Funding growth: Retained earnings or debt capital?

As the saying goes, “you have to spend money to make money”. At some point, just about every business has to raise funds to grow and develop. However, it’s important for small and midsize enterprises (SMEs) to carefully consider their funding options and strategies and choose those that align with their business goals, growth plans, and financial capabilities.

Based on data from the South African Reserve Bank regarding bank statistics, SMEs had a total credit exposure of R631 billion by the close of 2020. This constitutes just 25% of the overall business loan portfolio, even though formal SMEs contribute nearly 98.5% of the number of formal firms in the economy.

The limited availability of SME financing can be attributed to challenges on both the supply and demand sides. On the demand side, many SMEs are reluctant to seek loans from financial institutions. On the supply side, factors such as elevated financing costs and substantial collateral prerequisites could contribute to the reduced demand for loans.

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What sources of funding are available for SMEs?

SMEs often need to raise external funding or capital to expand their businesses, invest in research and development, or fend off the competition. And, while companies aim to use the profits from ongoing business operations to fund such projects, it is often advisable and necessary to procure funding from lenders or investors.

“Each funding type comes with its own set of advantages and considerations. Understanding these options allows businesses to choose the path that aligns best with their growth objectives and financial situation,” says Sandra Beswick, Founder and Director of Fluence Capital.

To fully appreciate how SME funding works, we need to unpack two of the different sources of capital available—retained earnings and debt capital.

1.Retained earnings

Retained earnings are an internal funding source, and thus a preferable SME funding strategy. Generated from profits after expenses and obligations are met, these earnings offer a versatile source of internal funding, granting companies autonomy, cost-effectiveness, and flexibility in decision-making.

As the cumulative net profits of a company that have been kept within the business rather than distributed to shareholders as dividends, retained earnings serve as the bedrock of any company’s financial stability. By carefully managing profits retained after expenses and keeping overheads low, companies can keep money in the company and bolster their financial stability. This approach provides a solid foundation for growth that generates money to keep in the company without incurring external debts/liabilities.

While retained earnings do not dilute ownership, it’s crucial to consider potential drawbacks, such as shareholders’ value fluctuations and the notion that these earnings ultimately belong to shareholders.

2.Debt capital

For companies with high-growth aspirations or short-term financial needs, debt capital can be a powerful tool (if caution prevails!). Common types of debt capital include asset finance, term loans, and overdrafts. “This form of funding provides companies with a financial edge,” says Beswick. “The benefits include tax deductions on interest payments, cost-effectiveness, and improved credit scores. However, it’s imperative to acknowledge the responsibilities that come with debt capital, such as the obligation to repay lenders and the potential risks associated with default.”

Here are some tips for debt capital management:

  • Explore different asset finance avenues

Although asset finance may seem like an easy solution, companies must understand the repercussions of repayments and interest rates. “I worked with a company that was considering buying a computerised whiteboard for the facilitation process for a training programme,” Beswick says, “The cost was R160,000 for the equipment. The asset finance for five years would have cost R300,000 with interest. Bear in mind that the tech may even be out of date after five years! In this instance, I suggested that, instead of seeking finance, the company arrange a payment plan with the actual software provider over a shorter term of three months on an interest-free basis.”

  • Avoid personal liability

Being personally liable for loans can have severe consequences, potentially risking personal assets. Be cautious when providing sureties or guarantees that could have detrimental effects on you and your business. For example, should your business not be able to pay back the loan repayments and you are forced into business rescue or liquidation, you, as the owner, will have to use your personal assets to offset the losses of the business. For smaller SMEs, this could mean losing a family home! 

  • Don’t over-borrow or pay too much for funding when you’re desperate

Business owners often rush into borrowing when facing cash shortages, leading to anxiety-driven decisions. When you’re in a state of desperation, it’s tempting to take anything you can get. But it’s important to weigh up the costs and carefully consider the terms. Rushing into agreements without a thorough assessment can lead to financial distress in the long run. Instead, take the time to do your homework, scrutinise interest costs, and evaluate whether you’ll have the capacity to pay off the debt ahead of schedule. This cautious approach will help avoid falling into a costly funding trap during trying times.

Empowering SME growth through strategic funding and planning

Business owners must approach borrowing with caution and make calculated decisions to safeguard their businesses. “Raising capital is a critical step in business growth, but it’s equally vital to retain ownership and control,” Beswick says. Strategic decision-making can help businesses achieve their vision without compromising their stake or their sustainability. By leveraging the right funding strategies, keeping a cool head, and planning effectively, South Africa’s SMEs can chart a course towards sustainable growth and resilience.

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As the saying goes, “you have to spend money to make money”. At some point, just about every business has to raise funds to grow and develop. However, it’s important for small and midsize enterprises (SMEs) to carefully consider their funding options and strategies and choose those that align with their business goals, growth plans, and financial capabilities.

Based on data from the South African Reserve Bank regarding bank statistics, SMEs had a total credit exposure of R631 billion by the close of 2020. This constitutes just 25% of the overall business loan portfolio, even though formal SMEs contribute nearly 98.5% of the number of formal firms in the economy.

The limited availability of SME financing can be attributed to challenges on both the supply and demand sides. On the demand side, many SMEs are reluctant to seek loans from financial institutions. On the supply side, factors such as elevated financing costs and substantial collateral prerequisites could contribute to the reduced demand for loans.

- Advertisement -

What sources of funding are available for SMEs?

SMEs often need to raise external funding or capital to expand their businesses, invest in research and development, or fend off the competition. And, while companies aim to use the profits from ongoing business operations to fund such projects, it is often advisable and necessary to procure funding from lenders or investors.

“Each funding type comes with its own set of advantages and considerations. Understanding these options allows businesses to choose the path that aligns best with their growth objectives and financial situation,” says Sandra Beswick, Founder and Director of Fluence Capital.

To fully appreciate how SME funding works, we need to unpack two of the different sources of capital available—retained earnings and debt capital.

1.Retained earnings

Retained earnings are an internal funding source, and thus a preferable SME funding strategy. Generated from profits after expenses and obligations are met, these earnings offer a versatile source of internal funding, granting companies autonomy, cost-effectiveness, and flexibility in decision-making.

As the cumulative net profits of a company that have been kept within the business rather than distributed to shareholders as dividends, retained earnings serve as the bedrock of any company’s financial stability. By carefully managing profits retained after expenses and keeping overheads low, companies can keep money in the company and bolster their financial stability. This approach provides a solid foundation for growth that generates money to keep in the company without incurring external debts/liabilities.

While retained earnings do not dilute ownership, it’s crucial to consider potential drawbacks, such as shareholders’ value fluctuations and the notion that these earnings ultimately belong to shareholders.

2.Debt capital

For companies with high-growth aspirations or short-term financial needs, debt capital can be a powerful tool (if caution prevails!). Common types of debt capital include asset finance, term loans, and overdrafts. “This form of funding provides companies with a financial edge,” says Beswick. “The benefits include tax deductions on interest payments, cost-effectiveness, and improved credit scores. However, it’s imperative to acknowledge the responsibilities that come with debt capital, such as the obligation to repay lenders and the potential risks associated with default.”

Here are some tips for debt capital management:

  • Explore different asset finance avenues

Although asset finance may seem like an easy solution, companies must understand the repercussions of repayments and interest rates. “I worked with a company that was considering buying a computerised whiteboard for the facilitation process for a training programme,” Beswick says, “The cost was R160,000 for the equipment. The asset finance for five years would have cost R300,000 with interest. Bear in mind that the tech may even be out of date after five years! In this instance, I suggested that, instead of seeking finance, the company arrange a payment plan with the actual software provider over a shorter term of three months on an interest-free basis.”

  • Avoid personal liability

Being personally liable for loans can have severe consequences, potentially risking personal assets. Be cautious when providing sureties or guarantees that could have detrimental effects on you and your business. For example, should your business not be able to pay back the loan repayments and you are forced into business rescue or liquidation, you, as the owner, will have to use your personal assets to offset the losses of the business. For smaller SMEs, this could mean losing a family home! 

  • Don’t over-borrow or pay too much for funding when you’re desperate

Business owners often rush into borrowing when facing cash shortages, leading to anxiety-driven decisions. When you’re in a state of desperation, it’s tempting to take anything you can get. But it’s important to weigh up the costs and carefully consider the terms. Rushing into agreements without a thorough assessment can lead to financial distress in the long run. Instead, take the time to do your homework, scrutinise interest costs, and evaluate whether you’ll have the capacity to pay off the debt ahead of schedule. This cautious approach will help avoid falling into a costly funding trap during trying times.

Empowering SME growth through strategic funding and planning

Business owners must approach borrowing with caution and make calculated decisions to safeguard their businesses. “Raising capital is a critical step in business growth, but it’s equally vital to retain ownership and control,” Beswick says. Strategic decision-making can help businesses achieve their vision without compromising their stake or their sustainability. By leveraging the right funding strategies, keeping a cool head, and planning effectively, South Africa’s SMEs can chart a course towards sustainable growth and resilience.

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