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Types of borrowing

Introduction to Debt and Equity

Understanding the basic types of financing may help you to decide which options are best suited to your business and circumstances. Typically, finance for businesses falls into two categories, debt and equity.

Debt means borrowing money that will have to be paid back over time, with interest charged on the amount borrowed. Equity is financing that is provided by the business owner or by investors and may not necessarily have to be repaid, although investors will expect a return on their investment.

The ratio of debt to equity is referred to as 'gearing'. The terms 'highly geared' or 'highly leveraged' simply means that the business has a high proportion of borrowed money compared to the amount of equity in the business.

Providers of debt, such as banks, and equity investors have different requirements and criteria. A bank will assess your ability to repay the amount borrowed plus the interest and any applicable fees. See Applying for borrowing for an outline of the types of information a bank will use to consider a borrowing application.

Equity investors are generally looking for good growth potential and profitability. They want to see the value of the business grow over time.

Debt
Bank overdrafts and loans are common forms of debt. Some of the general characteristics of debt finance are:

  • You do not have to give up a share in your business to a lender in order to borrow
  • Your obligation is to repay the amount borrowed with interest and any applicable fees
  • Interest payments may be a deductible expense against tax
  • The borrower has an obligation to make the agreed repayments to the lender and to abide by the terms and conditions of the finance agreement and any related security documentation.

Equity
To obtain equity investment, the business needs to convince investors to provide finance in return for a stake in the business. This means they will share in the profits the business. Some of the general characteristics of equity finance are:

  • There may be no money to be repaid to investors should the business fail
  • You will have to give up a share in your business to an investor to raise equity finance
  • You have no obligation to make regular repayments and pay interest on the amount invested
  • Investors may require a degree of control over the running of the business, sitting on the board of directors.
  • The investors are ultimately repaid by the sale of shares in the business.

Banks and finance companies offer a range of commonly used types of debt financing including overdrafts, loans and other alternatives.

Overdrafts and loans

Overdraft
An overdraft is a borrowing facility linked to a bank current account. Overdrafts are designed to help manage short term borrowing needs, when you need to pay money out (for example, to purchase raw materials) before receiving money in from sales.

An overdraft is repayable on demand which means that, in principle, the bank could demand repayment in full at any time. Although, in practice, if there has been no significant deterioration in a customer's credit status or any breach of other existing facilities a customer may have, immediate repayment is unlikely to be requested. Overdrafts are usually agreed for six to twelve months, after which they may be renewed by negotiation.

An overdraft is a working capital facility and could be an excellent way to cover:

  • Short term cash flow fluctuations
  • Particularly heavy spending that can be repaid quickly
  • Unforeseen events.

Overdrafts are:

  • Flexible - they offer instant access and can be used just when they're needed
  • Cost effective - interest is only paid on the amount borrowed and is usually agreed at a margin above the Bank of England base rate, which can vary. The margin is based on risk factors and is generally cheaper than borrowing by credit card. Find out how you run your bank account can affect the interest rate you pay on your overdraft.
  • Easy to arrange - following receipt of all necessary information, we will do all we can to provide a decision on small business borrowing within two working days. For larger businesses, following receipt of all necessary information, we will do all we can to provide a decision within ten working days. Should further information be required, a second period of ten working days will begin from its receipt.

If a business relies heavily on its overdraft and finds it difficult to bring its account into credit, it should ask whether it is borrowing money in the best and most cost effective way. If your business finds itself in this position, please talk to us as we may be able to offer you alternative ways of borrowing.

Business loan
A business loan is an amount of money borrowed for an agreed period of time with an agreed repayment schedule. The repayment amount will depend on the size and period of the loan and the applicable rate of interest.

Loans are:

  • More suitable than overdrafts for longer-term finance needs
  • Cost effective - interest can be fixed (eg interest is generally fixed for smaller loans up to £25,000) or may be set at a margin above the base rate, which can vary. The margin is based on risk factors and is generally cheaper than borrowing by way of overdraft.
  • Easy to arrange - following receipt of all necessary information, we will do all we can to provide a decision on small business borrowing within two working days. For larger businesses, following receipt of all necessary information, we will do all we can to provide a decision within ten working days. Should further information be required, a second period of ten working days will begin from its receipt.

Business credit card
Business credit cards operate in a similar way to personal credit cards and are a way to pay for day to day expenditure. Business credit cards offer:

  • Help with cash flow - there's an interest free credit period on purchases
  • Flexibility - repay in full or make a payment and carry the balance over to the following month
  • Cost control - card transactions can be viewed on line and employees can be issued with cards

Commercial Property Loans
Commercial property lending is usually secured by a commercial mortgage which operates in a similar way to a personal mortgage. This type of lending is typically used for purchasing commercial property including shops, factories, offices and warehouses.

Other types of bank financing

Invoice finance
Invoice finance is the name for a range of services which improve cash flow by freeing up cash from invoices raised. The amount of money available can grow automatically as sales increase, avoiding the need to extend overdrafts or reapply for loans.

Invoice factoring enables suitable businesses which have a turnover in excess of £250k to turn invoices into cash straight away rather than having to wait for the customer to pay. The client submits their invoices to the factoring company, which advances a pre-agreed percentage of the invoice amount (say 80-90%). The factoring company then collects the payment from the customer once it falls due and then releases the balance back to the client.

Invoice discounting works in a similar way but is aimed at larger, more well established businesses with a turnover in excess of £1 million, except that the clients collect the invoice payments themselves.

With either service, credit protection is available to shield a business from the impact of bad debts. Both factoring and invoice discounting are suitable for UK and/or export sales

Asset finance
Asset finance describes the types of finance packages provided by banks and specialist finance companies which can be used by a customer to purchase or lease assets. The most common kinds of asset finance are:

  • Hire purchase is an agreement to buy an asset over a period of time - typically paying an initial deposit and then paying the balance plus interest over an agreed period. You do not own the asset until the end of the agreement when the full amount has been paid off
  • Leasing an asset (such as a piece of equipment or a vehicle) gives you the use of an asset in exchange for rental payments. The asset is owned by the company leasing it to you, though there may be an option for you to buy the asset at the end of the lease period.

Different kinds of asset finance suit different circumstances and have different tax implications. You should take advice from an expert on what is right for you.

Trade finance
If you are doing business internationally, there is a wide range of different financing options to help improve cash flow, handle payments and reduce risk. Options include documentary credits, bills of exchange, guarantees and foreign exchange services. For businesses that are new to trading internationally HSBC also offers EasyTrade - a collection of services and support that help make importing and exporting easier.

Syndicated loans
If a borrower requires a large or sophisticated borrowing facility this is commonly provided by a group of lenders known as a syndicate under a syndicated loan agreement. The borrower uses one agreement covering the whole group of banks and different types of facility rather than entering into a series of separate loans, each with different terms and conditions.

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Flexible finance

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While overdrafts, credit cards and loans meet the needs of many businesses, you may like to consider other finance options

Finance for international trade

Invoice finance

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