There are essentially two ways for a company to finance its activity: using own or external resources. In reality, financing using external resources only is not possible for most companies due to equity rules, but it is possible to use just own resources for financing. Nevertheless, the most common approach for companies is to obtain resources for their operations through mixed financing.
Of course, the actual composition of the financing largely depends on the financial possibilities and future plans of the owners, the capital requirements of the activity and the attractiveness of the company for investors. The amount of capital provided by owners for the company sends an important message to investors, since it clearly shows how confident the owners are regarding the success of the company.
Raising external funding
It is very important to align the duration of financing to the payback period of the financed asset, meaning it is not advisable to use short-term loans to finance tangible assets that generally have a payback period spanning several years. Such short-term loans, however, can be perfectly suitable for financing stocks on which the company expects a relatively quick return.
Bank or other loans
Owners of small companies typically obtain additional resources from their own network of acquaintances, from family and friends. In this case, the personal contacts mean it is a relatively easy way to gain resources without long loan approvals and other procedures, and in many cases it can be more favourable than bank financing in terms of the interest, repayment and duration conditions. The fact the lenders are relatives and the loan they provide is a substantial part of their savings can be a drawback too, however, as they want to have a say in the management of the company. Another disadvantage is that the limited resources mean it is difficult to carry out large projects with this financing method.
Borrowers have to meet stricter and more complex requirements in the case of bank financing, not only before taking out the loan but during the entire repayment period. In return, however, they have access to greater financial resources. In contrast to loans from family and friends, the company certainly retains power over its daily operative management because banks normally do not want to interfere. However, in the event of strategic decisions the bank reserves the right not to allow the company to make any decision without its approval, which acts as a kind of security for the bank.
Leasing is basically a cash saving way for financing tangible assets. It can be of great assistance for companies starting to operate in a sector that requires substantial assets if they finance their initial, large-scale investments through leasing. So instead of having to pay a considerable amount in one go, the company’s cash flow handles a monthly payment consisting of principal and interest on a much smaller scale, which means the investment can be financed from future revenues.
Factoring basically means selling a debt before the due date, which greatly helps to maintain a company’s liquidity. In addition, based on the type of factoring there can be a number of other advantages for companies. If a credit insurer is involved, a company can be completely protected from the risk of non-payment by customers for example. However, as the factor’s coverage is normally the trade receivable itself, the customer portfolio of the given company is very important. Factoring can be a useful tool for companies in financing trade receivables because at a certain cost they not only receive the given amount earlier, but depending on the structure they can also be fully protected from the risk that the customer may not pay the purchase price.