Another function of business finance for your organization is to guide financial planning. Where financial goals determine profitability, financial planning determines how much you need to operate on and have in reserves for slow periods. Financial planning also determines where operating dollars come from, such as business loans or revenue. Also part of financial planning is how to allocate and spend the money.
What Is Debt Financing?
Debt financing for your business is something you likely understand better than you think. Do you have a mortgage or an automobile loan? Both of these are forms of debt financing. It works the same way for your business. Debt financing comes from a bank or some other lending institution. Although private investors can offer it to you, this is not the norm.
For businesses that have a more complicated corporate structure or have been in existence for an extended period, banks will check other sources. The Dun & Bradstreet (D&B) file is one of the most important. D&B is the best-known company for compiling a credit history on businesses. The bank will want to examine your books and likely complete other due diligence along with your business credit history.
Before applying, make sure all business records are complete and organized. If the bank approves your loan request, it will set up payment terms, including interest. If the process sounds a lot like the process you have gone through numerous times to receive a bank loan, you are right.
Advantages of Debt Financing
Disadvantages of Debt Financing
The U.S. Small Business Administration (SBA) works with certain banks to offer small business loans. A portion of the loan is guaranteed by the credit and full faith of the government of the United States. Designed to decrease the risk to lending institutions, these loans allow business owners who might not otherwise be qualified to receive debt financing. You can find more information about these and other SBA loans on the SBA’s website.
What Is Mezzanine Capital?
Put yourself in the position of the lender for a moment. The lender is looking for the best value for its money relative to the least amount of risk. The problem with debt financing is that the lender does not share in the business’s success. All it gets is its money back with interest while taking on the risk of default. That interest rate will not provide an impressive return by investment standards. It will probably offer single-digit returns.
Mezzanine capital often combines the best features of equity and debt financing. Although there is no set structure for this type of business financing, debt capital often gives the lending institution the right to convert the loan to an equity interest in the company if you do not repay the loan on time or in full.
Advantages of Mezzanine Capital
Disadvantages of Mezzanine Capital
Off-balance balance financing is good for one-time large purposes, allowing a business to create a special purpose vehicle (SPV) that carries the expense on its balance sheet, making the business seem less in debt.
Business Finance Formulas
Generally, business formulas provide specific information related to investments made for growth opportunities and business operations. Each formula can help you compare the total cost of business decisions that can impact your organization financially in terms of profits or losses. A good practice is to set the minimum return percentage higher to give yourself a buffer. This helps to make sure your organization achieves maximum profitability.
Formulas are commonly used in various business finance functions to determine such things as return on investment, net present value and payback period. Generally, ROI formulas look at the total gain from an investment minus investment costs, which is divided by initial investment costs. This formula is important to help you ensure the long-term viability of your organization.
Net present value formula is used to determine the present value of cash inflows and future cash inflows from capital budget projects, which is discounted back to the present dollar value. As an example, assume that you wanted to expand your operations to another store across town. Future cash flow estimates for the additional location is projected at $500,000. The current owner of the store wants to sell it for less than $500,000. You would want to make that purchase because it would be a positive NPV investment.
For the payback period, you are using a basic calculation to divide initial capital inlay for a project by the number of months it would take to recuperate that amount. This formula is calculated as the cost of a project divided by the annual inflows of your organization. Typically, this is important to determine because the longer it takes to recover costs, the less desirable it is to begin a project.
Frequently asked questions
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