TYPES OF DEBT FINANCE

Borrowings divide into short or long-term funding. For accounting purposes, anything due for repayment on demand (such as an overdraft) or due within the next 12 months (such as trade creditors or the next year’s worth of lease instalments) will count as current liabilities on the company’s balance sheet, whilst money not due until in over a year’s time will count as long-term liabilities.

Short-term sources

Short-term sources include the following:

Trade creditors

When a supplier provides goods and allows the company time to pay, this is in effect an interest free loan (although the supplier should have costed in the credit they will allow the company in pricing the job). The more the company is able to borrow from suppliers with their agreement in this way, the less you have to borrow elsewhere.

Overdraft

Much UK business funding has traditionally been by way of overdrafts as they tend to be the most flexible banking facility offered.

An overdraft is a short-term facility intended by banks as a revolving credit to cover temporary timing differences between payments you have to make to suppliers and receipts from customers. Banks will therefore expect to see the account swing back into credit on a regular basis and do not expect to see it used for purchasing long-term assets. As a short-term facility, an overdraft is usually repayable on demand.

The bank will also generally look to take some form of security for an overdraft by way of charges over a parcel of assets, particularly debtors and, where not already used to support other borrowings, property.

Because of this approach to taking security over a range of assets (some of which, such as stock and debtors will vary in value significantly from day-to-day), banks will take a relatively cautious view in assessing the real value of their security, while specialists at lending against specific types of asset may be able to lend more.

Overdrafts are also time consuming for banks to manage, so you can expect to see banks moving more and more customers across to factoring facilities as an alternative to overdrafts.

Factoring/invoice discounting

These allow a business to raise money against its debtors by assigning the outstanding invoices to the lender who will advance you say 80% of the approved invoices immediately.

As the lender takes over the debtors as security, these are then not available for a bank to secure its overdraft. So completion of a factoring deal usually involves paying off the overdraft out of the proceeds of factoring the ledger being taken over.

In factoring, the lender takes over management of the sales ledger and actively chases in payment, which can in itself be an advantage if the business’s credit control has been poor. In some cases factors will allow a CHOCs arrangement for key accounts (client handles own customers) whereby the company retains control of the contact with the customer.

Invoice discounting is usually only available to businesses with turnovers of greater than £lm. It differs from factoring in that the company continues to run its own sales ledger and collect in the debtors. As the company is continuing to do the work, it is therefore possible to have confidential invoice discounting (CID), which means that the customers will not be aware of the arrangement.

Some invoice discounters will take stock into account and are then able to offer higher levels of advance against invoices (sometimes exceeding 100% of the debtor book).

The issues you need to consider are the following.

• With factoring you will lose control of how your customers are chased for payment.
• Your facility will be based on a percentage advance against approved invoices. The actual advance you receive as a percentage of your total debtors can be significantly less than this headline percentage as the factor may disallow debts over three months old, overseas debts, or may set concentration limits where individual customers’ debts cannot be more than a set percentage of your sales ledger. You need to look at the nature of your debts and ensure that you will not run into such problems with your factor.
• Some debts are difficult to factor. They have to be business to business debts, and not sales to consumers and there are only a limited number of factors who will deal with contractual debt involving stage payments (such as construction contracts).
• As the advance is tied directly to invoicing, factoring is well suited to fast growing companies as the financing automatically expands as the business grows, reducing the danger of overtrading.
• However, as the facility is tied to sales volume, if sales fall, so does the funding available (which may be just the moment that you need finance the most).
• Once you have this type of facility in place, it can be extremely difficult to get to a position where you can exit the arrangement.
• There is still a stigma attached to factoring in some circles as it has been seen as financing of last resort. However, as banks have moved more customers to this form of financing, and this type of finance becomes a standard part of the funding package for buy outs, this stigma is disappearing (and of course is avoided with confidential invoice discounting).
• Factoring and invoice discounting are often perceived as expensive; however, when comparing costs against bank facilities it is important to compare against the total cost of equivalent bank facilities including interest, management charges, etc to get a fair comparison.

Block discounting

Where you have a long-term stream of income such as a rental income from property or machinery that is rented out, you may be able to borrow what is in effect an advance against this future income through block discounting. This is a specialist market where each deal is very much a one-off, so you are likely to need to use an independent broker to explore this if it is appropriate.

Bridging loans

Bridging loans are normally short-term loans that typically allow you to spend income that is anticipated (usually from the sale of an asset such as a property), before the cash has been received.

There are some specialist funders who will offer bridging loans against property essentially as emergency funding. However, while this can raise say 70% of the security value of a property within two weeks, this type of funding is extremely expensive and interest rates can often run at 2% a month together with substantial arrangement fees.

Long-term sources

Long-term sources include the following.

Bank loans (term loans)

If you are looking to invest in long-term assets, such as plant and machinery or property, you should borrow over a period that matches the expected useful life of the asset being bought, so that it repays the borrowing over its useful life.

Fixed rate loans

These offer you certainty over the payments you will make (but can therefore be inflexible and have repayment penalties built in).

Variable rate loans

These tend to be more flexible, but leave you exposed to uncertainty as interest rates change over time. If you are borrowing significant sums (say over £250,000) you may be able to buy what is in effect an insurance policy against interest rates going up in the form of a rate cap.

Mortgages

Mortgages, which are simply an example of a long-term loan secured against a property, and all the points above apply.

Where a business has a property that is not fully lent against, remortgaging this is usually the cheapest and easiest way to obtain finance.

Hire purchase

Hire purchase involves you in agreeing to purchase an asset by making payments in instalments over a set period.

Hire purchase agreements vary widely in their terms, offering fixed or variable interest rates. You need to check the rates carefully (particularly where there is an interest free period as rates for the balance of the term are likely to be high).

Some hire purchase agreements are structured with low ongoing payments and a large (balloon) final payment in settlement at the end.

In general, while you will be responsible for maintaining and insuring the asset from day one, legal ownership will remain with the finance company until the last instalment is paid.

Leasing

Leasing, by contrast, involves a finance company retaining ownership of the asset which is then rented to you. There are three basic types of lease:

• Finance lease, usually used for major items of plant and equipment where the finance company buys the asset and the business pays a long-term rental that covers the capital cost, interest and charges and is responsible for insurance and maintenance. Once the capital is repaid there may be an option to purchase the equipment outright, or to continue to rent it indefinitely for a small fee (peppercorn rent).
• Operating leases are typically used for smaller items such as photocopiers, where the equipment is rented for a specified period and the finance company is responsible for servicing and maintaining the equipment.
• Contract hire is a type of operating lease where the renter is responsible for day-to-day maintenance and servicing (for example, often used for motor cars).

You may need to pay an initial deposit in setting up a lease and, from a tax point of view, while the rental can usually be treated as a cost, as you do not own the asset you cannot usually claim capital allowances on it (nor can you generally use the asset as security for other borrowings as it does not belong to you).

Sale and leaseback

Sale and leaseback is an alternative to borrowing against an asset, where it is sometimes possible to arrange to sell the asset (plant and machinery or property) to a finance company to release cash and then to rent it back so that you can continue to use it. The amount of cash you can obtain will depend on the value of the asset being sold. This is a specialist area (particularly in relation to property, where this is only normally applicable to properties worth over £500,000) and you will need to engage a good finance broker.

Directors’ loans

There is nothing to stop you as a director putting money into the business by way of a loan rather than equity if you have the funds available. This should be considered when discussing the appropriate financial structure of the business with your advisers.

PG tips

Don’t do personal guarantees if you can avoid them. The taking of personal guarantees from company directors by lenders is becoming increasingly common. By giving a personal guarantee, you are promising that if your company cannot repay whatever has been guaranteed, then you will do so personally.

If you have to give a personal guarantee then try to follow these steps.

• Have the guarantee limited to a specific amount (such as 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.
• 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.
• Ensure that you understand the circumstances under which the guarantee can be called and in practice you (and your spouse if there is to be a charge on your matrimonial home) will be advised by the lender to obtain legal advice.

How much you can borrow

To allow you to estimate how much you may be able to borrow against the target business’s assets from these different sources, a ready reckoner is given in Figure 19. By completing this with estimates as to the value of the business’s assets, you can calculate how much you are likely to be able to borrow either from a mainstream bank or from a mix of asset based lenders.

In particular this form only takes into account the security value available from the business’s assets. It does not make any allowance for other security you may be able to provide, eg personal guarantees, or that may be available through schemes such as the Small Firms Loan Guarantee Scheme.