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+1-802-778-9005Borrowed capital, also known as loan capital, is the amount of capital raised from debt the company gets through loans or by issuing bonds. While equity capital is a portion of the company or with shareholders, borrowed capital requires payment of interest.
Borrowed capital is also referred to as “loan capital” and can be used to grow profits, but it can also result in a loss of the lender’s money. According to a Congressional Research Service report from 2019, almost 80% of small businesses in the U.S. relied on borrowed capital to operate their businesses. In 2018, small business loans amounted to $632.5 billion.
Borrowed capital can take many forms, depending on the business’s needs. Here are three commonly used forms of borrowed capital, with examples to illustrate how they operate in real-life situations.
Bank loans are a common type of working capital in which a business approaches a bank for a certain quantity of money and promises to refund that amount with certain interest within a given period.
Firms need working capital to settle their operational expenses; hence, they seek business loans from industries such as commercial banks, including Wells Fargo, Chase, and Bank of America, among others. These banks provide different kinds of loans, such as term loans, credit facilities, and goods and equipment financing. Interest offered is higher, and the borrowed amount and cost incidence are lower based on credit rating and the historical performance of the business.
Business loans or overdrafts are ideal for firms that need flexible structures with organized repayment that a commercial bank can offer for expansion, operations, or to finance a purchase.
SBA Loan Program
The SBA Loan Program is another government contribution that allows loans for business concerns that are unable to secure loans with conventional banks. This type of loan provides reasonable and relatively lower interest rates as well as longer periods to repay the advances it offers, which is ideal for new start-ups and expanding companies.
The various SBA loan products include 7(a) loans, 504 loans, and microloans, each targeted to a specific business purpose.
ABC Manufacturing requires the acquisition of new asset equipment, which will cost $100,000. Since they don’t have the whole amount of money in cash, they go to a bank to borrow some money, known as a loan. The bank gives them $100,000 at a 6 percent interest rate, with a 5-year recovery term.
They have to make a monthly installment payment of $1,933 to ABC Manufacturing, which includes both the principal and the interest charged by the bank. In total, within 5 years, they will make payments equal to $116 000, of which the interest will be $6 000 at the bank.
It is favorable for firms that require steady and certain periodic cash inflow. The main disadvantage is the interest that would be charged on the borrowed equipment. Still, it enables ABC Manufacturing to purchase the equipment without undertaking a waiting process for several years.
The second method with which companies can obtain funds is through bond offering, where companies offer bonds to finance institutions or individuals to get funds. There can also be private placement of bonds or public issue of bonds. While in private placement, the bond is directly offered to a specific and limited number of buyers, in public issues, bonds are offered to the ordinary public. In both cases, investors give the company cash in exchange for interest payments and the promise of the bond face amount or value, which is paid at the bond’s maturity.
Bonds as Secured Loans
Bonds are a form of credit instrument and typically come under fixed-income security, which are secured for the company’s assets. If the company fails to make the payments, bondholders can demand that payment be made on their bond. Thus, bonds are relatively less risky investments than unsecured loans, as the investor has more assurance of recovering his invested money.
XYZ Tech is planning to expand into a new area and will need to spend $1 million on advertising and product development. However, rather than borrowing from a bank, it will sell bonds to investors.
Certainly, the bondholders are paid $50,000 in interest every year, reflecting 5% on that $1 million, and the principal is paid at the end of 10 years.
Most large organizations use bonds to source most of their cash without sacrificing much control of ownership. However, the company has to pay the bondholders interest on its debts, which could prove expensive if the cash flow is low.
A credit line is useful for business firms because they are given a credit limit. They can borrow money at any time but should not surpass the limit set for them. The borrower only pays interest on the amount of the credit received and used. Because of this, it can be an effective way of controlling daily spending, smoothing out cash inflow, traveling expenses, or any number of things.
Example: The following are business lines of credit: Wells Fargo, Chase, and Citibank are some of the banks that offer them. These lines of credit allow access to cash without the hassle of frequently applying for loans.
123 Retail has an overdraft facility with its banker, which includes a $ 200,000 credit limit with an interest charge of 8%. In December, for example, they require $50,000 to purchase inventory. They withdraw $50,000 from the line of credit and intend to make the payment within the three months to maturity.
While borrowing $50,000, they can afford to pay $333 in interest monthly, and when repaying the principal, they will pay $50,000 more in total interest, or $999.
Here, 123 Retail can borrow only as much as it requires and does not have to pay interest on the amount borrowed in the case of a line of credit. This type of borrowed capital is ideal for companies, especially those that receive/want cash intermittently.
Commercial paper is an exact-term tool for financing receivables. It is used mainly for short-term purposes, usually for terms of 1 to 270 days.
Example: For current liabilities, XYZ Corp. needs $500,000. They have committed to constant and timely orders from buyers to enable them to honor the commercial paper they produce, which has a maturity period of 60 days. Consumers can purchase the paper at a lower price, and when the paper becomes due, XYZ Corp reimburses the full value.
Debentures are always long-term securities issued without physical security. Instead, they depend on the credit histories of the business entity.
Example: Global Enterprises offers $1 million debentures at a 7% interest rate. The issuer offers a semi-annual coupon, and the company can pay interest for five years. The principal is paid on the bond’s maturity date.
Lease financing, on the other hand, is a method of acquiring and using specific assets without buying them for commitment. Leasing occurs when a company acquires equipment, vehicles, or property for use by paying a lease as agreed.
Example: Bright Future School will need to purchase new computers but needs to be equipped to make a large capital investment. They lease the computers for $15,000 per annum for three years. At the expiration of the lease, they can either purchase the computers or take them back.
P2P lending is an industrial technique that uses Internet marketplaces to link credit seekers to individual fund providers. This procedure can afford better conditions than traditional banks.
Example: Handcrafted Home Goods is a small business that needs $10000 to purchase the raw materials. They go to a P2P lending platform, which means that people who need loans are funded individually. Terms are set up for the payment of the loan within 3 years at agreed-upon interest rates.
Factoring involves selling accounts receivable to a third party (the factor) with the aim of realizing cash at a cheaper price. It is useful for businesses, specifically those that require cash on short notice. This would mean a lot to those firms requiring capital, capital that they need in the shortest time possible.
Example: Currently, ABC Logistics has 5$50,000 in accounts receivable. But in order to get cash soon, they decide to sell those receivables to the factoring firm for $45000. They then have ready cash to enable them to run other operations as the factor seeks to recover on the invoices.
When a company needs to raise capital, it has two types of financing available: equity financing and debt financing. Debt is money borrowed from financial institutions, individuals, or the bond market. Equity is money the company already has in its coffers or can raise from would-be owners or investors. The term “borrowed capital” distinguishes capital acquired with debt from capital acquired with equity.
Debt financing involves borrowing money from different sources like financial institutions or individuals and paying it back with interest. They are cheaper and lower-risk alternatives for getting finances as compared to equity capital.
Once you pay the loan back, the lender has no control over your business. Also, it is easy to forecast your expenses because loan payments do not fluctuate.
Debt Capital is of three types:
Debt financing includes bank loans, loans from family and friends, government-backed loans such as SBA loans, lines of credit, credit cards, mortgages, and equipment loans.
Equity Capital is the total amount of funds invested by the owners in their business. A company’s equity is divided into several units, each called a share. The owners can sell some of these shares to the general public to raise funds. There are two types of shares: Equity Shares and Preference Shares. In Equity financing, there is no obligation to repay the money acquired through it and no requirement for monthly payments.
Short-term credit facilities are useful for small businesses when it comes to meeting working capital needs and exploitation of business opportunities. These are usually available for use by the business for a short time, a maximum of one year in most cases. Here are some common short-term credit facilities available for small businesses:
A line of credit grants credit up to a particular amount and acts as a bank account whereby the business can borrow as much as required from this amount. Where it relates to interest charges, the business only reclaims the interest charged in proportion to the used amount and not the overall credit limit provided.
Example: A microloan can be a $50,000 line of credit that a small business uses to meet its operating expenses in the slow season. They can use $10,000 to purchase inventory and then return the same once the firm’s cash flow strengthens.
Given the variation in some companies’ short-term cash requirements, finance or working capital management is best for managing variable working capital requirements.
Trade credit involves using credit extended to a business by a supplier to purchase goods or services on an installment payment basis for a specified period, normally thirty, sixty, or ninety days.
Example: One firm buys goods from another firm for $20000 and is allowed to pay the amount after 60 days. This allows the retailer to sell the goods before they can pay the supplier for them.
Best for: Any firm that buys and needs to keep large stocks of inventory but does not need to pay cash at the time.
Factoring or invoice financing eliminates the possibility of a business having to wait for payment from a customer by providing cash on the same invoices. The business passes its invoice to a lender and receives a cash amount less than the invoice’s value, and the lender is paid when the invoice is due.
Example: At the end of the prior period, a small marketing firm had $50,000 of unpaid invoices. They offered these invoices to a factoring company with $45,000 in cash in exchange for waiting for clients to pay the company.
Best for Companies that must receive money quickly while holding receivables in accounts receivable.
Short-term loans are also a shot facility, and in most cases, their repayment is expected within one year, possibly on a monthly or weekly payback basis. These loans are incurred to finance cash needs or to finance an investment.
Example: A small restaurant borrows $20,000 in short-term funding to purchase necessary kitchen equipment and complete some work within the next six months of the loan repayment period.
Best for Companies that require funds for particular activities in the short run and within a specific period.
An MC is often a large sum of money paid to a business and then repaid by the business, deducting a certain percentage of its daily credit card receipts until the advance is fully paid. This is not lending in a strict sense but a direct acquisition of sales receivables that will be realized in the future.
Example: A small café takes a $15,000 merchant cash advance on the condition that the business pays back 10% of daily credit card sales. This comes close to daily sales, where repayment varies depending on the daily sales yielded to the company.
This is best for Venture capitalists who require large funds to finance their companies and those with stable revenues and high credit card sales.
Credit cards are used in business to offer a small business a line of credit that is usable for short-term business expenses. There is always an incentive, cash back, and flexible payments to meet fees.
Example: A consultant has a business credit card to pay your travel and office expenses but always clears the balance after each month so as to avoid accumulating a high amount of interest.
Best for: Minor everyday business expenses or expenses for purchasing items that are necessary in an emergency.
Supplier financing enables a business to delay the payments of goods or services provided within a short period. This could be a perfected agreement with interest or an open account agreement.
Example: A local construction company will select a supplier and negotiate that he will pay for raw materials in the next 90 days so that the cash flow will be well controlled once the project is over.
Best for Companies that could benefit from more time within the supply chain before having to pay suppliers back.
Borrowed capital is money that a company raises through borrowing from individuals or institutions. The company must repay the entire amount after a specific time interval. The most common form of borrowed capital is a loan. It allows the lender to sell the asset and recover its money if it does not repay within a fixed duration. For instance, if you take out a small business loan and you turn no profit, you still need to pay back the loan plus interest, known as borrowed capital.
