Business Finance Products Explained

There are two main types of finance for any business. Often seen as opposite sides of the ledger, they are equity and debt.

Equity is the cash or capital invested into the business, usually in return for a share of ownership. Debt is money that has been borrowed and needs to be paid back, typically along with interest and/or fees.

In this article we’ll look at some of the common types of debt funding available to businesses in Australia and New Zealand, and the types of “security” associated with each.

First — what do we mean by “security”?

Security and collateral are terms sometimes used interchangeably. Collateral refers to the things a lender could potentially repossess and sell to recoup their losses if a loan isn’t repaid. We describe collateral as being “pledged as security” for a loan. For example, if you take out a loan for a car, the lender has security over the car (sometimes called a “security interest” in the car).

Specific security vs general security

In the car loan example, the car is what we call a specific security — we can identify the collateral, sometimes by serial number but often by description (e.g. “1x Cheeseburner 2000 pizza oven”). When you take out a loan for a particular piece of equipment, the lender will typically have a specific security interest in just that item.

General security, on the other hand, means security over a range of assets (which may change from time to time). For example, a lender may take a General Security Interest in all of the assets of a business — including vehicles, plant and equipment, stock, the business name, and any intellectual property. If the business acquires new assets, they can also be captured under the general security interest.

Secured vs unsecured

A secured loan means the borrower has pledged something as collateral. An unsecured loan is one where the lender has no collateral to fall back on in the event of default. Whether a loan is secured — and the value of any collateral — will impact how much you can borrow, over what term, and at what interest rate.

Key takeaway: The type of security affects your interest rate, borrowing limit, and loan terms. Understanding the difference helps you compare products on a level playing field.

Business Loans

A business loan is an all-encompassing term for a loan from a bank or finance company. You borrow a lump sum of cash that can generally be used for a wide variety of purposes — such as the cost of buying or setting up a business. Business loans typically have fixed payments over an agreed term (perhaps 3 to 5 years, but occasionally longer for larger amounts).

A business loan is very often secured over all of the assets of the business (a General Security Interest).

Advantages: Can be used for a very broad range of requirements. Loan amounts are typically higher and terms to repay often longer — making business loans a go-to product for larger funding needs.

Considerations: Applications may require quite a lot of information. You may be restricted on what you can do with some business assets until the loan is repaid — with some exceptions (like stock), you typically can’t sell pledged assets without the lender’s permission.

Chattel Mortgages

A chattel mortgage is another name for a secured asset loan (sometimes called a “loan and specific security agreement”). The “chattel” is the equipment or asset pledged as security. Chattel mortgages are one of the most common types of asset finance, used for everything from vehicles to coffee machines. They offer the benefits of ownership with the convenience of matching expenses to revenue.

Leasing

A lease is another common form of asset finance. The lessor (finance company or bank) buys the equipment you need and leases it to you, in return for regular lease or rental payments.

Although this may sound restrictive, in practice leases generally work much the same way as loans — they’re more often than not purely financial arrangements. However, leases and loans may have different treatments for things like income tax and depreciation, and importantly, they may differ in what happens to the equipment at the end of the agreement term.

Tip: Leases and chattel mortgages can look very similar on paper, but the tax treatment and end-of-term obligations can be quite different. Always ask your lender to explain both options.

Overdrafts and Lines of Credit

An overdraft is a term typically used when your bank lets you spend more money than you have in your account. A line of credit is much the same, although not necessarily obtained through a bank.

In either case, you’ll generally have a fixed limit you can borrow up to, and you’ll pay a fee for having the facility available (whether you use it or not). When you use funds, you’ll pay interest on the amount outstanding until it’s repaid.

An overdraft or line of credit may come with or without minimum payments, and may be either secured or unsecured. It’s most commonly used to deal with timing mismatches — such as when you’re waiting for a large invoice to be paid but need to pay staff or buy more stock.

Invoice Finance

Invoice finance is often used by businesses that supply goods or services on credit, particularly to larger organisations. Many big businesses use their buying power to force suppliers onto 30 or 60 day terms (or longer), meaning you know the cash will come in eventually — but you might be caught short while you wait.

There are two main types:

Factoring — you sell the invoice to a finance company (and the customer may be aware)
Discounting — the customer generally isn’t aware of the financing arrangement

In either case, the primary security is the invoices themselves, and the costs are often deducted from the invoices when they’re paid. This can make invoice finance an attractive option for constrained working capital, particularly for businesses with large debtor ledgers.

Merchant Cash Advance

This type of finance is sometimes used by businesses that receive much of their income through card terminals (EFTPOS, credit cards, etc.). A lender will look at your regular daily or weekly takings and work out an amount you can borrow (usually up to around an average month’s sales). The loan is secured by your future takings, and a percentage is taken from daily receipts until the loan is repaid.

Advantages: Repayments move up and down in line with your revenue.

Considerations: Loan amounts are often smaller than other products, and rates may be higher (as they’re often otherwise unsecured). You also need established regular merchant facility takings to qualify.

Business Credit Cards

Business credit cards function just like personal cards — you have a limit to spend up to, and a minimum repayment on any outstanding balance. Just like a personal card, the minimum payment won’t make much of a dent, and you’ll pay interest on anything outstanding at the end of the month.

You can often earn reward points, and if you’re disciplined about paying the full balance each month, you may be able to take advantage of a substantial interest-free period. But if you don’t pay in full, expect a very high interest rate on the outstanding amount — just like a personal card.

So which type of finance should you choose?

The right one. That might sound flippant, but there are a wide variety of finance options available to businesses today, and it can easily get confusing — especially when different lenders use different product names.

The bottom line: The important thing is to match the right finance product to your specific needs. Short-term cash flow needs are very different from long-term equipment purchases, and using the wrong product can cost you more than it should.

If you’re unsure whether a product is right for you, talk to a specialist — and better yet, seek professional advice from your accountant or business advisor.