What is the best method of financing a small business?

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Answered by: Ian, An Expert in the Business Finance - General Category
Small businesses have a unique set of problems when it comes to meeting their financial requirements. A small business is defined as a business which has a small number of employees, below 100, low annual turnover (below $1million) and a generally limited scope of operations. Most start-ups fall under this category with some operations comprising of only family members.



The mainstream sources of finance i.e. banks and other financial institutions seldom offer credit to small businesses. Small businesses are viewed by these institutions as having high business risk, also known as unsystematic risk, because their business models, cashflows, networks and business relationships have neither matured nor stood the test of time. The statistic that 90% of all start-ups fail in the first year only works to fuel the banker's fears that the money lent to these small businesses will not be paid back.

For many business owners, financing a small business presents a very big challenge. Most of these business are initially financed using the owner's savings or through borrowings from family and friends. This initial capital injection goes to purchase of assets, which takes up most of the capital, and the rest goes to financing the working capital of the business. Working capital is the portion of capital that is used to meet the short term obligations of the business such as paying for stocks, payroll, renting of premises, marketing and the other expenses incidental to running a business.



Small businesses generally use up this initial financing very fast and this is the main reason why most start-ups fail. Under-estimating the capital requirements of the business is a major cost of failure and a generally accepted rule is to have a working capital reserve which is sufficient to cover 6 months operating expenses for the businesses.

In the cases where a business survives the initial stages of finance, the stage which follows, generally known as the growth stage requires a steady supply of funds to ensure smooth running.

Financing a small business which is growing requires some bit of financial acumen. In this stage the financing can be split into two categories: fixed capital finance and working capital finance. Fixed capital generally requires a huge investments and most businesses mainly use credit, obtained from banks and other financial institutions to finance fixed capital. Another alternative is to attract additional equity by inviting new partners or shareholders to put their money into the business.

Working capital finance is all about managing your cashflows to ensure that your short-term obligations are met. A trick that is applied by all businesses is to negotiate favourable terms with their creditors and to offer not so favourable terms to their debtors. This ensures that you delay paying your creditors as much as possible and collect what your debtors owe you at the earliest possible instance. Through this, your creditors will essentially be financing your short-term cash requirements.

A business owner should however ensure that the method he chooses for financing a small business does not have a negative impact on the business's risk profile. Excessive delays in meeting accounts payable will make new creditors view the business as being risky and this will have an adverse effect on the business's ability to obtain additional financing.

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