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Business Basics: How to Understand Small Business Finance

Statistics show that there are around 58 million small businesses in the US.

Most of these will have required some sort of external financing over their lifetime. Whether it’s initial setup costs or funding for an expansion of some kind, it’s usually necessary at some point.

If you’re looking at different business finance options, you may be wondering which one will best suit your needs.

Read on as we tell you everything you need to know about small business finance.

The Broad Types of Business Finance

When discussing external financing for businesses, two broad categories are relevant. The one you choose will depend on the size and scope of your business, as well as your long-term goals.

Equity

You raise equity funding by selling a stake in your business. An investor will give you a sum of money to fund your operations, and they receive a percentage of your proceeds from that point onward.

The advantage of this type of finance is the transfer of risk to the investor. In the event of losses, you won’t have to pay them back.

The disadvantage, of course, is that you lose a portion of your business.

Equity financing is an approach taken by most larger companies. Shares of bigger organizations are publicly traded, with investors buying and selling them on stock exchanges.

Debt

Debt finance is borrowed from a third party, usually a bank or some other provider of credit.

This approach allows you to keep full ownership of your business. however, you’ll have to pay the money back with interest.

Finance for Small Businesses

Most small business finance is debt-based. This is because small businesses tend not to have sufficient inflows to justify selling equity, at least not initially.

Equity investors look for companies with proven profitability and reach. Even investors that deal with smaller companies usually look to invest relatively large sums, often for a significant percentage of your business.

Unless you want to bring a family member or friend on board as a partner, you will probably be using debt finance to fund your small business.

Debt finance for small business comes in various forms. We’ve outlined some of the most common ones here.

Startup Loans

This kind of financing funds businesses while they are in their early stages, as the name suggests. Startup loans are used to pay all business expenses until your enterprise becomes profitable enough to pay them itself.

Mortgages

These are similar to startup loans. The main difference is that mortgages are taken out to pay for a piece of property, usually your business premises.

This means that the lending institution has the right to foreclose on this property if you are unable to make the necessary repayments. However, because this security is available to lenders, they are more willing to give out mortgages than startup loans, and at more attractive rates of interest.

Business Credit Cards

Startup loans and mortgages are large, one-off payments. Business credit cards, on the other hand, are used to pay for everyday expenses, much like personal credit cards.

Many small businesses hold credit cards without ever using them. They can be used as a backup plan in case your business runs out of liquidity in the short run.

If credit cards are used responsibly, they can be a useful and affordable financing option. If you regularly delay bill repayments, however, they can start to get expensive very quickly.

Accounts Receivable Financing

Accounts receivable financing allows businesses to sell invoices that have not yet become due.

In this way, you can unlock liquidity from future inflows. This can be very helpful for businesses that have a solid financial structure but need funding in the short run that outweighs their cash reserves.

Accounts receivable financing providers will forward you a percentage of the value of your invoice. They keep the remainder as their payment for the transaction.

How to Manage Your Money

Getting finance is an important step. However, the key to the success of your business is how you manage your funds once you have them in place.

The following are key factors to keep in mind regarding the management of your small business’s finances.

Record Everything

This is one of the most important things to keep in mind for any small business owner, especially those that are new to the game. You need to be able to determine your assets and liabilities accurately at any time.

If your business runs into difficulty and you are unable to pay amounts owing due to improper recording practices, you may be guilty of an offense.

Open a Business Account

You must keep your finances separate from those of your business. The easiest way to do this is by opening a business account.

Use this account for all inflows and outflows related to your business. Pay your account a salary from this business account, and limit interactions between the two as much as possible.

Manage Your Invoices Carefully

Develop a strategy for payment of invoices and stick to it.

It can be useful to delay payment of invoices if you are stuck for cash in the short run. however, this will only benefit you if you spread out payments properly.

If all your invoices become due at once, this can lead you to have to take out expensive short-term loans.

Getting the Help You Need to Succeed

Getting business finance is one of the biggest steps you’ll take as a small business owner. Doing it right gives your venture a much greater chance of success.

Did you find this article valuable? If so, be sure to have a look at some of our others. We post regular content on everything to do with investing.