If you are starting or buying a small business, you may have some concerns about financing your business. There are several kinds of loans available to help you purchase the business and to help you keep the business going.

Types of Debt Financing

There are two main types of debt financing: short term debt and long term debt. Generally, short term debt, or unfunded debt, is any obligation which must be repaid in full within less than one year after the funds were originally borrowed. Long term debt, or funded debt, consists of obligations that are repayable in full more than one year from their issue dates. Financing decisions depend on the nature of the assets for which the borrowed funds are necessary: short term financing is used for current assets and long term financing for fixed assets.

Short term loans generally have lower interest rates than long term loans. However, short term interest rates can go up from year to year, while the interest rate on a long term loan is usually fixed for the term of the loan.

Short Term Debt

Companies borrow on the short term in order to meet operating costs or to finance inventories. Types of short term financing include:

• Trade Credit or Accounts Payable - A company can purchase goods from a supplier on credit and pay the supplier later. For example, if a company orders goods from a supplier and the supplier delivers them, the supplier expects to be paid. The supplier may offer a one or two percent discount if the company pays for the shipment within ten days of receiving it. If the company cannot pay for the shipment within that time, the company uses its trade credit with the supplier to delay payment. The company has an account payable, and it has to pay the supplier interest on the outstanding balance.
• Bank Loans - A company can obtain a short term loan from a bank to finance its business. These loans can be either secured or unsecured, meaning that collateral may or may not be required, depending on the company's credit rating. Basically, the bank lends the company money, and the company signs a promissory note which contains the essential terms of the loan:
  
  • Amount
  • Agreed upon interest rate
  • Maturity date
  • Repayment method
  • Any collateral that may have been required, and
  • Any special conditions to which the parties agreed
  
  The cost of a commercial bank loan can vary significantly depending on the amount borrowed, the credit rating of the borrower, and the condition of the economy.
  
  When a company does not have a strong credit rating, it often has to borrow on the strength of collateral such as inventory and accounts receivable. There are three widely used methods of inventory financing:
  
  • The floating or blanket lien, which gives the lender an interest in the total inventory of the borrower
  • Trust receipts, which describe specific items of inventory that a borrowing company holds in trust for the lending bank
  • Warehouse financing, which gives the lending bank a security interest in all goods located at a warehouse
  
  

  In accounts receivable financing, the borrower either pledges the accounts to a lender or sells them. In the former case, the bank or finance company has a claim on the borrowing corporation's receivables. If, for some reason, the borrower's customers do not pay on their accounts, the bank may then proceed against the borrower itself for any amounts still due on the loan. In the latter case, which is known as factoring, the bank actually purchases the borrower's receivables and assumes all of the risk involved in collecting on the accounts.

• Commercial Paper - The sale of commercial paper, known as unsecured promissory notes, is another way of raising short term debt funds. However, this method is only available to the largest and strongest national corporations. Commercial paper is sold on the money market to investors.

  Long Term Debt

  Companies use long term loans to finance their long term assets, such as equipment, buildings, and land. With long term loans, companies do not have to renegotiate the loan at inconvenient times, and they can get guaranteed or fixed interest rates. Types of long term financing include:

  • Term Loans - These are loans given by banks and/or insurance companies to the borrowing company. The maturity date of these loans always exceeds one year. Generally, terms loans are unsecured and are amortized over the loan's full period. Interest rates may be either fixed or variable.
  • Bonds - These are long term debt obligations of corporations. They are offered and sold on the public securities market. The interest rates are set by the financial managers of the corporation. Public issues of bonds are only economical for corporations wishing to borrow large sums of money. There are several kinds of bonds:
    
    • Mortgage bonds, which require a corporate borrower to execute a mortgage on real or personal property to a trustee (a bank or trust company) and the trustee oversees the property for the benefit of the purchasers of the bonds
    • Collateral trust bonds, in which the loan is supported by securities
    • Equipment trust certificates, which are most often used by railroads to finance rolling stock
    • Income bonds, which entitle their holders to interest payments only when the debtor corporation shows enough profits to cover the amount of interest due
    • Debentures, which are unsecured, long term bonds

Questions for Your Attorney

• How long does a borrower have to pay back a short term loan?
• If I delay in paying a supplier, do I have to pay interest on the outstanding debt?
• What are the available options for constructing, buying, or leasing an office building for my business?

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