Business Finance Products Explained

There are two main types of finance for any business, often seen as the opposite sides of the ledger, they are Debt and Equity.

Equity is the cash or capital that has been invested into the business, usually in return for a share of the business ownership. Debt is money that has been borrowed and needs to be paid back, typically along with some interest and or fees.

In this article we’ll look at some of the common types of debt funding that are available to businesses in Australia and New Zealand, we’ll also look at the broad types of ‘security’ associated with these finance products.

First of all, what do I mean by ‘security’? Security and collateral are terms that are sometimes used interchangeably. We often describe collateral (the things that a lender could potentially repossess and sell to recoup their losses if a loan isn’t repaid) as being pledged by borrowers as security for a loan. For example, if you take out a loan for a car, we could say that the lender has security over the car (or sometimes a security interest in the car).

Specific Security vs General Security. 

In our car loan example above, the car represents what we call a ‘specific security’. Specific security simply means we can describe or identify the collateral, sometimes by serial number but often by description. E.g., ‘1x Cheeseburner 2000 pizza oven’. When you take out a loan for a particular piece of equipment (or a lease), the lender will typically have a specific security interest in just that item. The security doesn’t really change over the life of the loan.

General Security on the other hand means security over a range of assets (which may change from time to time). For example, a lender may take a General Security Interest in all of the assets of a business. This can include everything from vehicles to plant & equipment, to stock and even the business name or any intellectual property. If the business acquires any new assets then they can also be captured under the general security interest.

Secured vs Unsecured.

A secured loan simply means that the borrower has pledged something as collateral for the loan (so Specific Security and General Security both relate to secured loans) whereas an un-secured loan is exactly that, a loan where the lender has no collateral to fall back on in an event of default. The value of any collateral, or whether the loan is secured at all, will impact things like how much money can be borrowed, over what term, and what interest rate the lender will charge.

Phew, with all of that out of the way we can take a look at some of the more common types of business finance products and see how they relate to the different types of security.

Business Loans

A business loan is an all-encompassing term for a loan from a bank or finance company, it could mean a few different things, but we’ll look at what it means most often. With a business loan you borrow a lump sum of cash which can generally be used for a wide variety of purposes, such as the cost of buying or setting up your business. A business loan typically has fixed payments over an agreed term (perhaps 3 to 5 years, but occasionally longer for large loans). A business loan is very often secured over all of the assets of the business (a General Security Interest).

The advantages of business loans are that they can be used for a very broad range of requirements, potential loan amounts are typically higher, and terms to repay often longer. All of this makes business loans a go-to finance product for larger loan amounts. Looking at some of the cons, business loan applications may require quite a lot of information, and you may be restricted on what you can do with some business assets until the loan is repaid; with some exceptions (for things like stock and other assets that change often), you typically can’t sell assets that you’ve pledged as security for a loan without the permission of the lender.

Chattel Mortgages

A chattel mortgage is just another name for a secured loan (it might also be called a ‘loan and specific security agreement’). The chattel is the equipment (or asset) that the borrower pledges as security for the loan. Chattel mortgages are one of the most common types of asset finance, used for everything from vehicles to coffee machines. They offer the benefits of ownership with the convenience of matching expenses to revenue.

Leasing

A lease is another common form of asset finance. With a lease the ‘lessor’ (finance company or bank) buys the equipment you need and leases it to you, in return you make regular lease or rental payments. Although this may sound rather restrictive, and perhaps quite different to a loan, in practice leases generally work much the same way, they are (more often than not) purely financial arrangements. Leases and loans may have different treatments for things like income tax and depreciation. Perhaps most importantly they may have very different treatments around what happens to the leased equipment at the end of the agreement term. 

Overdrafts & Lines of Credit

An overdraft is a term typically used when your bank will let you spend more money than you have in your account. A line of credit is much the same, although not necessarily obtained through a bank. In either case you’ll generally have a fixed limit that you can borrow up to, and you’ll pay a fee for having the facility available (whether you use it or not). When you do use funds, you’ll pay interest on the amount outstanding until it’s all repaid. An overdraft or line of credit may come with or without minimum payments, and may be either secured or unsecured. It’s most common for businesses to use this type of finance to deal with mismatches between cash coming and having to pay expenses, such as when you’re waiting for a large invoice to be paid but you need to pay staff or buy more stock.

Invoice Finance

Invoice finance is often used by businesses that supply goods or services on credit, particularly to larger organisations. Many big businesses use their buying power to force suppliers to provide 30 or 60 day terms (or even longer), meaning that whilst you know the cash will come in eventually, you might be caught short whilst you wait for it. 

There are two main types of invoice finance: Factoring, where you sell the invoice to a finance company (and the customer will often be aware that you’ve done so), and Discounting, where the customer generally isn’t aware of the financing arrangement. In either circumstance your primary security for the money you’re advanced is the invoices themselves, and the costs associated with this type of finance will often be deducted from the invoices when they’re paid. This can make invoice finance an attractive option to address constrained working capital, particularly for businesses with large debtor ledgers.

Merchant Cash Advance 

This type of finance is sometimes used by businesses that receive much of their regular income through card terminal (EFTPOS / credit cards / etc). A lender will look at your regular daily or weekly takings and work out an amount you can borrow (usually up to say an average months’ sales), the loan is secured by your future takings and a percentage is taken from your daily receipts until the loan is repaid. One of the advantages of this type of finance is that the repayments move up and down in line with your revenue. Loan amounts for merchant cash advance facilities are often smaller than other longer-term loan products and rates may be higher (as they are often otherwise unsecured). Also, of course you need to be able to show established regular merchant facility takings to qualify.

Business Credit Cards

Business credit cards function just like personal cards, you have a limit that you can spend up to and you will have a minimum repayment that needs to be made on any outstanding balance. Just like a personal card, the minimum payment will not make much of a dent in the balance and you’ll pay interest on anything that remains owing at the end of the month. You can often earn reward points with a business credit card and if you’re disciplined in paying off the full balance each month you may well be able to take advantage of a substantial interest-free period. Note though that if you don’t pay your whole balance each month then just like a personal card you might well be hit with a very high interest rate on the outstanding amount.

So, what sort of finance should you choose for your business?

That’s easy, the right one! I say that flippantly, but of course I also mean it. There are a wide variety of finance options available to businesses today, and it can easily get confusing. Overlaid with different product names and some variations to the way these basic products work and it gets more confusing still. The important thing is to make sure you’re getting the right finance products to suit your needs, now and in the future. So, if you’re unsure if a product is right for you, make sure you talk to your lender, and better yet seek professional advice from your accountant or business advisor.