, small business purchases, or top executives’ expenses. In a small business, the product’s convenience allows you (for example) to pay off most any supplier right at the time of purchase. I have to tell you, though, that this convenience comes at a great cost. Interest rates on these “plastics” are some of the highest among all debt products.
Overdraft (also called “line of credit”): a financial product intended to help a business in its routine operations. Here is how an overdraft works: You open a bank account, funded with your own funds; the account also has a negotiated credit limit (much higher than a typical credit card’s limit). You operate your business, as usual, banking revenues received and paying expenses using your new overdraft account. As long as your account balance is positive, you are not utilizing your loan (your overdraft or line of credit) and no interest is charged. However, one day you run into operating-cash-flow difficulties; your overdraft account allows you to pay your expenses, borrowing against the overdraft amount as needed, up to its negotiated limit. You ultimately pay interest only for the time periods when your account balance is negative (that is, when you are drawing on the overdraft amount).
Factoring: a financial product intended to speed up trade cash flows. You would typically use factoring when a client wants to pay you days or months after making a purchase. A supplier negotiating credit terms with a client is common business practice, but what if you, as a supplier, need to be able to use your receivables upfront? Factoring makes this possible. Here’s how it works: you give the factor (a financial institution) your invoices, which are unpaid and not yet due. The factor immediately pays you the total value of the invoices, minus an agreed-upon discount amount (which you should consider as an interest charge). The factor now collects the invoiced amounts from your clients as they come due. It’s important to know that factoring services rarely cover collecting issues – so you bear the risk of a client failing to pay. Factoring is often a three-party agreement between you, the factor (financial institution) and your client.
LONG-TERM FINANCING
products are designed to finance investment activities such as purchasing machinery, real estate or other major assets, or purchasing an entire company. Sound investing is all about buying assets you know.
Here are the major types of long-term financing:
Lease (financial lease in particular): A financial scheme offered for purchasing (closer to renting) expensive goods (such as cars), to pay for the item with scheduled monthly payments. The trickiest parts of the deal are (a) the interest component is embedded in your monthly payments, and (b) ownership is transferred to the buyer (if such an option exists) only after the lease has been paid in full – even though the buyer uses the item throughout the period of the lease agreement.
Investment Loan (mortgage): a loan granted for investment purposes. Such a loan may cover a substantial part of the total purchase price, which is why they are typically long-term – ten years or longer.
Bond: A financial instrument used by large corporations to finance their activities with funds from many (often changing) lenders. (The weird British call bonds “debentures.”) A company issues bonds with defined principal, maturity and interest payments. These bonds are placed on the established financial markets, where they are publicly traded. In our complex modern times, anyone can buy a bond, making him a lender to a big corporation or a government.
All investment products have one characteristic in common: there is always big money involved. That is why financial institutions offering such products want guarantees in the form of mortgages, collateral or co-debtors. Because investment loans have such long periods, and because of their strong guarantees of returns, they are considered less risky than operational financing – and that means they typically carry substantially lower interest rates.
COMPLEX FINANCIAL INSTRUMENTS
Now, for all you advanced debt users, there even more complicated games in town. So complicated that I’m not going to attempt to explain them in detail here.
Preference Shares: the owner of such shares has a role that’s quite complex – somewhere between an investor and a lender.
Convertible Debt: When this type of loan reaches maturity, the borrower can repay either in cash or in common shares, at a pre-defined conversion rate.
Options, Swaps and other crazy derivatives: These are sophisticated financial instruments whose values are based on one or more underperforming assets.
These complicated financial instruments may sound like all-inclusive products. The truth is, the more complicated the debt product, the more hidden risks it carries.
FINAL THOUGHTS AND RECOMMENDATIONS
Debt is debt, even if you do not owe interest on it.
Keep your debt low and your financial strategy as simple as possible, and you may sleep well.