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What you need to know about borrowing money for your start-up

Do you need cash to start your business?
By Henry Ong |

Are you setting up a new business? Or are you planning to expand your current business? Either way, you are likely to face some difficulties obtaining capital to finance it, especially during these times of economic uncertainty.

 

Your possible sources of funding can either be internal or external. If you are a starting a business, you will most likely use internal funds such as personal savings to finance your company. But if you are already in the expansion stage, you should be tapping more external financing in the form of debt or equity.

 

When borrowing money or raising funds from investors, you need to consider the three important factors that could affect the viability of the financing package, namely time duration, interest rate, and the management participation of the funds provider.

 

Say that you are considering whether or not to accept a short-term loan being offered by your bank. If you plan to increase your working capital requirements for your inventory, accounts receivables, or operating expense budget, this short-term loan might be appropriate. This is because this type of financing typically requires repayment of the loan within the next 12 months, so you can pay it back using profits derived from the business during the year.

 

But if you are looking at financing capital expenditures, such as buying new machinery or opening new stores, you would need a loan that can be repaid over a longer period of time. This is because to pay back the loan, your business would need to accumulate enough profits for a number of years, which would normally be during the economic life of the assets you have purchased with the loan proceeds.

 

Have you imagined what would happen if you borrowed short-term loans to finance the costs of opening a new store outlet? Since the interest rates of short-term loans are higher than those of long-term loans, the total cost would be much higher and it would be difficult for you to pay back the loan.

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Let’s say the loan amount is P2 million, requiring a monthly amortization of P187,000. If the new store produces a monthly average income of only P90,000, you would have a monthly cash shortfall of P97,000. Such a recurring cash shortage could technically force you to close shop even if your business is profitable. Indeed, many entrepreneurs, by mismatching the risky use of short-term financing with long-term assets, have fallen into this trap.

 

Another form of external financing is raising funds from investors by issuing equity ownership in form of common shares in your company. The advantage of equity financing over debt is that the capital provided is interest-free and there’s no requirement for you to pay back. Since your investors also become part-owners of your business, however, they can influence how you manage the business and have some control over it. For every major business decision that you make, you may need approval from your investors, who may not be as knowledgeable as you are about your industry.

 

This is sometimes good because it would force you to validate your ideas with outsiders, but if they disapprove of your ideas, they could also limit your creativity. Also, because your investors will demand a decent return on their investment, you would be constantly under pressure to hit your profit targets, and if you fail, you would need to give them an acceptable explanation.

 

You may want to consider internal financing if external financing is hard to come by, especially during this time when many banks and investors are struggling with financial insecurity. You can increase the internal cash flows generated by your business by increasing your profit, selling assets, and managing your working capital better. You can increase profits by looking at ways to cut your costs and improve gross margins. You can also get internal financing by converting slow-moving inventory into cash and reducing your accounts receivable balance.

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Another way to get internal funding is to sell the idle assets of your business. These are your assets that have already been fully depreciated and are no longer being used in your operations, such as old equipment, vehicles, or building property. You can also raise the cash you need by selling some of your company’s assets such as land, or by leasing them with the option to buy them back in the future. 

 

At whatever stage of growth you are in as an entrepreneur, it is very important to explore all possible sources of capital. You need to choose the right mix of debt and equity financing at the least cost that can provide you the most control in managing your business.

This article was originally published in the October 2009 issue of Entrepreneur Philippines.

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