Financing and Business Structures
The finance used (debt finance or equity finance), and the period of the finance, should be matched to the period which it required and for the purpose which it is to be used.
Trade credit is a form of short-term finance provided by a business by suppliers. It has few costs and security is not required.
Factoring provides short-term finance. Costs include an interest charge and debt management charge.
Bank overdrafte also provide finance for short-term cash flow issues. Usually includes a interest charge and perhaps a set-up fee. Some security is usually required.
Loans are generally made for a fixed period and specific purpose with variable interest rates. They are normally secured on assets.
Hire-purchase is a fixed period of payment whereby ownership of the good is transferred to the borrower at the end of the payment plan.
Leasing is for a fixed period; the costs are in the form of interest charges. A lease can be an operating lease where the underlying substance is a lease agreement or a finance lease where the underlying substance is a financing arrangement.
A debenture is a secured transferable loan instrument that can be listed on the stock exchange. It can be secured over specific assets or floating over all.
In sole proprietroship the only source of equity is that supplied by the owner. In a partnership all partners can provide equity finance, subject to the Partnership Acts and case law. Limited companies have liability limited to the amount invested; equity comes from the issue of ordinary shares.
In addition to ordinary shares preference shares has a fixed dividend and have preference in case a firm goes into liquidation. Whether these consitute equity or debt depends on the particular shares in question:
Redeemable preference share with fixed redemption rate: Debt
Redeemable preference share, redeemable on request: Debt
Redeemable preference share, redeemable on discretion of issuer: Equity
Gearing is the use of debt. High gearing can increase returns to the shareholders whilst making them more vulnerable to decreases in profit margin. An increase in interest rates affects high-geared companies disproportionally.