For SMEs, there’s a lot of terminology to get to grips with. In this article, finance experts reveal the top 10 most important terms businesses need to understand.
Money is the lifeblood of any business – cash is needed not just for day-to-day operations but also to underwrite growth and expansion plans or vital investment. For many firms, this means using some form of finance – but it can be a daunting and hugely complex task deciding on the type that’s most suitable for your business and its specific needs.
We spoke to the experts to identify the most commonly used and important bits of finance-related terminology to explain what they mean, and why they matter.
1. Finance: your options explained
Debt finance refers to funding that’s raised by the company or its owner borrowing money from some form of lender, says Clive Lewis, head of enterprise at the Institute of Chartered Accountants in England and Wales (ICAEW). “Debt finance covers the likes of loans and overdrafts as well as more specialised types of finance such as factoring or hire purchase,” Mr Lewis explains.
“In return for debt finance, the business will be expected to repay the debt with interest.”
Equity finance is another funding option involving issuing shares in the company to investors who then become part owners of the business. “Equity finance can be used to finance R&D, marketing, an acquisition or simply to fund growth. In return for an equity investment, investors will want to be paid dividends out of company profits, as well as to see an increase in the value of the shares they own.”
Asset finance, or asset-based lending (ABL), is a form of borrowing that lets you borrow against existing assets or land in order to fund new investments such as machinery, capital expenditure or building projects, explains Ben Guy, MD of Beacon Asset Finance. “It lets you release cash that’s tied up in assets you already own and you can usually agree lengthy repayment plans, so you can invest without affecting your immediate cash flow and spread the cost so your business growth isn’t stifled.”
2. Factoring and discounting
These are both ways of raising money from unpaid invoices as quickly as possible, says Mr Guy. “Factoring and discounting both come under the umbrella term of ‘invoice finance’, and they’re a solution to the all-too-common problem of late payments.”
He adds, “Invoice financing lets organisations that invoice other businesses for their goods and services release the money tied up in outstanding bills faster so it can be used for investment or cash flow. A third-party financier buys your unpaid invoice off you for a small fee. You then get the value of the overdue invoice minus the fee.”
With factoring, the invoice finance company collects money on your behalf, but with discounting you retain responsibility for chasing debts.
When a business borrows money, there will often be conditions or restrictions attached to the loan in the form of a loan covenant, Mr Lewis says. “For example, a loan-to-value [LTV] covenant will set out the minimum value for any property that is used as security against the loan.”
If the value of this property falls below the level set out by the covenant for any reason, the borrower may be in breach of their loan terms.
See also: Seven smart saving tips for start-ups
4. P2P borrowing
P2P – short for peer-to-peer – finance is available through a number of online platforms and has grown quickly in popularity over recent years. Both businesses and consumers can use P2P services to take out fixed-term loans directly from members of the public or from institutions that have money to invest.
Normally, the lenders on such platforms spread their loans among several borrowers in order to reduce the risk they face. For SME borrowers, this can be a useful and sometimes more cost-effective alternative source of finance.
5. Personal guarantees
Paul Stanley, regional managing partner at consultancy Begbies Traynor, says: “If you’re the director of a limited company, it’s standard practice for lenders to request you sign a personal guarantee to act as security for company borrowing. By doing this, they will have recourse to you, as the director, personally in the event your company fails to repay the debt.
“The terms of a guarantee can vary. For example, banks may request a legal charge over your home at the same time.”
6. Hire purchase
Hire purchase is a type of asset finance where you end up owning the equipment being financed, Mr Guy explains. “It’s similar to what’s commonly known in the car industry as a PCP [personal contract purchase] deal,” he says.
“The VAT and deposit is paid at the start, then the balance plus interest gets repaid over months or years. Usually, at the end of the finance deal, you then have the option to purchase the equipment by paying a ‘balloon payment’, but this can be done at some point in the middle if it suits your business better. That’s usually a good option for seasonal businesses with large fluctuations in cash flow.”
“When a limited company can’t pay its bills as they fall due, or the total of its liabilities is greater than its assets, it’s said to be insolvent,” Mr Stanley explains. “Insolvency can happen really quickly – for example, if the market changes or you lose a key customer – or it can take place over several years at a slower pace and isn't detected by directors.
“There may be routes out of insolvency, such as a company voluntary arrangement (CVA) or pre-pack administration, but if no such option is viable, liquidation may be the only outcome."
8. Working capital
Mr Stanley says that working capital is the value of your current assets minus the value of your current liabilities. “For example, if your balance sheet shows total current assets of £100,000 and total current liabilities of £90,000, the company's working capital is £10,000.
See also: Working capital: The basics
“Working capital is just one metric that signals the financial health of a company. Negative working capital indicates liquidity problems and, potentially, insolvency.”
“This is when you release the equity that’s tied up in an asset that you already own outright without losing ownership of it,” Mr Guy says. “This can work well for funding machinery or bigger one-off projects.”
Essentially, refinancing means borrowing more money against the value of an asset that’s used as security on the new loan.
Borrowers should pay attention to the annual percentage rate (APR) on any loan they take out, Mr Stanley says. “This allows you to compare the interest rates that are charged on different products.
“In the UK currently, the APR takes account of multiple factors such as the interest rate, the period the payments will be made over and certain other fees.”