At some stage, it becomes necessary for most growing businesses to borrow money to maintain business objectives.
The type of loan you take out will depend on your personal circumstances. However, there are several different options you can consider and each has its own pros and cons.
You have to consider not only the possible source of these funds, but whether any security will be needed, the current interest rates and the term of the loan.
Taking out a loan, or increasing an existing loan, will have a definite impact in your overall costs. Before taking that step, you need to consider whether the increase in production and/or sales will justify the increase in your costs. Borrowing does increase your financial resources, but the expected income must outweigh the expected cost.
If you are looking for finance, a good place to start is the Internet. Many banks now include personal loan calculators on their Web sites. Although they are used primarily for mortgages and personal loans which have a fixed interest rate over a set period of time, they will still give you a rough idea of what the increase in your costs will be.
For instance, if you borrowed $10,000 for a fixed term of five years at an interest rate of 10.1 percent, you would be paying approximately $217 a month. Of course, that does not take into account other banking charges, taxes and fees but it does give you the basic idea.
Business loans, however, have both fixed and variable interest rates, usually lower than those for a personal loan and minimum loan amounts over a certain period of time. Some types of loans will also need surety. You will need to consult with your financial adviser or bank manager for your exact costs and repayments.
Working out your financing options
You then need to analyse your existing costs and your current rate of return on your assets. Next, factor into your costs how much more you can afford to repay on a loan without it impacting too greatly on your profits.
Review your total “new” costing to decide whether your profit margin will be adversely affected. If so, decide by how much you have to increase your prices to cover the additional financing. Your borrowing strategy is based on three different factors – if you borrow X amount over a certain time period and Y is your repayments, how much extra revenue do you need to cover this expenditure?
Finally, you need to complete a financial forecast. While forecasting is not an exact science, it will give you an idea of your potential earnings and whether additional financing will help in the short or long term.
Having done that, the next step is to decide on the best way of financing that loan.
Your borrowing options include the following:
|Source Of Funds||Security||Interest Rate||Term Length|
|Family And Friends||Not Usually||Usually Low||Long|
|Personal Loan||Not Normally||Medium||Medium|
|Bank Business Development Loan||Yes||Low/Medium||Long|
|Finance Company Loan||Yes||Medium||Short/Medium|
|Trade Credit||No||Usually High||Short|
|Leasing||Retains Ownership of Goods||Medium||Medium|
|Hire Purchase||Secured on Goods||High||Medium|
Sources of funding
Family circumstances vary, but wealthy relations are a possible source of capital for a business. In some cases, money may be borrowed for long periods at no interest. Do not, however, borrow funds your relatives cannot afford to lose. Be aware that any perceived failure on your part may cause family dissension for many years to come.
Hence, the ‘risk’ in family arrangements is perhaps more personal than financial for the borrower (and hence often avoided for this reason).
Loans from friends should also be avoided unless you are prepared to risk losing the friendship or the transaction is carried out at arms’ length on a commercial basis. Again, such arrangements are not encouraged.
Mortgage and mortgage equity loans secured on real estate are the safest and cheapest way of borrowing money.
Be careful that the purpose of the loan is documented so that the interest becomes tax deductible. Interest on loans for purposes of income earning are tax deductible, but obviously not loans for private purposes (eg. dwellings).
Bank overdrafts are the next cheapest source of finance. They are usually granted for working capital and are expected to fluctuate in amount from the limit to zero during the year.
Overdrafts are usually reviewed annually by the lending manager assigned to your business and you will need to provide regular profit and loss statements and balance sheets.
Bank overdrafts may be recalled without notice, although this is unlikely to happen unless you persistently default in your repayments.
The interest charged depends on how risky the bank perceives the loan to be. The lowest rate occurs when the bank has a floating charge over some substantial asset, such as unencumbered real estate.
Bank Business Development Loan
Most banks offer business development loans, which are really term loans paid back over a long period at a regular rate. The surety requirement is usually similar to bank overdrafts.
Personal loans are not really designed for business purposes. They are not cheap and it becomes complicated when you try to deduct the costs of financing for tax purposes.
Finance Company Loan
Some finance companies offer similar term loans as banks, but at a higher rate of interest. You should seek the cheapest source of finance first.
Leasing and credit options
Trade credit may be both the cheapest and the most expensive source of credit. Most businesses allow 30 days credit on your purchases.
Businesses, which are cashed up, will find that they can often negotiate better terms with suppliers by offering cash payment at the time of sale or delivery.
Remember that just a two percent savings over a month is equivalent to 24 percent annual interest. Therefore, negotiating settlement discounts is worth pursuing.
Leasing is generally available on items such as motor vehicles and office equipment. It is also a popular option for items such as computers which can become obsolete in two years.
Since the items remain the property of the finance company interest per se is not charged, but a lease fee or rental is charged which is equivalent to an interest payment.
Rates are generally comparable to industrial hire purchase, remembering that lessors charge depreciation against their tax, not yours, and the item has residual value at the end of the lease which also belongs to them.
Leasing is a useful option for an expanding business which wants to limit its capital investment and prefers to pay the apparently low lease costs rather than hire purchase. Also, the benefit of leases is that they can fill short-medium term equipment needs, without over committing the business.
Hire purchase is the main alternative to leasing. Interest rates vary with the risk perceived by the finance company, but they are generally higher than bank loans. They are also limited to moveable and resaleable items (eg. equipment).
There are tax benefits to hire purchase as you can claim depreciation on the asset and of course, the interest payments are tax deductible. Additionally, at the end of the hire purchase contract period, ownership of the asset passes to the business.
Credit card interest rates are generally high, ranging from 15 to 22 percent. They have largely replaced personal loans for consumer credit and may provide short-term credit for businesses. Some credit cards charge no interest if goods are paid for within so many days, but these may attract an annual fee. A credit card can be used for business purchases. If you have a credit card in the business name, the monthly statement you receive may also act as the tax invoice.
Credit cards are useful for deferring payment and they are also helpful in minimising the paperwork. However, the cash flow benefits of the credit card only work where the balance of the statement is paid off monthly.