Types and Sources of Credit

Types of Credit

Credit is money a business can use now and pay for later. There are three main types.

Loan: a fixed sum borrowed for an agreed period and repaid in regular instalments, with interest.

A loan suits a one-off purchase that will earn money over several years, such as a delivery van. The repayments are known in advance, but they must be made every month whatever sales are like, and the bank may want collateral (see 1.4.1).

Overdraft: an arrangement that lets a business take its bank account below zero, up to an agreed limit.

An overdraft is flexible: the firm pays interest only on what it is overdrawn by, and only while it is overdrawn, so it suits short gaps between paying bills and being paid. But the rate is usually higher than on a loan, and the bank can cut the limit at short notice.

Trade credit: when a supplier lets a business take goods now and pay for them later, often 30 or 60 days later.

Trade credit costs nothing if the bill is paid on time, and a shop can sometimes sell the goods before it has to pay for them. A business that pays late may be charged extra, refused credit next time or lose the supplier altogether.

Sources of Credit: Banks and Other Firms

Banks are the main source of loans and overdrafts for most businesses, charging interest that reflects the risk of each borrower.

Other firms provide credit too. Suppliers give trade credit to their business customers. Specialist finance companies lend for vehicles and equipment, often using the item itself as security.

Other Types of Finance

Venture capital and share capital are not borrowed at all, and leasing lets a firm use an asset without buying it. All three are alternatives to credit.

Venture capital: money that specialist investment firms put into a small, fast-growing business, taking part ownership of it in exchange.

Venture capitalists back firms that are too risky for a bank but could grow very large, often in technology. They usually bring advice and contacts as well as money. In return they take a large stake, and often a say in how the business is run.

Share capital: money raised by selling shares in a company to investors, who become part owners.

Share capital never has to be repaid and carries no interest. The cost is control: each new shareholder owns part of the business and expects a share of the profit as dividends. Only companies can raise it, and only a plc can sell shares to the public (see 1.4.2).

Leasing: paying to use an asset, such as a vehicle or a photocopier, for a set period without buying it.

Leasing avoids a large payment up front, and the lease may include repairs. Over the life of the asset it usually costs more than buying, and the business never owns it.

Owner's Capital and Other Sources of Finance

Owner's capital: money the owners put into the business themselves.

• Personal savings are the most common way to start a small business. There is no interest to pay and no one else to answer to, but most people do not have much, and the owner can lose it all.
• Retained profit is profit kept in the business rather than paid out to the owners. It is the cheapest finance for an established firm, but a new business has none, and every pound kept is a pound the owners do not receive.
• Sale of assets raises money from things the business no longer needs, such as an empty warehouse or old equipment. It can only be done once per asset.

Finance can also come from outsiders:

• Individual investors, often called business angels, are wealthy people who invest their own money in small firms for a share of the business. Family and friends sometimes do the same on a smaller scale.
• Online collaborative funding raises money from many people over the internet, each putting in a small amount. In crowdfunding, backers receive a reward, such as the first products made, or a small share of the business. In peer-to-peer lending, individuals lend to a business through a website and are paid interest, with no bank in between.

Comparing Sources of Finance

Finance is internal if it comes from inside the business and external if it comes from outside. Short-term finance is repaid within a year; long-term finance is for longer, or never repaid at all.

Challenges in Obtaining Credit

Small and new businesses find it hardest to borrow. A bank weighing up a loan wants to know the borrower can repay, and a start-up cannot prove that:

• it has no trading record, credit history or past accounts
• it often has few assets to offer as collateral
• the owner knows far more about the business than the bank does, so the bank cannot easily tell a good plan from a weak one.

So a small firm may be refused, offered less than it asked for or charged a high interest rate. Credit is also harder to get when banks are cautious, as in a recession, just when many firms need it most. Crowdfunding, peer-to-peer lending and business angels give these firms another route to finance.

The Role and Impact of Credit on the Economy

Credit lets households and firms spend before they have the money:

• Credit flows easily: firms borrow to invest in equipment and premises, and households to buy houses and cars → more spending → more demand for other businesses → they hire more workers → investment and growth.
• Too much credit: households and firms borrow more than they can repay → a rise in interest rates or a fall in income leaves them unable to keep up the payments → spending falls sharply, and the banks that lent to them make losses.

When credit dries up, the first chain runs in reverse. Imagine a bakery whose bank turns down a £20,000 loan for a second oven. The oven maker loses a sale, and the bakery does not hire the extra baker it needed. When banks turn down thousands of firms at once, spending and jobs fall across the economy.

How much a change in credit matters depends on:

• How much firms rely on borrowing: a firm that can pay for investment out of retained profit barely notices when banks become cautious. A start-up with no profit has no such cushion.
• Confidence: easy credit only raises investment if firms expect demand to hold up.