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Any discussion on types of short term financing for business/es is incomplete without talking about the sources and types of business finance available to them. After all, business financing is crucial for every business, large and small, whether local or global. While banks and NBFCs offer diverse credit options to SMEs, a smart business owner understands the value and need of being knowledgeable about business finance types and options available to him/her.
On that note, let is dive into learning the meaning and function of business finance and the different types of business finance that businesses in India can avail.
What are the types of business finance for SMEs in India
The term business finance has been used in different ways over the years. At its core, the meaning of business finance refers to the different business loans and advances and other funding options available to run enterprises. It also refers to efficiently managing those funds and revenue. On the one hand it refers to borrowing of funds while on the other it refers to how to effectively manage those funds to generate revenue and profits, manage debts, and account for all expenses for the business.
On that note, let us take a look at what are the types of business finance available for businesses in India. There are two major categories of business finance: Equity finance and Debt finance.
1. Equity finance
If you have been following television watching a very popular show for entrepreneurs – Shark Tank India – the concept of equity financing will come easily to you.
The idea is simple. External investors who see potential in your product/service, invest in your business by purchasing a part of it (i.e., shares and stocks). So, if your business is valued at ₹10 crores and an investor is keen to invest ₹1 crore in it, then the investor buys 10% equity in your business (i.e., 10 shares).
This means that if your business is doing well and its valuation increases to ₹15 crore, then the investor’s shares value also now stand at ₹1.5 crores. Similarly, if the business runs into losses and is valued at ₹8 crores, the investor’s shares are now devalued to ₹80 lakhs only.
Key points for equity finance:
- Investors own a part of the company (based on their investments/shares)
- Their returns on investment are directly linked to the performance of the company and its profits/losses
- It’s a suitable type of financing for small business and start-up businesses that are bootstrapped
- Venture capital, angel investors and crowdfunding are the most common forms of equity finance
2. Debt finance
This is probably the most common form of small business financing solutions – the idea of a business bowing funds from a bank, NBFC or other lenders. There is interest incurred and the borrower will have to repay the amount borrowed with interest over a period of time. Common types of debt finance used by small businesses are:
- Business loans: These can be availed from banks and NBFCs for business expansion, repaying debts, meeting daily cash crunch challenges, paying rents and salaries. There are different types of business loans offered for working capital, commercial vehicle purchase, machinery purchase etc. Business loans are borrowed for a time-period (usually up to 60 months) and have specific business loan interest rates that the borrower has to repay as EMIs.
- Advances: Advances are usually borrowed for a short period (1 year) and enable businesses to solve their working capital challenges. These are given on the basis of the borrower’s creditworthiness and banking history. Though interest rates are higher, the repayment terms are flexible. Post the pandemic, the RBI has introduced new policies for restructuring MSME advances (and business loans) to help them in these difficult times.
- Overdraft facility: Banks offer overdraft facility (OD) to existing customers even when their account balance is low or close to zero. Based on the borrower’s credit history and relationship with the bank, the bank may offer a small amount to meet immediate business requirements. Though there are no collaterals required, there are interest rates charged. The OD limit is based on the current account’s history. Also, OD is different from a cash credit loan, which is primarily for businesses and has a lower rate of interest and flexible payment options.
Now that we have looked at the most common classifications of business finance, let us also understand other types of short term financing for businesses.
3. Invoice finance
Invoice financing is an upcoming form of credit option for financing businesses. It allows businesses to borrow funds against verified outstanding customer invoices. Among the types of business finance in entrepreneurship, invoice financing is a common choice especially when customer payments are delayed by a few weeks or days. Businesses have to pay a small percentage of the invoice amount (e.g., 1-3%) to the lender as fee.
Example of invoice financing:
Consider yourself a steel supplier in India and you have a large order for TMT bars from a customer. Considering the price of goods, you have agreed to provide the order (steel) on credit to be paid over 3 months. Now while this helps you to secure a big order value, giving credit option also ties up your funds which you could have used elsewhere. What do you do now?
In such cases, you can approach a bank or invoice financing lender to lend you funds against your verified customer invoice. Through a concept of invoice factoring or bill discounting (as the case may be), the lender agrees to offer up to 70%-95% of the unpaid invoice amount against a fee. As such, you get funds against your accounts receivables for daily operational needs and repay the lender on the dates agreed upon based on invoice repayment.
4. Merchant cash advance (MCA)
Among the types of short term financing for business, a merchant cash advance is another popular option. This is a kind of finance where businesses can get funding against their card income based on customer transactions and sales. Since the funding is based on card sales and income, this form of credit is usually offered to businesses that carry out most of their transactions via cards (e.g., credit cards). The amount offered as advance is based on monthly sales and card income.
How MCA works?
You will have to identify an MCA provider to provide credit. Once the terms and fund amount are agreed upon, every time there is a card payment made, a percentage of the value is automatically deducted (principal + interest). For instance, if a fee of 3% is decided upon, then every time a customer pays via card transactions, 3% of the amount is collected by the MCA payer as repayment on principal and interest.
So, if a customer pays ₹7,500 via card transactions, then 3% of the amount, that is, ₹225 is collected by the MCA provider, and you get to keep ₹7,275.
Who should go for MCA funding?
- Businesses that have high transactions (value and quantity) done via credit cards
- Seasonal businesses that need funds for short terms and can assure daily debt pay off
If, however, you are looking for small value funding (e.g., ₹20,000) to meet immediate business needs, microfinance loan is also a suitable option to consider.
5. Line of credit (LOC)
Of the different types of business finance, the next type you can consider is – Line of Credit.
Revolving or Open Line of Credit: In this form of lending, businesses can borrow funds, repay a part of it, and continue borrowing more as per the predefined limited. So, if your limit is ₹5 lakhs, you can borrow ₹2 lakhs today, keep repaying the amount, and borrow another sum of ₹3 lakhs as and when required.
Non-revolving Line of Credit: In this type, the borrower can borrow a certain sum as per their borrowing limit, repay the full amount and end the debt.
The advantage of line of credit is that it can be used for diverse business purposes such as an emergency expense or daily expense. It gives the borrower the flexibility to borrow funds as and when needed, though it must be planned to prevent over-borrowing.
In most cases, LOC borrowing does not require collateral and is primarily dependent on the borrower’s credit score, banking history, and relationship with the bank.
How to choose the right business finance type for business
There are several sources and types of business finance that one can avail for their business – each have their own merits and demerits. What’s imperative is to understand why a particular type of business finance is right or not right for you.
For instance, if you are looking for long-term funding options, a business loan could be the right choice for you. Of course, there is interest to be paid during loan repayment, but there are also tax benefits of business loans.
Here are a couple of questions to ask yourself when you decide to avail business financing options:
- How much funds do you require?
- How long do you require the funds for?
- What are the available sources of business finance?
- What are the business finance types you qualify for?
- Do you have/need any collateral?
- What is the application process?
- How soon will the funds be disbursed?
- How soon and how much do you need to pay?
- Where and how can you avail the funds? (i.e., via banks/NBFCs, investors, crowdfunding etc.)
- Are there any government loan schemes for SME funding?
It’s advisable to check with 4-5 lenders to understand your options. Borrowing after all will put you in debt, and as a smart business owner, you should evaluate your options before finalising your decision.
Financial planning and business finance:
As mentioned earlier, business finance is also about managing finances. It’s one thing to avail funds – the funds also need to be used smartly. This is where it’s important to plan finances.
Never discard the idea of seeking expert advice. There are financial planners who can help you plan finances for your business and guide you towards the right borrowing options.