There are many ways to finance a business, but the smart approach is choosing the right solution for particular needs. Stephen Preen considers financing options and the pitfalls.
There are many options for businesses considering external financing. However, what will work well for some will be unsuitable for others. All financing options should be exhaustively researched and reviewed before making a choice, or they could end up costing more than expected.
There are some simple steps for business owners to follow to help manage debt levels when considering external funding. A good starting point is to always keep business and private debt separate. Banks like to secure loans against real assets, but, wherever possible, business owners should avoid using personal assets to secure business loans.
Generally, long-term assets should be funded by longer term borrowings rather than trying to fund from trading cash flows, unless there is a good surplus after paying for all ongoing needs.
Owners need to consider a number of aspects, including the realistic amount needed, the term of the loan, and the type of loan that best suits their needs. For example, a bank overdraft, commercial bill or debtor finance, could well be appropriate short-term finance to fund the day-to-day running of a business. Medium-term finance, such as a term loan or leasing, may be used to fund the business operations for a matching period.
To purchase major assets such as land, buildings, plant or machinery, long-term finance such as a mortgage or leasing may be required. Raising the money against the actual use is a good practice, such as using hire purchase or leasing for motor vehicles. And, decide whether to arrange all funding needs into one source. There are situations when separate loans are best.
Business owners should also review funding arrangements regularly to ensure those in place are still the most effective business finance. Potential borrowers who can show that they have realistic calculations and supporting material to show their needs, improve their chances of getting loans at the best available rates.
Financing Options
I advise against using credit cards as a financing option because of their high interest rates. They should only be used if very quick short-term finance is needed, and will be fully repaid within the interest-free period. However, many find that the recordkeeping facilities offered by business credit cards can be useful. If they are used, have separate cards for business and personal use, and keep in mind that using a business credit card for personal expenses may raise FBT issues.
Businesses typically use credit cards to gain reward points but this should not be a driver for financing.
Leases and hire purchase can be used to purchase plant and equipment over a set period. The timeframe can vary, depending on the life of the equipment, but usually around four to six years. Both principal and interest are repaid, so businesses should be aware of how interest rate rises (or falls) will affect them.
While the interest rate on leases or hire purchase may be higher than other finance, the debt is usually secured only over the asset acquired, and owners’ personal assets are not put at risk.
The main difference between hire purchase and leasing is that the GST component can be claimed upfront under the hire purchase arrangements.
An overdraft is a good choice for businesses when the amount of financing needed will fluctuate, perhaps even on a day-to-day basis. It shouldn’t be considered for permanent or long-term financing requirements such as purchasing plant or equipment. Instead, it’s best used for times when an inflow of funds is needed for the short term. For example, seasonal purchases.
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If you’re looking for a bank loan, it pays to shop around, as there are many alternative financing methods. Even within the various business bank accounts offered there is a wide range of options, and other lenders offer products to meet business needs.
The most important consideration is to structure any loan or overdraft to suit circumstances. For example, recognise peaks and troughs in cash flow to identify periods when additional funds are needed.
Bank loans should be seen as a long-term financing option when permanent needs can be defined. They can be used to purchase plant or machinery, or to finance expansion plans or growth.
Factoring is the means by which a business can obtain funds from a financier based on the value of their debtor ledger. The financier may lend up to 80 percent of the invoices raised and will charge an administration fee and interest on the loan.
The financier will then typically take responsibility for the debts. This method of financing enables businesses to gear their accounts receivable. It removes the risk of defaulters but reduces the business’ profit.
Checking Your Finance Options
Before seeking the most appropriate sources of external debt, businesses should check to see what sources of capital exist internally. Good internal financial management will make it easier to access debt externally.
Credit controls
If the economy slows, as many predict, customers will take longer to pay their bills. Businesses should tighten their credit control before this happens. Nothing will depress a business (and its owners) faster than finding that funding is drying up as accounts receivable blow out. Indeed, accounts receivable should be the prime source of funding for businesses, otherwise they are funding customers’ businesses.
It can take a long time to recover from one bad debt, and if a customer is not paying promptly they are probably not worth having anyway, so why worry about offending them?
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Stop funding losses
Whether it is a top 50 company or a small family concern, if it continues to lose money eventually a business will run out of cash and/or the ability to raise further funds.
Check margins on particular lines and activities. Is the owner being businesslike or sentimental? Is the new branch ever going to make money, or is it simply chewing up capital?
Inventories
Investing in inventories that have a long shelf life but require creditors to be paid promptly can hurt cash flow. Inventories that are obsolete and will never convert to cash means businesses are carrying book losses by overvaluing inventories, and probably creating other unnecessary costs that need funding, and denying tax deductions.
Excessive drawings
Excessive drawings from a business by owners for personal use can lead to cash shortages.
Using business funds for external projects or other ventures will likewise have the potential to deplete cash in the business.
Waste
Waste is still a fact of life in many businesses. A major focus on waste and operating expenses generally will show areas of waste, and thus reduce funding needs.
For example, it can be false economy ordering in volume to get a lower price. Ordering 10 or even two years’ supply and being forced to throw most away because of changes in operation or detail is waste that could have been avoided with a more prudent approach.
* Stephen Preen is a partner with accountants and business and financial advisers HLB Mann Judd Sydney.
