Essential Financing Terms for Small and Mid-size Businesses
Enhancing your knowledge of business financing terms can help you understand your options and manage your business more effectively.
Few business owners begin their journey with advanced financial knowledge. Most are professionals, experts, or entrepreneurs who learn the details of business management through trial and error as they grow their operations.
At AR Funding, we work with businesses of all types and sizes, from owner-operated small businesses to multimillion-dollar, global corporations. In some cases, the business owner has never needed to pursue financing before, and the learning curve can be steep as they familiarize themselves with the concepts and terminology.
To help business owners access the information they need to make informed decisions about business financing, we have compiled a list of essential terms and definitions. If you are exploring your financing options or plan to do so in future, this page is worth bookmarking.
You can also talk to the experts at AR Funding to learn more about invoice factoring and how it can help you accelerate cash flow for your business.
Amortization is the process of paying a loan on a fixed schedule. Each payment goes toward both the loan principal (the original loan amount) and the loan interest (the fee charged to the borrower on top of the principal repayment). and the scheduling out a fixed-rate loan into equal payments. The easiest way to calculate payments on an amortized loan is to use a loan amortization calculator.
Annual percentage rate
The annual percentage rate (APR) is a standardized measure of the costs of credit, including the interest rate and other fees charged by a lender. It is used to help borrowers compare the cost of different loans, as it provides a more comprehensive view of the total cost of borrowing compared to the interest rate alone.
While the APR must be disclosed in the case of consumer loans, such as credit cards and personal loans, it may not be disclosed for business loans. Because of this, it’s especially important for business owners to be aware of the components that contribute to the cost of borrowing, including interest rates, loan fees, loan terms, and amortization schedules.
An asset-based loan is a type of secured loan that uses business assets such as accounts receivable, inventory, or equipment to protect the lender’s interests. The lender uses the value of the assets as collateral, which provides some security and enables the lender to offer more favorable terms to the borrower.
Asset-based loans are commonly used by businesses that need to borrow funds but may not have a strong credit history or may not be able to secure traditional bank loans. The loan amount is often based on the value of the assets used as collateral.
Note that an asset-based loan that uses accounts receivable to secure the loan amount is different from invoice factoring. In the case of invoice factoring, the factor purchases the invoices outright from the business and then collects payment directly from the business’s customers.
Business line of credit
While traditional loans provide a lump sum that must be paid back on a specific schedule, business lines of credit provide access to cash that can be drawn from or paid back at the borrower’s discretion. Lines of credit can be non-revolving or revolving. Non-revolving lines of credit are one-time arrangements in which repaid funds cease to be available for use. Revolving lines of credit, on the other hand, allow business owners to dip into the available funds any time, borrowing a little or a lot, and paying interest only on the amount they have borrowed. Learn more about business lines of credit here.
Collateral is property or other assets that a borrower pledges to a lender as security for a loan. If the borrower fails to repay the loan as agreed, the lender has the right to take and sell the collateral to recover the money they loaned.
Common types of collateral are real estate, vehicles, machinery and equipment, inventory, stocks, and bonds. Business owners can also use their invoices or purchase orders as collateral. When invoices are used as collateral, the type of financing is called invoice factoring. When purchase orders are used as collateral, the type of financing is called purchase order (PO) financing.
Because collateral reduces the lender’s risk, it makes it easier for borrowers to obtain financing. It can also result in lower service or interest fees for the borrower.
Compound interest is interest charged on a loan that is calculated based on both the initial principal and the accumulated interest. By contrast, simple interest is calculated based on the principal only. When savings and investments pay compound interest, it allows the money to grow at a faster rate than simple interest. Conversely, when a loan charges compound interest, the borrower pays interest on the interest, which increases the overall borrowing costs.
A business credit report is a record of a company’s credit history, including its payment history, the amount of debt it owes, the length of its credit history, and the types of credit it has used. It is like a consumer credit report but focuses specifically on a business’s financial information.
Business credit reports are provided by specialized agencies such as Dun & Bradstreet, Experian Business, and Equifax Business. These agencies collect financial and payment data from a variety of sources, including banks, suppliers, and other creditors. They also offer credit monitoring and credit management tools, which can help businesses stay on top of their creditworthiness and take steps to improve it if necessary.
A credit score is a number that represents a business’s creditworthiness for business loans and other types of financing based on their credit history. It provides lenders with the information they need to assess the risk of lending money to a borrower and helps them determine the interest rate and loan terms they will offer.
Younger businesses may not be able to obtain a favorable credit score because they are too new to have a credit history. This can prevent them from qualifying for traditional financing or limit them to high-interest loan products.
For some types of financing, such as invoice factoring, the credit score of the business is less important. In the case of invoice factoring, the creditworthiness of the business’s customers is the factor that determines whether the business qualifies for financing.
The current ratio is a financial metric that measures a company’s ability to pay its short-term obligations. It is calculated by dividing the company’s current assets by its current liabilities. The current ratio is often used as an indicator of a company’s liquidity, or its ability to pay its debts as they come due.
A current ratio of 1:1 is considered ideal, as it indicates that a company has an equal amount of current assets as current liabilities. A ratio greater than 1:1 suggests that a company has sufficient assets to pay its short-term debts, while a ratio less than 1:1 indicates that a company may struggle to meet its short-term obligations.
The current ratio is an important consideration for lenders and investors, as it provides insight into a company’s financial stability and ability to repay its debts.
Debt consolidation is the process of combining multiple debts into one, typically with the goal of simplifying the payment process, reducing the overall interest rate, and reducing the amount of the monthly payment. This can be accomplished by taking out a single loan to pay off multiple debts, or by transferring multiple high-interest debts to a single credit card with a lower interest rate. However, debt consolidation can also extend the repayment period or incur hidden fees. Before consolidating debt, businesses should seek the advice of a financial professional.
Debt financing refers to the process of accessing cash by borrowing money. Debt financing can take various forms, such as term loans, lines of credit, bonds, and commercial paper (an unsecured, short-term loan). This form of financing allows companies to raise capital without giving up ownership and control, but it also involves incurring obligations to repay the loan, with interest, which can impact their financial flexibility and stability.
Debt service cover ratio
The debt service cover ratio (DSCR) is a financial metric used by lenders and investors to assess a company’s ability to repay its debts. It is calculated as the ratio of a company’s annual net operating income (NOI) to its annual debt service, which is the amount of money the company must pay in principal and interest payments on its loans. A higher DSCR indicates that a company has a stronger ability to repay its debts, while a lower DSCR may indicate that the company is at a higher risk of default. A low DSCR could disqualify a business from obtaining a loan, or it may result in higher interest rates or stricter loan terms.
A low DSCR does not affect a business’s ability to obtain cash through invoice factoring.
The debt-to-income (DTI) ratio measures the amount of debt a business has compared to its income. This provides a snapshot of the business’s ability to pay back its debt obligations. The DTI is calculated by dividing the business’s total recurring debt obligations (principal and interest payments and any additional borrowing fees) by its gross income. A high DTI ratio indicates that a business has a higher level of debt compared to its income, which can increase the risk of default.
The DTI ratio is an important factor that lenders consider when deciding whether to lend the business money and what terms to apply to the loan.
Equity financing refers to the process of raising cash by selling ownership stakes (shares of stock) in a business. This allows companies to access cash to operate and grow the business without incurring debt or interest expenses. However, it requires the business owner to give up some ownership, control, and profit, because the investors who purchase stock in the business become shareholders with the right to receive dividends and vote on business decisions.
Accounts receivable factoring, also known as invoice factoring, is a form of financing that turns outstanding invoices into cash. Factoring is ideal for B2B businesses that experience cash-flow issues due to a lengthy payment cycle. The factor purchases the business’s outstanding invoices and advances the business up to 90% of the value of those invoices. The factor also takes care of collecting payment and returns the balance of the funds to the business (minus the factoring fees) once the invoice is paid.
Because payment is collected directly from the business’s customers, factors will work with businesses that have no credit history or low credit scores. Learn more about factoring here.
An interest rate is the percentage charged by a lender for the use of money. It represents the cost to the borrower of borrowing money and is typically expressed as an annual percentage rate (APR).
A fixed interest rate is set at the time the loan is made and remains the same for the duration of the loan. This means that the borrower owes the same payment every time payment is due. The advantage is that the borrower is never surprised by higher-than-usual payments.
A variable interest rate fluctuates in response to changes in market interest rates. Because of this fluctuation, the borrower’s payments can increase or decrease throughout the lifespan of the loan. Because of this, it’s an option that is best suited to borrowers with a higher risk tolerance.
Liquidity is a business’s ability to convert its assets into cash, either by selling them or borrowing against them, in order to pay its short-term obligations. Business assets may include securities, accounts receivable, inventory, vehicles, equipment, or real estate. However, many of these assets are considered less liquid because they cannot be converted to cash quickly.
A business needs to understand and ensure its liquidity to stay resilient. Liquidity impacts the business’s ability to remain financially stable, respond to emergencies, take advantage of opportunities, and obtain favorable financing.
Merchant cash advance
A merchant cash advance (MCA) is a type of business funding that the business receives in exchange for a percentage of its future sales, plus a high rate of interest and additional fees. While they provide fast, easy access to cash in as little as one day, they are one of the most expensive types of funding. An MCA can charge an APR as high as 350% (compared to high-interest credit cards, with APRs of 18-29%) and require an aggressive weekly or even daily repayment schedule. Learn more about MCAs here.
Online loans, a relatively new form of business financing, are similar to bank term loans, with many of the top online lenders having been in business for less than a decade. Online loans are a popular option for many businesses because online lenders have less stringent lending criteria and deliver funds faster than traditional banks. However, online loans often charge interest rates as high as 80%, plus additional fees, so they are best used as a last resort. Learn more about online loans here.
An operating lease is a type of lease agreement in which the lessee (the business that took out the lease) has the right to use an asset, such as equipment, machinery, vehicles, or real estate, for a specified time period in exchange for a monthly or annual fee. The lessor (the company that owns the asset) retains ownership of the asset and is responsible for its maintenance and repair.
An operating lease allows the business to benefit from the asset without having to incur the cost of purchasing it or maintaining and servicing it. This helps the business to conserve cash or avoid large capital expenditures. However, an operating lease can result in higher overall costs compared to purchasing the asset outright.
Purchase order financing
Purchase order (PO) financing is a type of short-term financing used by businesses to pay suppliers for the goods and services they need to fill confirmed orders from their customers. Usually, a cash advance is paid directly to the company’s suppliers before a sale is finalized to facilitate the order. This type of financing can help companies who are selling goods faster than their cash flow can handle. Learn more about PO financing here.
A secured loan is a loan that is backed by collateral in the form of property or assets that the lender can claim if the borrower fails to repay the loan. Because this provides the lender with security and reduces their risk, secured loans tend to be easier to obtain and charge lower interest rates.
Conversely, an unsecured loan is not backed by collateral, resulting in much higher risk for the lender. As a result, unsecured loans are much harder to obtain and come with high-interest rates and stricter terms and penalties.
Shareholder loans refer to secured or unsecured loans made to a business by its shareholders in order to help the business weather financial difficulty or pursue growth and expansion. Shareholder loans are a source of financing for a company, similar to loans from banks or other financial institutions. However, unlike traditional loans, shareholder loans do not typically accrue interest, and the repayment terms may be more flexible.
The risks associated with shareholder loans include the potential impact on the business’s balance sheet and financial statements, potential tax implications, and the potential for conflict between the shareholder and the company. Businesses should seek the advice of a financial advisor or tax professional before entering into a shareholder loan agreement.
A term loan is simply a bank loan that covers the purchase of assets or operating expenses. The business owner applies directly to a bank and, if they qualify, they receive a lump sum to be paid back, with interest, over a specific period of time. Term loans tend to offer lower costs and rates than other types of financing, but they can take time to obtain and require the business to demonstrate a lengthy and excellent credit history. Learn more about term loans here.