RSS feedsJust as credit card companies are cutting consumers’ credit limits and in some circumstances terminating facilities, so banks are likely to be re-appraising the extent of loan facilities made to businesses.
Finance directors must ensure that they have more than sufficient finance in place to survive and prosper in the most challenging business conditions. Past ICAEW Enterprise surveys suggest that more than 25% of business have difficulties raising finance. For high-growth businesses the figure rises nearer to 50%.
Companies must have the right mix of equity and debt finance. With an array of potential financing options available, choosing the most appropriate can be time consuming, but having the right financing in place can be the difference between surviving and not.
Equity Finance
Many private companies are reluctant to issue equity capital as they are concerned about ‘losing control’, but high-growth businesses can be constrained by the lack of equity capital. Businesses planning a major investment in marketing, product development or incurring significant expenditure to acquire market share will, at some point, need equity finance. But banks do not lend for these activities.
Because of the uncertainty attached to these activities equity providers expect a higher potential return than for debt finance. For sums in excess of at least £2m, private equity providers require rates of return in excess of 50% and an exit in three to seven years.
For smaller equity investments ‘business angels’ will accept lower rates of return, but many expect involvement in management of the company.
Few businesses have the high growth potential to attract outside equity finance. So examining all the debt options is likely to be more rewarding. Leveraging your security to provide the maximum financing is the key. Choosing between mortgages, loans or leasing and hire purchase is a critical decision.
Debt Finance
Term loans have replaced bank overdrafts as the most popular form of business finance. Term loans are usually debentures or bank loans and mortgages.
Debentures are loans that are usually secured, and have either fixed or floating charges with them. A secured debenture is usually one that is specifically tied to the financing of a particular asset such as a building, machinery or equipment.
The debenture holder has a legal interest in the asset and the business cannot sell it unless the debenture holder agrees. Debenture holders have a right to receive interest before dividends are paid to shareholders. They rank as preferential creditors and will be entitled to repayment of the realised value of the assets subject of the debenture in the event of the company being liquidated.
Debentures subject to a floating charge do not have a fixed rate of interest and are not usually tied to any specific asset. Banks now more frequently encourage businesses to use in-house factoring or invoice discounting companies.
Most banks and building societies offer commercial mortgages, but you have to satisfy their lending criteria. Some lenders may accept applications where there is an adverse credit history, but most require clear evidence that a business is credit worthy.
A bank loan is another form of finance for an SME where property or some other asset acts as security for the loan. The key features are an amount of money borrowed for a set period with an agreed repayment schedule.
Interest rates can be fixed or variable and there will be an arrangement fee at commencement and annually thereafter. The drawback of term loans is that breach of the loan conditions can result in the bank appointing a receiver to realise the assets to achieve repayment, although banks will seek to avoid this if at all possible.
The Small Firms Loan Guarantee (SFLG) is a form of loan available from banks
where businesses run by people without a business track record or security can
be given a loan up to £250,000 partially backed by a government guarantee.
Bank overdrafts
Overdrafts are repayable on demand and during the 1990s many businesses were taken by surprise when banks asked for repayment of the overdraft and businesses struggled to find alternative sources of finance. An overdraft can be a good source of temporary additional finance. Interest rates are usually variable and higher than on a term loan and charges can be high for exceeding an agreed limit. Overdrafts are not suitable for businesses with widely fluctuating current assets.
Leasing, HP and contract hire
Faced with the acquisition of other business assets, businesses that do not
own
a commercial property tend to finance the asset according to pre-determined
expectations.
Buying an asset outright is often the cheapest option, but businesses lacking working capital should not tie up finance that may be desperately needed for other purposes. Leasing affords the opportunity to defer payment.
Leasing deals vary between finance companies. With direct leasing, the business decides on the asset it wants and the leasing company buys it and rents it to the business.
An asset purchased outright can be re-financed later, but the amount offered for plant or equipment as part of a secured loan is usually significantly less than the purchase price. Hire purchase is an option if the business eventually wants to own the asset. The interest rate on hire purchase is cheaper than a loan or overdraft to purchase the asset outright.
The tax implications of differing financing options also need to be considered. Assets purchased either outright or on hire purchase are usually eligible for capital allowances. The rate of the allowance will depend on the type of asset.
Significant changes in the capital allowances regime take place in April 2008. The first-year allowance of 50% (for small businesses) in place for plant and machinery will be replaced. Up to £50,000 spent on equipment in one year by a business will be set off in full against the profits for that year. In the case of hire purchase, the appropriate interest element is allowable as a deduction against taxable profits. More generous allowances are allowed for certain energy efficient assets.
In the case of leasing or hiring, the full cost is usually allowable as a deduction against taxable profits. The lease or hire cost of an expensive car (a car where the original market value exceeded £12,000) is restricted. Capital allowances for buying such cars are restricted to a maximum of £3,000 in the early years of ownership, but, in effect, full relief for the cost is given eventually.
It is vital that the business’s financing arrangements are regularly reviewed to ensure the finance in place is appropriate for the business. It is worthwhile to periodically check with existing and potential new finance providers to make sure not only that facilities are adequate, but that future business developments can be supported.
Clive Lewis is head of SME issues at the ICAEW
