The starting point for most businesses looking to raise finance is bank borrowing. This is also a useful point to start with in discussing debt finance in general as the banks offer most types of lending services either directly or through their specialist subsidiaries. Discussing how the banks work therefore illustrates in general how the business of borrowing works in the UK, what the issues are, how things are changing and what this means for your business.

This then acts as background with which to compare the offerings available from alternative suppliers, discussed over the next two chapters.

MANAGING YOUR BANK MANAGER

The first thing to remember when dealing with a bank is that banks are businesses like any other, albeit large ones. They have their structures and processes, their shareholders, a requirement to be profitable, their products and policies, their employees’ career paths and office politics.

The second thing to remember is that bank managers are employees like any other. They have their place in the organisation’s structure chart, they have their levels of authority, their reporting deadlines, their processes and bank policies to comply with, their targets, bonus schemes, annual objectives and own bosses to think about.

So if you understand how the bank is managing your bank manager and what they are being tasked to do and rewarded for, then you can arrange to manage your bank manager so that you get what you want out of the relationship.

The face of the bank that is most familiar is the high street branch network; however, this is only one aspect of the banks’ operations and for business borrowing purposes most of the banks have segmented their market into three distinct business units, based largely on customer size, and a typical split is now:

The exact dividing points and how rigorously these are enforced will differ from bank to bank.

Within each of these units, customers will be given a credit rating based on a range of factors, from the strength of the balance sheet and robustness of the profitability, to the strength of the management team and robustness of the financial controls and forecasting. Often the length of the existing relationship will be taken into account as banks see their customers as streams of revenue stretching into the future and tend to want to stick with customers who have stuck with them in the past, as they feel it is likely that the customer will continue to do so. A customer with a record of frequent switching to chase the lowest interest rate or service charges (a ‘rate tart’) on the other hand obviously has no loyalty to the bank, and the bank has much less long-term interest in the relationship.

This internal credit rating by the bank is absolutely crucial as this matrix determines how the bank views and manages the relationship and governs, for example:

• whether the bank should consider lending more under any circumstances;
• what interest rates to charge;
• whether to require formal security; and even
• whether the bank should be looking to retain the relationship or should be seeking an exit.

At its crudest each of the above business units of the bank will have:

• a good book; and
• a doubtful book (sometimes further divided into doubtful and bad books) which may be referred to as ‘intensive care’, ‘specialised lending services’ or ‘business support’.

Staying in the bank’s ‘good book’

The good book represents the bulk of the bank’s customers that the bank is happy with in terms of performance and the bank’s perceived risk. These customers will be dealt with by the appropriate local manager. The bank will have some requirements for information such as annual accounts and forecasts, but these will not generally be too onerous for most businesses. The bank may also be relaxed about taking security, may be predisposed to lend on the basis of an appropriate request and the margin sought on borrowings will be at the lower end of the bank’s scale.

If your business’s credit score starts to fall, you will start to drift towards the doubtful book and you will notice the bank’s approach hardening as you pass down through their matrix. Seeking loans will be harder, interest rates will be higher, security and personal guarantees will be sought and the bank will be looking for more regular information. Eventually, if your business is dealt with by the commercial level of the bank, the relationship will be passed across to the business support arm of the bank, which will have its own managers and reporting structures that you will need to deal with and will be looking to either return the relationship to the good book or to exit.

This is a particular issue if you have a change in your relationship manager. Human nature being what it is, your relationship is at maximum risk during the first three to six months of a new manager’s appointment. They will tend to take a hard look at the portfolio they have inherited to identify and weed out problem accounts while these can be blamed on the previous incumbent and before they become items that have arisen on the new manager’s watch.

You therefore want to ensure that your business remains firmly in the bank’s good book. Remember that:

Maximised credit score = minimal reporting + maximum ease of borrowing

You do so largely by communicating with and managing your relationship with your bank manager. Remember they are employees with a boss that they have to satisfy. They will have targets to meet and reports to file, so the last thing you want to do is flag your business up as an exception in their reporting or adversely affect their input into your credit rating by being a problem for your manager.

Your relationship with your bank manager is usually one of your business’s key relationships. I am always surprised by the number of business people who have given little or no thought to actively managing this relationship.

Your job is to make it as easy as possible for them to lend to you, which means making your internal credit scoring as high as possible.

Creating a quiet life

That means managing, first and foremost, the provision of financial information which will impact on their assessment of your business and therefore on the subjective aspects of your score. The critical steps that you should take are therefore the following.

• Report on time – for example if your bank manager has asked for quarterly management accounts this may well because they have an internal reporting calendar to comply with, so assuming the requirement is for these within a reasonable period after the quarter, delivering on time makes their life easier, demonstrates financial reporting is in place and avoids the absence of accounts being flagged up as a warning sign of potential problems.
• Report fully – agree the package of information that you are going to supply to the bank manager and ensure that you supply it.
• Report accurately – check what you are sending in to the bank manager to avoid problems. Faxing a set of accounts across to the bank that had accidentally failed to include the month’s sales caused difficulties for one business.
• Know your numbers – make sure that you are familiar with any numbers provided to the bank manager and can answer at least general questions about what they contain. One business was plunged into an immediate crisis when the bank manager asked the managing director why the forecast cash position showed a £1m greater overdraft requirement than had been advised a month before, only for the latter to respond: ‘does it?’
• Demonstrate the strength of your financial controls and management information – ensure that you are providing a full package of management information, which should include a budget for the year, comparisons of your actual performance with the budget, and information explaining the differences that have arisen between the budgeted performance and the actual performance (known as variances).
• Avoid surprises – which more than anything means ensuring that when it comes to preparing your annual accounts these are in line with the management accounts you have been presenting during the year, and on which the bank manager has been completing internal reports. If there are major differences this will immediately raise concerns about the accuracy and adequacy of your management controls. Remember the bank is relying upon you to manage the finances and accounting of your business, they cannot do it for you, and if the accounts produce a major surprise at a year-end this will undermine their confidence in the strength of your management.
• Report in time – in addition to reporting about historical performance, you should also be using forecasts to look forwards so that if you are going to need cash, you can flag this requirement up early enough in advance. Don’t forget, your bank manager will have a process they will need to go through within the bank in order to approve any increase in borrowings. Issuing a payment which you are unable to meet because you have not applied for an overdraft (‘application for overdraft by way of cheque’) not only counts as a surprise to the bank (see above), but worse tells them that you are not in control of your cash.

Being a high value account

The more valuable your business is to the bank, the more you would expect it to want to keep your business by providing you with what you want. In terms of managing your relationship this means making yourself of high value to your bank manager who you need to think of as being the bank’s salesperson. The bank is a business like any other and it needs to generate revenue by selling you services. Your bank manager will therefore be incentivised by the bank to win the types of business that the bank wants, but it is a mistake to think that the bank is particularly interested in lending you money.

Whilst banks obviously do earn money from making loans by way of both charges and interest, bank managers may not be targeted on growing their loan book. This is because the bank may make more money at less risk by selling other services such as insurance, where obviously they don’t run the risk of suffering bad debts. Similarly banks make much of their money out of transmission charges, so your bank manager will be very interested in talking to you about overseas trade as this can provide opportunities for the bank to earn significant sums in payment transmission and exchange charges.

If you therefore find your bank manager acting in their dealings with you more like an insurance salesman than you might expect, this is simply likely to be because of the targets they are looking to meet.

Your bank manager will also undoubtedly have a personal target for a number of new banking relationships to be achieved over the year. Given that most business owners seem to perceive banks as being interested only in lending, it may come as a surprise that banks are often very interested in finding customers whose accounts will remain in credit, because this will provide the bank with cash to lend out to other customers. They may also have targets for the number of introductions they have to make to other arms of the bank, such as factoring or leasing leads.

So if you are able to introduce potential prospects the bank manager will be keen to look after you.

Keeping your account swinging

Bear in mind that the thing that your bank manager sees day-today is how your current account is being operated. They will be looking for signs that show whether it is operating safely from the bank’s point of view, or indicating that there is a potential problem.

The graphs in Figures 6 and 7 give examples of what might be described as good and bad account behaviours. Although as a bank will be looking at its lending to you, if they physically prepare such graphs the scale will tend to be inverted as they are measuring their exposure to you.

The account in Figure 6 is showing the behaviour a bank would expect to see on an overdraft facility in that the account is swinging back into credit on a regular basis. Since banks regard overdrafts as temporary facilities which are designed to meet short-term timing requirements arising out of working capital needs, banks do expect to see the account swinging back regularly into credit as the business realises profits from its transactions.

The company also has a reasonable degree of headroom before it runs up against its current overdraft facility of £300,000.

The account in Figure 7 by contrast is showing a number of worrying signs.

• The company has a £200,000 level of hardcore overdraft borrowing that is never being repaid, indicating that the overdraft has become part of the long-term funding business. The bank will often suspect, particularly in the absence of any management accounts, that this is as a result of losses having been incurred.
• The company has had ‘excesses’ where its overdraft has exceeded the agreed facility of £300,000.
• The degree of swing in the company’s account has reduced to a very small level, indicating that the company has been trying to manage its payments to creditors to keep within the facility. This shows the bank that the company has a cashflow problem and may be suffering disruption and difficulties as this becomes evident to its suppliers.

Together these signs will be causing the bank concern and are likely to lead to a reduction in the company’s credit rating.

Approach to funding requirements

If you do need to ask your bank manager for an increase in borrowings you should do so on the basis of providing a cashflow forecast, including details of the assumptions underlying the numbers you are presenting so that you can give them the fundamental data they are going to need to consider your request.

• How much? What size of loan do you need? Is the bank the only source of funding or are you putting some cash in as well? Are you asking for enough to meet the whole requirement?
• Why? What is causing the requirement for cash? What do you need to do with the money you are borrowing?
• How long? What period does the loan need to be for?
• How will the borrowing be repaid? What will be the source of cash that will enable repayment?

The number of businesses which approach their bankers to borrow money without having given any thought that they might need to answer the questions above never ceases to amaze me.

Don’t forget also that your bank manager will have to make a judgement about the case for their business (the bank) to take the risk of making the advance. The typical banker’s CAMPARI checklist has already been given in Chapter 5, which you will see covers a wide range of financial and business issues on which your lender will need to feel comfortable. If you are looking to borrow money because your business is in difficulty you will need to prepare your case carefully and some guidance on this is given in my book Turning a Business Around.

However, how much you can borrow usually comes down in the end to the level of security available to support the borrowings.

WHAT CAN YOU BORROW?

Loans such as a mortgage are known as secured debt as the loan is backed by a charge over assets that can be sold to recover the lending if the borrower defaults.

Loans which are not covered this way are known as unsecured lending.

Since banks earn a limited margin in terms of interest on any money that they lend your business they tend to be risk averse. They therefore will seek to lend only where there is sufficient security cover available (although at the outset they may not always put formal charges in place over these assets).

While you may be able to find some unsecured lending this will tend to either be at a very limited level, or from non-bank sources such as the Wageroller and mezzanine finance products described in Chapter 6.

Most normal bank lending therefore rests on two legs:

• Can the client afford to make the payments?
• How do I get my money back if it all goes wrong?

You can see the sort of process in action if you’ve ever applied for a mortgage to buy a house. If you do so there are two things the lender will generally want to satisfy themselves about.

• How much you earn, and to a degree what your outgoings are, so they can see that your income (or to be more precise your personal cashflow) is enough to allow you to make the payments.
• What the value of the property is compared with the loan, so that if you cannot make the payments and they had to take possession of the house (their security), they would be able to sell it for enough to recover the loan.

The position in respect of a business borrowing from a bank is exactly the same. The bank will want to see the company’s forecast cashflows are sufficient to enable it to make the payments and it will also want to see that the assets over which it can take charges are sufficient to cover its borrowings.

The difference from an individual taking out a mortgage to purchase a house (which is a specific loan, for a specific amount, secured against a specific asset and to be repaid over a set schedule) is that a company may be arranging an overdraft the level of which may vary from time to time, the funds from which will be used for a variety of purposes and the company will have a variety of assets which might be offered by way of security.

Debentures

The way that this situation is dealt with is that instead of a single charge given over a single asset, a bank will seek to take a standard bank debenture. This would give it a mix of what are known as fixed and floating charges over the whole of the business’s assets from physical items such as property, plant and machinery, and stock, through financial assets such as money due in from debtors, and even intangible assets such as the business’s goodwill.

This type of debenture will give the bank the right to appoint a receiver over all of the business’s assets in the event that you default on their loans. The receiver will have the right to sell those assets, which in practice means your business, in order to generate cash with which to repay the lending.

Security statements

The steps required to calculate the basic security statement which underlies the banks’ and any other secured lenders’ approach to lending are to:

• obtain an up to date balance sheet (a statement of assets and liabilities);
• restate assets at current values;
• reorder the assets and liabilities according to their relative priorities;
• apply appropriate recovery estimates.

Widget Co Ltd’s balance sheet is shown in Chapter 2.

The company, which employs five staff, has net assets, so you might think that the bank would feel secure. However, to check, we need to produce an estimated security position statement by applying the steps set out above.

Restate assets at current values

Realistically, for the purposes of most discussions with banks, this usually needs only to be done for land and buildings where the book value based on the property’s original purchase price may be wildly different from actual current value. In Widget Co Ltd’s case the property is recorded in the books at its cost of many years ago of £100k (book value). However, as the property is currently worth £200k on an Open Market Value (OMV) basis this is the value that will need to be used in looking at the security position.

If, however, plant and equipment have a significant value then it may also be worth requesting a desktop valuation of its realisable value from chattel agents.

Where plant and machinery are held under hire purchase or a lease, it is not actually the company’s property. Nevertheless, if the value of the plant exceeds the outstanding hire purchase or lease liability, then this surplus value (equity) is owned by the company and has a value, as in theory a receiver could pay off the HP, sell the assets and realise the difference in cash. So where there is such equity this needs to be shown as an asset in a security calculation.

If the outstanding HP is greater than the value of the assets, the net value of the plant and machinery available to the bank should be shown as nil. Any apparent deficit suffered by the HP company would be added to other trade creditors.

Reorder assets and liabilities according to the relative priorities

A normal UK bank debenture will give the bank fixed and floating charges. Assets must therefore be divided into these two categories.

• Those subject to the lender’s fixed charge (generally land and buildings for a bank) which are assets that the company can there fore not sell without the bank’s agreement.
• All the other assets, which will be covered by the bank’s floating charge and which the company is free to buy and sell on a day-to-day basis.

If it has to call on its security, the bank will be paid out first from the net proceeds of sale of the assets subject to its fixed charge before any of these funds are available for other creditors.

What will effectively be covered by a fixed charge is a matter both of how the charge is drafted (and therefore what it claims to have a fixed charge over), and the current status of case law which will determine whether such a claim will be successful.

If a bank has a fixed and floating charge, and its fixed charge is ineffective, then the asset will be swept into the group of assets covered by its floating charge.

Fixed assets and fixed charges

This case law approach can unfortunately make the position appear complex. You also must be careful not to confuse the accounting term ‘fixed assets’ with what is meant by assets subject to a fixed charge.

For example, a bank’s debenture will probably state that plant and machinery (which are fixed assets in accounting terms) are covered by a fixed charge. This will not generally be effective and therefore plant and machinery will instead be caught by the bank’s floating charge. If, however, the bank has taken a chattel mortgage over specific listed and identified items of plant and machinery, then these items should be included under the fixed charge.

For many years debtors (a current asset in accounting terms) were regarded as effectively covered by bank’s fixed charges; however, as a result of recent cases called Brumark and Spectrum Paints, debts are now only covered by a bank’s floating charge.

Creditors

The proceeds of sale of the assets subject to the bank’s floating charge are used to first settle certain creditors (known as the preferential creditors). Under the Enterprise Act with effect from September 2003 these are now broadly limited to employees’ arrears of wages of up to £800 per month for the last four months (but not redundancy).

Only once the preferential creditors have been paid is any surplus cash paid to the bank under its floating charge.

Also, only once the bank’s lending has been settled are any funds then available for all the other creditors such as trade suppliers, landlords, other sums due to employees, the Crown and so on, (collectively known as the unsecured creditors). This has generally meant that there has been very little left for unsecured creditors in insolvencies. Under the Enterprise Act therefore, where a floating charge has been created after 15 September 2003, a portion of the cash generated from floating charge assets will be retained in a ring fenced fund for the benefit of the unsecured creditors.

As set out above therefore, creditors fall into one of four general categories for deciding where they rank in priority to be paid, which are in order:

• secured creditors with fixed charges;
• preferential creditors;
• secured creditors with floating charges;
• unsecured creditors.

Where you have more than one secured lender (and remember if you have a director’s loan there is no reason why you should not have taken security for it) their priority is determined by the following three rules.

• An effective fixed charge over an asset beats a floating charge. Different lenders may have charges over the same asset, but if one is an effective fixed charge, this will trump either a straightforward floating charge or an attempted fixed charge which is only in practice working as a floating charge. So for example, factors and invoice discounters can take effective fixed charges over debtors, but following Brumark and Spectrum Paints, banks’ fixed charges are no longer effective and will only operate as floating charges. So a factor or invoice discounter’s fixed charge on debts should beat a bank’s.
• An earlier charge beats a later one. Charges have to be registered at Companies House to be effective and priority runs in order of registration.
• But secured lenders can vary their relative priorities by agreement between themselves.

As secured lenders are in a better position than other creditors, debt that is secured is sometimes known as ‘senior debt’.

Apply appropriate recovery estimates

Having established current open market or book values for the assets as appropriate, for an estimated security position (also known by its insolvency terminology as a statement of affairs) these values would then be discounted to reflect the values that can realistically be expected to be achieved if the business fails.

These will usually be estimated on:

• a going concern sale, where the business may be traded on in receivership or administration and sold as a trading entity; and
• a gone basis, reflecting a liquidation and break-up of the business.

Some typical rules of thumb that are applied by the investigating accountants who prepare these sorts of analysis for the banks on businesses in difficulty are shown below.

The result of applying this approach to Widget Co Ltd’s balance sheet is a security position statement that might show:

Obviously this shows that the values that can be obtained through selling off the assets (including the recovery of the outstanding debtor book that can be expected) on a gone or break-up basis, say in a liquidation, are less than might be expected if the business and all its assets can be sold on as a package on a going concern basis, say in a receivership or an administration.

So on a going concern basis the bank clearly has substantial cover as the statement is showing a surplus of £218k. However, while the statement also shows a surplus on a gone basis, this statement is drawn up without taking into account the costs of any insolvency procedure that might be required to recover the money which would have to be met from the business’s assets. Since these can easily escalate into tens of thousands, the apparent surplus of £114k on a gone basis gives less cover than you might think.

If you were a director of Widget Co Ltd it’s also worth noting that this statement has only covered the bank’s position (and the employees’ preferential claims). Even though there is a surplus as regards the bank, this statement is already showing that there is a deficit on a gone basis to the £200k of unsecured trade and Crown creditors remaining on the balance sheet before any crystallising claims such as employees’ redundancy, customers’ warranty claims, or landlords’ claims for dilapidations or the balance of the lease term.

This should be a matter of concern, both in terms of keeping an eye on your potential personal liabilities for the company’s debts under insolvency legislation, and more directly your personal exposure should you have given a personal guarantee in respect of any of these items (such as a property lease) where the creditor can therefore look to you to make up any loss that they suffer.

SECURITY FROM OUTSIDE THE BUSINESS

So far we have looked only at the security available to a lender from the assets within the business. But security can also be provided from sources outside the business.

Personal guarantees

Where a borrower is a limited liability company, lenders will often look to take personal guarantees (PGs) from directors or shareholders to support repayment. By giving such a personal guarantee, you are promising that if your company cannot repay whatever has been guaranteed, then you will do so personally.

There are three general reasons for requesting personal guarantees.

• Most commonly, where there is insufficient security available within the company itself in terms of the value of assets that can be pledged to the lender, so the lender wants to look to the owner’s personal assets outside of the business in order to meet their requirements for security cover.
• To ensure that the directors/shareholders remain focused on and committed to the business and are not simply able to walk away if it runs into difficulty while the lender’s funding remains outstanding.
• To act in effect as a warranty to ensure that the lender is able to rely on the facts that have been given to them. For example, the terms of a sale and lease back of a company’s machinery will often include a requirement for the directors to give personal guarantees that:
  • the plant and machinery involved in the transaction does actually belong to the company; and
  • the directors will ensure that none of the machinery is subsequently disposed of without the agreement of the financing company.

While the use of personal guarantees is most common in respect of loans by banks and other financiers, they are also sought by other suppliers with a medium-term exposure to risks of non-payment by the company such as leasing companies and landlords.

The advice in respect of personal guarantees is simply to avoid them wherever possible and, if you have to give them, to seek to minimise the risk you are taking on.

If you have to give a personal guarantee then always ensure that you understand the circumstances under which it can be called, and in practice you (and your spouse if there is to be a charge on your matrimonial home as discussed below) will be advised by the lender to obtain legal advice.

To manage the risk you should try to ensure the following.

• Have the guarantee limited to a specific amount (eg up to £25,000 of the company’s overdraft) rather than unlimited which would mean that you are liable for the whole of the company’s borrowings from the lender.
• Have the length of the guarantee limited to a specific period or until a defined event.
• Avoid giving a supported guarantee (where the guarantee is backed up by charges over specific assets such as a charge on your home) and instead give an unsupported guarantee, not tied to any particular asset that can be seized.
• Speak to your insurance broker about obtaining insurance cover for your personal guarantee risk.

A personal guarantee is, however, not a simple substitute for normal security over a business’s assets, as banks and other lenders do not like having to rely on personal guarantees for a number of reasons:

• they can be costly, difficult and time-consuming to pursue;
• pursuing a claim against someone’s home can lead to bad publicity;
• most importantly they can be difficult to actually take effectively as the law is complex and can change.

For example, if a personal guarantee is to be supported by a charge against property co-owned with your spouse, they will have to confirm to the lender that they have received independent legal advice as to the nature of the charge being taken and its implications, or confirm to the lender that they have opted not to do so.

Challenges to personal guarantees

There have been successful challenges to personal guarantees backed up by the matrimonial home by a spouse, where the spouse has claimed that they didn’t know what they were signing. Lenders therefore will now insist on the spouse taking or electing to waive the taking of advice so that they can defeat any subsequent challenge to the guarantee by the spouse on the grounds that they did not understand what they were agreeing to.

Recent cases involving personal guarantees have centred around the legal position that a guarantee given in respect of a loan is only effective for that specific loan, or another loan that was being contemplated at the same time.

In one case a borrower gave a guarantee in respect of a loan which was later refinanced with a new loan from the same lender. The court held that despite the new loan simply replacing the original, the personal guarantee was no longer effective. This means that to ensure they can rely on any personal guarantee, lenders in practice may need to ensure that they get a new personal guarantee signed each time the borrowing changes, as they may not necessarily be able to rely on old guarantees.

Confusingly, another case in progress at the same time suggests exactly the opposite, so each of these cases will need to be settled through the appeal process in order to actually decide the law.

Financial guarantors

Where your business has a financial investor in its equity such as a venture capitalist, it may be that the investor may be willing to act as a guarantor for borrowings if needed, as an alternative to being required to introduce further funds itself.

Small Firms Loan Guarantee (SFLG)

If bank borrowing is so dependent on the assets available to provide security, what happens if you have a viable business plan which requires a loan, but do not have the security required? In some circumstances all is not lost. The DTI, in cooperation with a number of participating lenders, operates a scheme designed to meet these types of cases called the Small Firms Loan Guarantee (SFLG), whereby the government will provide the lender with a guarantee against default by the borrower.

To qualify for this scheme your business must be less than five years old and have a turnover of less than £5.6m. Under the scheme the government provides the lender with a guarantee for 75% of the loan amount in respect of loans of up to £250,000 and terms of up to ten years which can be used for most purposes, although there are some business sectors which are not eligible.

The cost to the borrower of this guarantee is a payment to the DTI of a premium of 2% of the outstanding loan, in addition obviously to the lender’s own charges and interest.

The scheme has been reviewed recently in order to increase the level of take-up, which has resulted in the removal of a lot of bureaucracy which had meant many lenders were reluctant to get involved in referring cases across to the DTI for approval. Under the new arrangements the participating lenders, which include both banks and asset based lenders, are allocated a level of guarantee which they are able to administer themselves.

WHAT IS CHANGING IN THE LENDING MARKET

Having looked at the basic question of security, to then understand how much your business can borrow it helps to be aware of what is happening with bank lending, and why banks are moving customers away from overdraft borrowings and on to factoring or invoice discounting and other forms of lending, to the extent that some commentators are predicting the death of the overdraft as a means of financing businesses.

Bank lending is always based on a mixture of cashflow and the security available. Banks are moving away from old fashioned overdraft lending because of two main problems:

• risk; and
• cost.

Traditionally a bank’s overdraft lending has been secured by a fixed charge on the company’s debtor book, which gave the bank first call on the cash collected in from a business’s customers if it failed. This comfort has disappeared following rulings in the Brumark and Spectrum cases, although the removal of PAYE and VAT’s preferential status has mitigated this problem for the banks.

Banks’ problem – your opportunity

There is a more fundamental problem for banks with this type of lending in that they will set the overdraft limit at infrequent intervals. When taken out, a £100k overdraft might be well secured against £200k of debtors. But who knows what the security will be worth tomorrow, next week, three months later, or if the business fails and the bank has to rely on its security?

The point being that the level of overdraft will move up and down at the same time as the level of debtors (the bank’s supporting security) is also changing. There is always a risk that the bank can become exposed if the business is in difficulties as the security reduces, fewer sales leading to fewer debtors, while the overdraft increases. Therefore to ensure that they are well covered by their security, banks are conservative in the loan to value (LTV) amounts they will advance. Even so, it is still difficult to manage exposure, which means this type of lending is inherently risky.

To manage this risk the bank therefore needs to employ people with sufficient skills and experience to look at company accounts and speak to businesses to monitor their performance, and these people cost money.

By contrast, an invoice discounter or factor only ever advances against invoices that are issued. As a result it automatically matches its exposure in funds advanced to the level of security available. This makes an invoice discounter or factor’s lending much less risky and the automatic nature of the cover makes it less costly to manage.

This problem may be exacerbated for banks over the next few years as the results of an international agreement known as Basle 2 start to make themselves felt. This agreement is designed to improve the stability of banks by setting the level of capital that they need to have in order to support the loans that they make. This is a technical subject and opinion is divided on how much impact it will have on UK banking, but the principle is that the higher the level of risk in their loan book, the greater the capital the bank will need to retain to support it. The implication therefore is that banks may be even less willing to lend money that is perceived as being high risk, or if they do, the rates charged will be higher.

The bank’s problem is, however, your opportunity, as the range of asset based funders available now means that you have a real choice of independent specialist funders. You can there fore look at mixing and matching your funding to provide a package of lending better tailored to your business’s needs.