This is a simple explaination of Business Borrowing - I make no apology for keeping it simple.
There are four common ways that a business can borrow off a Bank or Finance Company
1. Overdraft – permission to go into a negative figure on a Bank account.
2. Loan – this can be unsecured or secured. If secured against property it is commonly called a Mortgage.
3. Asset Finance – usually secured against the asset, typically machinery, being purchased.
4. Sales Finance or Invoice Discounting – as you issue invoices, rather than await the period of credit given to your customer the Bank or finance Company pays you a percentage up front as you issue invoices to debtors.
Which is the best way for a business to borrow money?
•This will depend on the following key questions.
•What is the purpose of the borrowing?
•What is the nature of the business?
•How is the debt to be repaid?
•What assets does the business hold?
•What type of legal entity is the business trading as?
Types of legal entity.
The 3 most common types of legal entity in business are:
1.Sole Trader - a person who is the exclusive owner of a business, entitled to keep all profits after tax has been paid but liable for all losses.
2.Partnership - Partnership. Sometimes referred to as a general partnership. The relationship which subsists between two or more persons carrying on business in common with a view to profit. Partnerships are governed in the UK by the Partnership Act 1890. A partnership is not a separate legal entity. Partners generally have unlimited liability.
3.A Company - an association of persons formed for the purpose of some business or undertaking, which has a legal personality separate from that of its members. A company may be formed by charter, by special Act of Parliament or by registration under the Companies Acts.
Other Types of Legal Entity and considerations to be given to them
Trusts – Formed by a deed. This is not an uncommon form of business, but any Trust Deed must give the trustees authority to borrow for the debt to be enforceable. If a trustee borrows money on behalf of the Trust without that authority they may become personally liable for the debt.
Limited Liability Partnership – this has the same basic principle as a Partnership, but differs in one key aspect, that is the Partner’s liability for any debt incurred is limited by an amount, or limited to the assets of the partnership. In this aspect they are more akin to Companies. They do have to be registered at Company House in the UK.
Clubs and Associations – these are people joining together for a common interest or cause, but not for profit. Whilst not impossible for them to borrow, if borrowing is required it is more usual for them to incorporate (become Companies). Current identification and verification requirements make them increasingly hard to Bank if they are not incorporated.
Charities – these can be registered or unregistered and may take the form of a Trust or Company. If they are not formulated by a clear process (as a Company or Trust) the ability for them to Bank let alone borrow can be restricted.
Matching the borrowing purpose to the type of borrowing examples:
WHAT DOES A BANK OR FINANCE COMPANY LOOK AT?
SECURITY – what will repay the loan if the business cannot repay it.
Personal Covenant – this is the financial worth of the individual or partners of the business and is particularly relevant for sole traders and partnerships where they have personal liability. In the case of a Company the personal covenant can be tied into the Company’s borrowing by the individual issuing a personal guarantee for the Company’s debts.
Mortgage – this is a charge usually over land assets that means if the business fails any proceeds of sale clear the debt. It is possible to have a chattels mortgage over machinery. In the case of Agriculture there is an “Agricultural Charge “ available that can secure the crops, livestock and machinery on a specific area of freehold or tenanted land. This gives the lender the ability to trade through an agricultural cycle to get the best out of a failing farm’s assets.
Debenture – a Company can give a debenture over its fixed and floating assets. In times of failure the beneficiary of the debenture can take steps to control and realise these assets. If you give a new lender a debenture it can push prior lenders down the pecking order, this can be controlled to the satisfaction of multiple borrowers by the issue of a deed of priority for the amount of the debt. But care should be taken where multiple debentures are issued.
Hire Purchase – this is commonly used with vehicles and some machinery where the asset remains the property of the lender until the final payment is made. Alternatively a charge can be made over the asset securing that debt.
Personal guarantee – this is most often used when a Company borrows money, but the premises may be owned by a director or shareholder so they will possibly give a personal guarantee supported with a mortgage over their property. A sometimes tidier alternative is for a third party mortgage to be given by the asset owner as this captures the full value of the asset for the mutual benefit of both borrower and lender.
EXAMPLES OF GOOD AND BAD SECURITY
I give the following examples to enable you to understand how a Bank may view security.
Good security:
•Freehold land and buildings used by the business.
•Agricultural land without a tenant.
•Vehicles or machinery on wheels.
•A floating charge over book debts owed by good quality Companies.
Bad security:
•Personal dwelling house – whilst this may be good security for the Bank your home is at risk. Banks do not like kicking people out of their homes. There are additional regulations that affect this type of security and can increase costs for the borrower.
•A Zoo – a lender does not wish to end up with an asset that will incur feeding costs and vets bills.
An empty pub, shop or nightclub – a pub, shop or nightclub has a greater value whilst it is occupied – for this reason a lender may take a supplementary charge to give it the right to keep it open to realise a greater value.
SERVICEABILITY – the most important factor of all , how the debt will be repaid.
Examples of sources of repayment:
The trading cycle – typically the period from when stock and raw materials are purchased to when the finished goods are sold and payment received.
Profits – more correctly surplus profits - a business can make a profit but still be short of cash to service a debt - often EBITDA is used Earnings before interest, tax, depreciation and amortisation less drawings to identify the amount of funds available to service debt. You then have to consider all the debt that the business repays.
Future sale of an asset
Serviceability – The Trading Cycle
The key to this is that the lender understands the different trading cycles of a business and a good borrower takes time to explain this clearly to the lender in order to get the right type of borrowing sanctioned.
Typically an overdraft or invoice discounting will each be repaid comfortably within a trading cycle. But this will vary greatly from business to business and one business may have many cycles – examples as follows:
Mr Bennett the Butcher purchases carcasses from a wholesaler on a Monday. He makes sausages, pies and butchers the meat into joints and these are mostly sold within a week. This means that he needs to fund a trading cycle of one week from when the carcasses are purchased to when they are sold.
Mr Giles the Farmer buys calves from the local dairy, he feeds them on grass for eighteen months and then sells them to the abattoir who pays him within a month. This means that Mr Giles needs to fund a trading cycle, the cost of animals, feed, vets etc for nineteen months.
Serviceability - EBITDA
Earnings Before Interest Tax Depreciation and Amortisation is a key method of calculating serviceability of debt. Provided you have up to date full annual accounts this can be easily done.
1. Take Net Profit before tax
2. Add Depreciation
3.Add interest charged during the year for debt
4.Add amortisation (most common item amortised is Goodwill, or it can include other intangibles such as patents, copyrights and trademarks that is the value of an asset, often intangible, that is being written off over time in the same way as depreciation - it therefore reduces profits without using cash).
This should give you the EBITDA figure, from this you then take off any essential drawings or dividends this gives you the amount of cash the business has generated that is available to repay debt. If the business already has debt the repayments should also be taken off this figure to calculate the amount of available cash left to service new debt. But, if the new debt is bein g used to repay the old one this need not be adjusted. If you perform this task you may work out that you cannot afford to borrow morre money.(N.B. Essential drawings are the minimum required by the partners or directors to enable them to live)
EBITDA is important as it enables the lender to stress test your borrowing and to consider whether it is still affordable at a higher interest rate. But perhaps more importantly it helps you consider what you can afford, or wish to afford in terms of future commitment.
Management
When borrowing money you will increase your chances by demonstrating good management in both past experience and actions and current and proposed practises:
Good management looks like:
Good records and up to date accounts.
Low bad debts.
Contingency or “what if” plans
Management of change and ability to adapt.
Clear communication within business and happy people
Planned expenditure and cost control
Bad management looks like:
Poor records, bad accounts , bad debts
Poor communication between people
No contingency or “what if” planning repeatedly blaming on bad luck or the actions of others.
Unhappy people with high staff turnover
Poor organisation, waste of money and resources
Inability to accept change, even if that change requires drastic action.
PURPOSE OF DEBT
Debt reduces the choices of what a business or an individual can do with their cash in the future as the debt will need to be repaid. With this in mind consideration to what is good debt or bad debt should be given.
For a business good borrowing purpose would typically be: purchase of land and premises; purchase of machinery; working capital; funding expansion of business; funding a new project that has been costed and forecasted to increase profit; funding recovery from a disaster such as flood.
For a business bad borrowing purposes could be: funding of luxury vehicles; funding growing year on year losses; funding lifestyle of owners; funding uncosted and ad hoc projects that may not increase income.
So if you work through the above and consider each section carefully you will able to prepare better to borrow money for your business.