06 Jul Types of debt finance explained
With the rise of alternative finance, the types of debt finance available for UK businesses have increased dramatically in number. Flexible, growth-focused solutions now use advanced data and risk analysis methods to tailor their solutions directly to your needs. This gives you the flexibility to use different types of debt finance for longer-term investments and immediate working capital requirements. Choosing which option will be suitable for you depends on the stage your business is at in its development and the plans it has to grow. Here we take a look at the types of debt finance products now available, to help you make the right decision for your business.
This is a common option for businesses that have a large time discrepancy between delivering goods and services and receiving customer payment. Invoice factoring is where the lender (a factoring company) buys your invoices, then advances you the majority of their value (around 80%). Once the invoices are paid, the factor then provides you with the remaining balance (minus fees of around 5% of the invoice value)
The factor takes over the administration of your sales ledger and collects money from your customers. This can help small businesses suffering from late payment problems, yet can also expose the financial workings of businesses to potentially sensitive clients. Export factoring is also available to help businesses selling internationally.
Invoice discounting is similar to factoring, but your business retains control over its sales ledger. In this case, the lender will usually want to assess the quality of ledger and collections systems of the borrower business.
Fees and charges associated with Invoice Finance
- Setup cost based on gross value of debtor book (factoring)
- Charges per transaction
- Base interest rate
- Commission percentage applied to gross turnover
- Minimum service fees
- Charges for early termination or inadequate usage
- Credit insurance service fees for non-recourse factoring contracts
Pros of using Invoice Finance
- Avoids lengthy applications
- Factoring can help with late payment issues
- Your credit score is not as important
- Relatively clear pricing models
Cons of using Invoice Finance
- Relatively high APR rates of 15% to 35%
- High arrangement fees
- Monthly service fees
- Onerous security and contractual obligations, including debentures and personal guarantees
- Your customers will know if you use invoice factoring
- Factors can dictate the configuration of your customer base to protect themselves from debtor insolvency
- Doesn’t help if you have upfront costs before selling to a customer
- Funding potential growth opportunities in advance can be problematic
- Limitations for overseas debtors, contract debtors, a cash-buying client base, or seasonal demand cycles
- the amount of funding available can vary depending on the invoices being funded and the lender’s view on the end customer
- Generally doesn’t work for B2C businesses because of the lack of customer invoices
Supply Chain Finance
Supply chain finance is designed to mitigate the risks and smooth the transactions involved when buying or shipping goods. Rather than involving your customers and securing the funding against their invoices, supply chain finance gets your suppliers involved in the financing process. Sometimes known as ‘reverse factoring’, it allows the trading parties to work together to close the working capital gaps that suppliers face when shipping goods.
Because your supplier is involved in the finance arrangement too, the funding process for each transaction can be initiated by either you or them.
In supplier-initiated programmes, your suppliers request early payment on invoices that have been approved by the lender. The lender then pays the supplier early (minus a fee), and subsequently collects the balance from you when the invoice is due.
In contrast, with buyer-initiated programmes, you instruct the lender to pay your suppliers directly, either early or on the due date. The fee is then charged to you, and you pay the balance and fee on a pre-agreed later date.
Supply chain finance is one of the more useful types of debt finance if you need to ensure your supply chain is resilient, as it can provide your key suppliers with greater financial certainty. This is particularly important when trading with suppliers from emerging markets where local financing can be difficult for them to secure.
To apply for these types of debt finance, you (as the buyer) need to have a strong credit rating, as this is what the interest rates and credit availability are based on. You also need to have robust ‘procure to pay’ controls in place and make sure that your Accounts Payable team processes and confirms invoices efficiently.
Fees and charges associated with Supply Chain Finance
For buyer-initiated programmes, the buyer pays interest as well as other associated fees. In supplier-initiated programmes, the supplier also pays a discount for early payment.
Pros of using Supply Chain Finance
- Can be used to attract suppliers
- Financing rates are based only on the buyer’s risk, not the supplier’s
- Provides additional liquidity to fund growth and smooth seasonal cycles
- Can strengthen your supply chain
- In cases where the supplier cannot secure cost-effective finance, both parties can benefit by sharing the savings
Cons of using Supply Chain Finance
- A relatively complicated procedure involving all parties
- Risk of bank failure or withdrawal in the case of a single facility
- Trade payables can be reclassified as bank loans
- Once confirmed, invoices can’t be disqualified for funding due to a supplier dispute
- Can be administratively time-consuming
- Comes with associated fees in addition to normal interest charges, so it’s often more appropriate for larger businesses.
Usually used for a single financial transaction, trade finance is one of the types of debt finance that can be useful if you export or import goods. It’s designed to help protect buyers and sellers in an international marketplace and assist in the completion of transactions involving multiple currencies. If you’re an exporter, it helps to ensure that you’re paid for the goods you provide, and if you’re an importer, it helps to make sure that you receive the goods that you’ve paid for.
For example, if you’re importing goods, then your supplier may want you to pay for the goods in advance. On the other hand, you (as the importer) will want to mitigate risk by seeking assurances that your goods have indeed been shipped. The conflicting priorities of the parties are resolved by your lender providing a letter of credit to the exporter’s bank, offering payment in return for documentation proving that the goods have been shipped (e.g. a bill of lading). The exporter’s bank then lends the money to the exporter to cover their trade cycle funding gap.
Importantly, when you apply for trade finance, the asset being used as security is not your invoices but the goods in question. This means that the finance provider takes ownership of your goods until your debt is repaid. However, in some circumstances, the funding can be secured against trade insurance. Credit can be anything from £1,000 to millions of pounds.
Application for trade finance is usually made on a case by case basis and involves different forms and processes depending upon which form of guarantee you use. Your credit standing generally determines the interest rate and other terms of the credit provided.
Fees and charges associated with Trade Finance
Market conditions and your recent business performance will determine the rate of interest you pay.
Pros of using Trade Finance
- Relatively easy to arrange
- Secured against the goods in question or insurance-backed
- Facilitates international trade
Cons of using Trade Finance
- Designed for short-term usage
- Obtaining letters of credit can be a cumbersome process
- Requires healthy track record of repayments and operations
- Less accessible for newer businesses
- Can become expensive if payments not met on time
Revolving Credit Facility (structured)
A structured revolving credit facility, such as the product offered by Pay4, provides a credit facility that can be used to pay any supplier invoices, as and when they arise. These facilities provide up to three or four months credit, so can be used to ensure payments are made on time while keeping a healthy cash balance within the business.
If businesses have no invoices to draw credit from, or their business model or industry isn’t suitable for invoice finance, then supplier payments finance provides a flexible, usable solution.
Indicative credit decisions can be swift, and the application involves a relatively simple assessment of the business and its finances. Financial information will need to be provided, and a final decision will take around a week. Once approved, the facility can pay invoices almost immediately. This can be one of the most useful and cost-effective types of debt finance for successful, growing businesses.
Fees and charges associated with a Structured Revolving Credit Facility
There is normally only a simple transaction fee each time the facility is used and there are generally no setup, ongoing management or non-utilisation fees.
Pros of using a Structured Revolving Credit Facility
- Fast, flexible working capital solution
- Doesn’t require customer invoices to be raised
- Does not take title of goods, invoices or other business assets
- Cash accessible earlier in the supply chain to ease cash flow pressure
- Simple, cost-effective fee structure
Cons of using a Structured Revolving Credit Facility
- The facility is structured so you cannot use the credit for all purposes
- You must repay the amount borrowed within 120 days
A business overdraft is essentially a line of credit that becomes available when you make a withdrawal from your business bank account for an amount greater than your current balance.
As one of the most popular types of debt finance, they’re often used to cover short-term gaps in cash flow. For example, you can use it to pay for machinery repairs while awaiting customer payment or to cover seasonal cash flow fluctuations. They range from hundreds to millions of pounds and can be unsecured or secured by using business assets or property as security. Secured overdrafts usually offer a lower interest rate.
Business overdrafts are relatively easy to arrange, as long as you have an existing bank account, a good record with your bank, and a healthy credit rating. Your bank will also need to see that you’re running your business in a financially sound way, and you’ll need to explain why you need the overdraft, and how you intend to repay it. If you’re seeking a larger overdraft, then the bank will want to see your business plan in more depth.
Business overdrafts are usually set up for terms of six to twelve months, however, this can often be renegotiated at the end of the pre-agreed term.
Fees and charges associated with a Business Overdraft
Your lender will charge interest on the overdraft, based on the amount of credit being used. Rates often sit between 5% and 15%. Other charges can include:
- Application and setup fees
- Renewal fees
- Unauthorised borrowing charges
Pros of using a Business Overdraft
- Simple to arrange
- Instant access to funds (once approved)
- Only charged when used
- Tax relief on interest payments
Cons of using a Business Overdraft
- Interest rates are variable and higher than fixed-term loans
- Significant penalties for exceeding the limit
- Personal guarantee sometimes required
- Can be withdrawn at any time
Business Credit Card
Business credit cards are available to companies of all sizes and are one of the most popular and flexible types of debt finance.
They work just the same as a personal credit card in that you can use them to buy anything that you would normally pay for with a credit card. They can improve your cash flow in the short term.
Just like a personal credit card, you can use them online, in person or over the phone. Your bank can issue multiple cards from one account, which allows your employees to use them for travel and other expenses, thereby streamlining your accounts procedures.
When using a business credit card, you’ll need to make at least the minimum payment every month by the due date on the balance. If you can pay back the credit quickly enough, you can also use one for larger purchases rather than applying for a short-term loan.
Credit card debt is unsecured, meaning that it takes no business or personal assets as collateral. Consequently, this means interest rates can be high, and charges can increase rapidly for late or missed payments.
Applying for a business credit card is essentially the same process as applying for a personal one. When applying, you will need to provide details of your business, including:
- Income and turnover
- Number of employees
- When you established your business
- Countries within which your business trades
The amount of credit you are issued will depend on the turnover of your business and your credit standing. Furthermore, some issuers will need to see your company’s accounts covering a period of up to two years. Lenders will sometimes take into account both your business and personal credit history when you apply, although this varies by issuer, and usually only applies to sole traders. Regular, consistent usage and repayment can be a good way for a young business to build up a credit rating.
Fees and charges associated with a Business Credit Card
- Interest on any borrowed money
- Annual or monthly fees
- Late payment charges
- Penalties for exceeding your credit limit
- Non-usage charges
- Extra feature charges – withdrawing cash, using abroad and balance transfers
Pros of using a Business Credit Card
- Easy to qualify
- Instant access to cash
- Can build up your business credit history
Cons of using a Business Credit Card
- High penalty fees
- Interest rates costly over long-term
- Multiple cards can adversely affect your credit rating
“Businesses that need to borrow money for more than the grace period provided by credit cards should consider other sources of financing. Credit cards are typically an expensive financing option compared with other types of loans, such as bank loans and lines of credit.” - Investopedia
Business loans are a type of credit, commonly in the form of a fixed cash sum. Usually borrowed and then repaid over a pre-agreed length of time, for the majority of businesses, term loans remain the most common types of debt finance. They most commonly come from banks, however alternative sources such as crowdfunding platforms, P2P lenders and community development finance institutions also offer loans to businesses.
You can use a business loan to expand your operations, buy equipment or inventory, and spread out the cost of large purchases. Interest rates and monthly payments can be fixed with some lenders, which helps you to forecast future ongoing costs, and just like other forms of finance, you can offset the interest payments against your tax liabilities.
Some types of business loans allow you to set out both the amount you wish to borrow and the loan term. Some also offer flexible repayment plans, while others come with no fees for early repayment.
You can apply for unsecured or secured business loans. Secured loans take personal or business assets such as property, vehicles and other equipment as security, and offer lower interest rates. Unsecured loans on the other hand, usually have higher rates of interest to help the lender hedge against the added risk. These are normally designed to provide smaller sums of money over shorter time periods. In contrast, large business loans can structure repayments over periods of up to 25 years.
In order to apply you will usually need to provide:
- A business plan
- Cash flow forecasts
- Management accounts and historical accounts
- Evidence of ability to repay
- Security/assets as collateral
Fees and charges associated with a Business Loan
Loans have fixed or variable interest rates. Variable interest rates are subject to factors such as the Bank of England base rate, while fixed rates can range from 4% to 25% APR. Bank loans often include an arrangement fee and early repayment charges.
Pros of using a Business Loan
- No surrender of profits or shares in the company
- Fixed repayments help you plan more reliably
- Loans can be tied to the lifetime of the assets you are using them to purchase
Cons of using a Business Loan
- Inflexible – the lender can penalise you for early repayment
- You can lose your property or assets if you have used them as security
- Variable loan rates can change, making it harder to plan ahead
Debt finance comes in all shapes and sizes and can be an excellent option for businesses that do not want to raise equity. We hope this outline of the types of debt finance will help you make the right decision about what kind of finance is right for your business.