Sources of debt financing and Commercial banks

Debt financing

A small business owner or entrepreneur who uses debt financing borrows money that they must later repay with interest. It takes place when a company raises funds for operating capital or capital expenditures by offering bonds, notes, or bills to retail and/or institutional investors. Institutions or people who lend money obtain the promise that the principal and interest on the loan will be repaid in exchange for becoming creditors.

Sources of debt financing

Commercial Banks

The financial market's hub, commercial banks offer the widest range and most loans to small enterprises. Small business firms receive a specific percentage of all loans made by commercial banks. Banks may be the owners of small businesses' first choice lenders, particularly when those businesses expand.

• Short-Term Loans: The most typical kind of commercial loan that banks give to small business organizations lasts less than a year. In order to finance the purchase of inventory, take advantage of cash discounts, finance credit sales to consumers, or increase output, these monies are frequently utilized to make provision for the working capital account. Therefore, a business owner pays back the loan by turning receivables and inventories into cash. Short-term loans come in a number of different forms.
  • Commercial Loan (or Traditional Bank Loan): The fundamental short-term loan is a characteristic or area of expertise for commercial banks. The loan is often repaid in full by the business owner within three to six months and is typically unsecured because secured loans are far more expensive to administer and maintain.
  • Credit lines: One of the most frequent requests that business owners make to banks is to establish a line of credit, which is a brief loan with a predetermined limit that provides crucial cash flow for the venture's ongoing operations. By writing oneself a loan with a revolving (or commercial) line of credit, the business owner can readily and rapidly borrow up to the predetermined ceiling at any point during the year.
  • Floor planning is a method of financing that is frequently used by retailers of "big-ticket items" that are easily distinguishable from one another (typically by their serial number), such as vehicles used for recreation, boats, cars, major appliances, and so forth.
• Intermediate and Long-Term loans: Despite the fact that they will occasionally offer intermediate and long-term loans, banks are primarily the lenders of short-term cash to small company ventures. These loans, which have a maximum one-year term, are typically employed to increase fixed and growth capital balances. These loans are provided by commercial banks for launching a business, buying property and equipment, building a facility, and other long-term investments. Loan payments are frequently made on a monthly or quarterly basis.
  • Term loans are another typical loan product that banks offer to start-up small enterprises. Banks offer these loans, which are often unsecured, to companies that have a strong chance of repaying them based on their prior performance. Some banks, however, exclusively issue secured term loans.
  • Installment loans: Small businesses frequently receive these loans to buy properties, buildings, equipment, and other fixed assets. When a small business endeavor needs to finance equipment, banks frequently give them between 60% and 80% of the equipment's worth in exchange for a security interest in the asset.
  • Character loans are now possible thanks to changes in banking regulations that are meant to create jobs by making more financing available to small and medium-sized businesses. Banks base their lending decisions for character loans on the borrower's dependability and reputation, as opposed to requiring business owners to demonstrate their trustworthiness through financial statements, evaluations, appraisals, tax returns, and other documents.

Nonbank Sources of Debt Capital

Banks are typically the first place businesses look when looking for debt finance, but they are not the only source. We now focus on other debt capital options that business owners might use to raise money to fund their operations.

• Asset-Based Lenders: The small business venture can borrow money from asset-based lenders, who are typically commercial financing companies, smaller commercial banks, or specialist lenders, by pledging assets like inventory, accounts receivable, or purchase orders as security. Only distributors, wholesalers, manufacturers, and other businesses with sizable inventories, equipment, real estate, accounts receivable, or other assets can benefit from this type of financing.
  • Discounting accounts receivable: Accounts receivable financing is the most typical form of secured credit. In accordance with this clause, a small company venture commits its accounts receivable as security in exchange for a loan secured by the amount of ratified accounts receivable. However, neither the face value nor the total value of the receivables are equivalent to the amount of the loan that has been issued.
  • Finance for inventory: A small business's inventory of finished goods, work-in-progress, or raw materials serves as security for a venture loan in this situation. Considering that the bank's claim is superior to those of other creditors, if an owner defaults on the loan repayment, the lender may seize the company's inventory, sell it, and use the proceeds to repay the loan that was advanced.
  • Purchase order loans: Small firms can use their purchase orders as security or a guarantee for loans if they receive orders from big clients or a lot of product. A tiny business endeavor receives an order from a customer, but it lacks funding to complete the purchase.
• Trade Credit: Due to its widespread availability, trade credit is used extensively by most business owners. In reality, 60% of small business initiatives rely on trade credit as a reliable source of finance. In order to do this, suppliers and sellers must be convinced to accept payment after the sale rather than in before. If a bank fails to lend money to a small company venture because they perceive it to be a poor credit risk, an entrepreneur may use trade credit as a source of finance.
• Equipment Suppliers: The majority of equipment vendors allow their customers to finance the purchase over time, which encourages business owners to buy their goods. Although the parameters of this financing method are a little different from trade credit, it is similar. Equipment vendors typically provide appropriate credit terms with only a proper down payment and the remaining balance financed during the equipment's lifetime (commonly several years).
• Commercial Finance Companies: When bank loans are declined, small business owners frequently turn to commercial financing providers for the same types of loans. These lenders are second only to banks in providing loans to start-up enterprises, and unlike their more conservative competitors, they are willing to take on greater risk in their lending portfolios.
• Savings and Loan Associations (S&Ls): Loans for real estate are its area of expertise. S&Ls offer financing for commercial and industrial assets in addition to their typical function of lending mortgages for private homes.
• Stock Brokerage Houses: Loans are another service offered by stockbrokers, and many of them charge their clients interest rates that are cheaper than those of banks. These margin loans have lower interest rates since the bonds and stocks in the customer's portfolio, which serve as the collateral, are both high-quality and highly liquid. Additionally, borrowing is made simple by brokerage firms.
• Insurance Companies: For many small firms, life insurance companies can be a substantial source of funding. Mortgage loans and policy loans are the two main categories of loans that insurance companies often offer. With a policy loan, a business owner acts as his or her own bank by borrowing against the money amassed in the investment component of an insurance policy. Policy loans are extended based on the amount of money deposited into the insurance policy through premiums.
• Credit Unions: The nonprofit financial cooperatives, or credit unions, that encourage saving and offer loans to their members are best known for providing consumer and auto loans. Despite the fact that many banks have curtailed loans to higher-risk start-up enterprises, many are also willing to give money to their members to launch new businesses.
• Bonds: Bonds, which are corporate IOUs, have always been a popular and widespread method of debt financing for commercial organizations, particularly large ones. However, few small business owners are aware that they can use bonds as a beneficial source of money for managing their company. A growing number of small businesses are turning to bonds for finance when banks and other lenders turn them down, even though small company endeavors are not ideal candidates for bond issuance.

Reference:

Agrawal, Dr. Govinda (2014). Entrepreneurship and small business management in Nepal . KTM: M.K Publishers and Distributors.

Baumol, WJ. (2004). Entrepreneurial enterprises, large established firms and other components of the free–market growth machine. Small Business Economics

Glaberson, B. (2011). http://ebooks.narotama.ac.id. Retrieved from ebooks.narotama.ac.id: http://ebooks.narotama.ac.id/files/Effective Small Business Management; An Entrepreneurial Approach (10th Edition)/Chapter 15 Sources of Debt Financing.pdf

Rise, E. (2011). The Lean Startup.