It might seem counterintuitive to suggest that debt funding has advantages over equity funding, but it is the preferred method of capital raising for the majority of small businesses. These benefits include lower financing costs, retention of profits and tax deductions on interest payments.
However, there are a few mistakes that small businesses commonly make when it comes to their finances. In this article, we discuss some common financing mistakes made by small-business owners.
Not monitoring the financial performance of the business
A very common mistake that I have seen over my 30 years in invoice finance is small-business owners not monitoring the financial position of their businesses. Without an intimate understanding of business cashflows – how much you are making and where that money is going – it becomes practically impossible to cover all of your commitments.
Not only is money not readily at hand to pay creditors, it then becomes a situation of scrambling for whatever funding is available to cover these costs. Desperation is not a good mindset to have when seeking credit as you will inevitably end up paying more than you should.
Insufficient working capital
The pool of working capital is the most important asset that your business has. These funds are required for regular expenses such as wages, utility bills, and tax obligations.
To ensure that working capital is always available, many small businesses set up a short-term finance facility as a working capital buffer. The benefit is that interest is only charged on the amount that is drawn down.
Many businesses automatically turn to their bank as their source of debt funding, without considering that they could save a considerable amount of money by researching their options with alternative lenders. Major banks have also tightened their lending criteria in recent years, meaning that the process of applying for a funding extension has become considerably more onerous and there is no guarantee of a successful outcome at the end.
Many small-business owners are not aware of the variety of funding options available to them. Meeting with a finance broker to discuss your finance options is a good first step.
Choosing the wrong kind of finance
Using a long-term funding facility such as a secured loan might not be appropriate for covering short-term needs as it can take longer to process (it can take up to two weeks for banks to approve a loan application) and you may be charged a penalty fee for repaying the loan early.
A line of credit facility such as invoice finance (also known as factoring) has a number of advantages over other types of finance:
- Cash is immediately available.
- Flexibility – funds are only drawn down as needed.
- Interest is only paid on what is drawn down.
- Comparatively simple application process.
Not understanding the costs of finance
Knowing the costs of finance is also crucial. Offering your customers a discount for paying invoices early could be costing your business more than you think. For example, giving customers a 1.5 per cent discount for paying a $1,000 invoice within 10 days instead of 30 days, is the equivalent of paying a 55 per cent annual interest charge (APR = $15/$1,000 x 365/10 x 100 = 54.75 per cent). Smoothing out uneven cashflow through factoring is a viable alternative.
Business loans often have fees that are not immediately obvious such as application fees, contract fees and administration fees. As mentioned, there may also be a fee for paying out the loan early. Be sure that your lender outlines all fees before signing up for the loan.
Greg Charlwood, Managing Director, Australian Invoice Finance