Debt financing is where business requires funding and a lender provides that funding to the business. In return the lender will agree with the business to repay the funding and the interest(profit) that the lender will charge over a specific period. Calculations of interest takes different forms.
Within the industry there are many names often used to describe debt finance. Below is a list of those names and a short write up.
Mezzanine finance bridges the gap between equity and debt and is one of the most expensive and onerous forms of debt. When lenders perceive the risks to be high, they will offer mezzanine finance.
Generally ‘Mezz’ debt, as sometimes it is called if often used to capitalise projects and initial burn of costs until the project has positive cash flows. The lender may impose restrictions on the borrower to ensure that project or the business can survive. Some example of these restrictions may include the subornation of debt, which means that will contractually put in place a mechanism that says their ‘Mezz’ debt takes priority of payment over other debt that may exist in the business. A restrictive dividend policy is another example of a restriction a lender may impose, this basically means that the owners of the business may not declare any dividends or take out money from the business except a salary. Some contracts may include a debt conversion clause which means that you give up your shares if some event happens in the business.
Despite the restrictions ‘Mezz’ debt can be quite flexible in terms of repayments of capital and interest. The lender generally takes long term view of your business and not just a transaction. In some way lenders who eventually offer ‘Mezz’ debt to your company are actually affirming your business.
Supply chain finance(SCF) is an umbrella term used to describe some form of financing in a company’s supply chain (All the businesses and activities involved in getting your product or service to market). SCF tries to optimise working capital and liquidity in your business. It operates primarily between a buyer and seller where some trade has occurred or is about to occur.
At every stage of a trade, for example raising a purchase order, or at invoicing stage a type of financing can be applied. The particular types may have different names and forms.
There are two types of forms that SCF can take i) receivable purchases and ii) loan or advance-based.
i) receivable purchases
Some of common names in the market under this category of form may include, invoice discounting, debtors finance, factoring, confirming, reverse factoring. All of the types of receivable purchase have there own subtle differences for the buyer and seller. Probably the biggest difference is where the risk for recourse lies.
ii) loan or advance-based
Some of the common names in the market under this category of form may include. invoice financing, trade loans, dealer finance, floor plan finance, inventory finance, purchase order finance. In all cases under this category is that the receiver of finance will have to declare this finance in the books of the business.
Micro finance as the name suggest is loans of smaller sizes. One may also find that the terms are shorter. This may mean that these types of loans are aimed at smaller businesses. A distinctive feature of Micro finance is how lenders mitigate their risk, they use social collateral and graduation as mechanisms.
Social collateral is where if you as a business needs to borrow, the lender will instruct you to find business in similar need that will also take a loan out at the same time. when the loan has to be paid and is not the the other business stands as collateral. Generally lenders seek 4-5 five businesses in this group lending technique.
Graduation means that after you have a proven track record of group lending under you belt, the business graduates to individual lending. This happens that over time the lending institution via its loan officers get to know you well and recommend that you are not a risk.
Micro finance are usually quoted using the flat rate calculation method and can be quite deceiving in price making them actually cheaper than they really are.
Also an umbrella term usually reserved for larger corporations when seeking finance in some form. It can include capital raising in the form of equity participation or from plain old debt. Generally, larger firms have corporate finance advisers that specialise in capital raising and this tends to yield custom and structured solutions for the business.
A company can engage with corporate finance advisers, when listing a company on the stock exchange, or need long term money for huge infrastructure projects, when deciding to buy out another firm or wanting to raise corporate bonds( a promissory note issue by a business saying that it will pay the holder certain amounts at certain periods).
Generally SMEs sometimes require these services but cannot afford them.
Islamic finance is a type of finance that operate by the dictates of Islam. Islam does not advocate for interest (time based returns) in any of its financial instruments. The source principle is the principle of fairness amongst society and interest or riba as Muslims call it not compatible.
There are different financial instrument that can assist business owners.
- equity participation
- Asset based finance based on the cost plus method
- Rental Asset based finance based on the diminishing balance
- Lease finance
All of these instruments do not include any calculation of riba.
Islamic finance is not just for Muslims business owners but for all who seek a more equitable and fair approach to finance.