Most small businesses will need to look for external funding at some stage, with loan (sometimes called debt) finance being one of the most common sources of funds for both start ups and existing businesses. There are many different types of loan finance, and your ability to raise external finance will depend on a number of factors, such as trading history, business type and security. Borrowing money often requires you to give personal guarantees, which risks your own finances.
Most loan or debt finance is provided as a loan to your business that ultimately has to be repaid to the lender. The cost to your business is the interest on the debt and any additional fees, such as arrangement and valuation fees.
Bank loans are one of the most common forms of loan finance as they are flexible and relatively accessible. Typically referred to as 'term loans', they are repaid over a specific period at an agreed rate. The loan is usually secured against a business asset so if you fail to make repayments the lender has some security, which they can seize to recover the sum owed.
You have to pay interest on the full amount of the outstanding loan so make sure you need all the money you borrow. So long as you adhere to the terms of the loan, it cannot be recalled early, though many lenders now insert a clause allowing them to foreclose.
An advantage of bank loans is that you can match the term of the loan to the expected life of the asset. For example, match a short-term asset (such as a computer) with a short-term loan, and a long-term asset (such as a piece of machinery) with a long-term loan.
When taking out a bank loan, shop around to see what deals are available. Interest rates and the term of the loan should be negotiated to ensure you can meet the repayments. It is also worth asking whether incentives such as an initial capital repayment holiday, reduced initial interest rate or reduced set-up fees are available.
When banks are assessing whether to offer you a loan, they will look at the 'gearing'. Gearing is the ratio of debt to equity in a business. The equity is the money that you (and maybe family, friends and others) have invested in the business. Gearing is usually calculated as debt divided by capital employed - and capital employed is the sum of the debt and equity - expressed as a percentage. Increasing the debt in your business will increase your gearing, which, in turn, will increase the perceived risks associated with your business. Banks aim to ensure that the gearing does not exceed 50%, though will sometimes be persuaded to go much higher.
The banks are also likely to look at the 'interest cover'. This is a ratio of the net profit to the interest. Banks look for interest cover of at least two and ideally higher.
When looking for financing for your business there are a number of factors to take into account. These include what you need it for, as well as the size and type of your company. Assuming you don’t have a ready line of credit, an expansive bank manager, wealthy relatives or a substantial stash of retirement savings you’re willing to risk, you’re going to have to do some serious homework and legwork. Fortunately, there are a number of sources of finance for the fledgling small business entrepreneur, at least one of which may be right for you.
The primary consideration for government backed loans is repayment ability from the cashflow of the business as well as “good character, management capability, collateral and owner’s equity”. You will be expected to personally guarantee your loan. This means your personal assets are at risk.
As for the types of businesses eligible for government supported loans, the following criteria is normally used :
- the business must be “for-profit” (all that means is that your business has a profit motive, not that it has actually generated a profit yet),
- be engaged in business within the country,
- there must be “reasonable” owner equity (what’s reasonable will depend on the circumstances) and you are expected to use alternative financial resources first, including your own assets where practicable.
Governments also impose limitations on the use of loan proceeds. For example, although the proceeds can be used for most business purposes (the examples given include “the purchase of real estate to house the business operations; construction, renovation or leasehold improvements; acquisition of furniture, fixtures, machinery and equipment; purchase of inventory; and working capital”), you can’t use the loan proceeds for financing floor plan needs, to pay existing debt, to make payments to the business owners or to pay delinquent taxes etc.
As a general rule, loans for working capital must be repaid within seven years and loans for fixed assets must be paid for by the end of the economic life of the assets (but not to exceed 25 years). Interest rates are negotiated between the borrower and the lender.
It is rare for a small and medium size businesses to have a financial plan that is being monitored. Most financial plans are generated to obtain a bank loan and once that purpose is served the plan usually finds its way to the lower bottom draw of the owner’s desk to collect dust. The other day I had an occasion to check one of these plans out with a client whose business was in trouble and sure enough, most everything in the plan had been ignored. If only part of the plan had been followed and monitored the business would have been profitable and not in need of any outside help.
Usually when a financial plan or budget is first put together it is based on the business history, knowledge of the business and industry, and some valid assumptions about the business future. A flight plan is put together in much the same way, however as soon as the plane takes off and winds change, adjustments must be made in order for the plane to reach its destination. The same holds true for a financial plan. Once the business is put into operation, some things change either with the product or the marketplace, and adjustments must be made to achieve the profit objective. Therefore, a financial plan must be monitored to identify the variables as they present themselves.
In a business these variables usually present themselves when a Profit and Loss statement is compared to a financial plan. Unfortunately, since most small business owners do not value their financial plan there is no urgency to check it against a P&L statement that tells you what actually happened in the business for the particular period of the report. Since the plan is not being monitored it is very easy for the business to head off course and in the opposite direction of its profit objective.
Comparing each item in the Profit and Loss Statement (What is actually happening in a period) to the Financial Plan (What you want to happen) will identify the variables and help you identify where problem(s) exist in meeting your profit objectives. However, identifying the problem is only the first step in solving it. You must research further to find what is really causing the problem and then make the necessary adjustments. Various solutions should be considered before picking the best solution, and after implemented, the new solution should be monitored to see if it really solved the problem.
The importance of a Variance Report that compares a financial plan (budget) with a profit and loss statement cannot be overstated. These are two important management tools to control your business and reach your profit objectives. If you have a financial plan, start using it to control your business, and if you do not have one, create one, it could mean the difference between success and survival.
Angel investors are good souls with a healthy sense of self- interest. Figuring they can get a higher return if they’re prepared to take a bit of a risk, they’re also often successful entrepreneurs themselves and want to give their fellow travelers a hand up. Think of funding from an angel investor as a bridge or gap-filler between being a start-up and qualifying for venture capital. The kinds of dollars we’re talking about here are between about $150,000 and $1.5 million. Beyond that point you’re in low venture-capital territory.
One of the common concerns about venture capital financing, however, is that you may have to part with an unacceptable amount of control over your own business. In return for their risk, venture capital firms will usually want some control over how the business is run and a say in business decisions. A venture capitalist will expect a seat on the board, for example.
Do you already own a home business but need cash? Perhaps you can qualify for a small business loan.
However, before you attempt to borrow any money, you first have to figure out how much money you need. The easiest way to do this is by putting together a business plan. A good business plan is critical to your business success.
It can be a simple one page outline or it can be many pages, but it should spell out exactly how much money is needed and what it will be used for; your potential market and customers and potential for growth; what makes your business unique from others; and a rational and conservative projection of your business's cash flow.
Your plan will also help you set business goals and define the steps necessary to help you reach those goals. It is a guide for you to refer to on a regular basis to help evaluate your business progress and help keep you focused on your priorities.
Besides, a business plan is almost always required when applying for a bank loan. If you need assistance in writing a business plan, your local library should have several books on the subject. You can also try Amazon.com. In addition, you should be able to get help on writing a business plan from one or more of the sources listed below:
- The Small Business Administration (SBA) offers numerous loan programs to assist small businesses. It is important to note, however, that the SBA is primarily a guarantor of loans made by private and other institutions.
- The Service Corps of Retired Executives (SCORE) is a volunteer management assistance program of the SBA that provides one-on-one counseling, workshops, and seminars. SCORE has chapters throughout the country. Many work in conjunction with local Chambers of Commerce. SCORE and Visa have also joined forces to help home-based and small business owners.
- Talk to your local bank. Find out what they require for a business loan application and also if they are participants in the SBA loan programs. Be diligent and shop around for the best loan packages, and make sure you fully understand the terms.
- You may be able to borrow from insurance policies, IRAs, 401k's, stocks and securities, etc. Check with your insurance agent. Also, investigate what the policies are regarding borrowing from your mutual funds or retirement account. Before borrowing, make sure you fully understand the pay-back terms and any potential penalties.
- Apply for a home equity loan. Borrowing against the equity on your home is permitted in all states except Texas. Just make sure you're diligent about paying back the loan or you could end up losing your home.
- If you're a woman, you may be eligible for a Specialty Loan. These types of loans are now being offered by local banks. Who knows? Filling out a one-page application just might get you an unsecured credit line or loan ranging from $2500 to $50,000.
- Try borrowing from family members and / or relatives. If you have a good relationship with your family, perhaps you can make a persuasive argument for them to loan you money for your home business. Just remember, borrowing from family or relatives should not be treated any differently than borrowing from a bank. It's just as important to pay them back on time as well.
Business Financing Mistakes
If you start committing these business financing mistakes too often, you will greatly reduce any chance you have for longer term business success. The key is to understand the causes and significance of each so that you're in a position to make better decisions.
No Monthly Bookkeeping.
Regardless of the size of your business, inaccurate record keeping creates all sorts of issues relating to cash flow, planning, and business decision making. While everything has a cost, bookkeeping services are dirt cheap compared to most other costs a business will incur and once a bookkeeping process gets established, the cost usually goes down or becomes more cost effective as there is no wasted effort in recording all the business activity.
By itself, this one mistake tends to lead to all the others in one way or another and should be avoided at all costs.
No Projected Cash Flow.
No meaningful bookkeeping creates a lack of knowing where you've been. No projected cash flow creates a lack of knowing where you're going. Without keeping score, businesses tend to stray further and further away from their targets and wait for a crisis that forces a change in monthly spending habits.
Even if you have a projected cash flow, it needs to be realistic.
A certain level of conservatism needs to be present, or it will become meaningless in very short order.
Inadequate Working Capital
No amount of record keeping will help you if you don't have enough working capital to properly operate the business. That's why its important to accurately create a cash flow forecast before you even start up, acquire, or expand a business. Too often the working capital component is completely ignored with the primary focus going towards capital asset investments.
When this happens, the cash flow crunch is usually felt quickly as there is insufficient funds to properly manage through the normal sales cycle.
Poor Payment Management.
Unless you have meaningful working capital, forecasting, and bookkeeping in place, you're likely going to have cash management problems. The result is the need to stretch out and defer payments that have come due. This can be the very edge of the slippery slope.
If you do not find out what's causing the cash flow problem in the first place, stretching out payments may only help you dig a deeper hole.
The primary targets are government remittances, trade payables, and credit card payments.
Poor Credit Management
There can be severe credit consequences to deferring payments for both short periods of time and indefinite periods of time.
- First, late payments of credit cards are probably the most common ways in which both businesses and individuals destroy their credit.
- Second, NSF checks are also recorded through business credit reports and are another form of black mark.
- Third, if you put off a payment too long, a creditor could file a judgement against you further damaging your credit.
- Fourth, when you apply for future credit, being behind with government payments can result in an automatic turndown by many lenders.
Each time you apply for credit, credit inquiries are listed on your credit report.
This can cause two additional problems.
- First, multiple inquiries can reduce you overall credit rating or score.
- Second, lenders tend to be less willing to grant credit to a business that has a multitude of inquiries on its credit report.
If you do get into situations where you're short cash for a finite period of time, make sure you proactively discuss the situation with your creditors and negotiate repayment arrangements that you can both live with and that won't jeopardize your credit.
No Recorded Profitability
For startups, the most important thing you can do from a financing point of view is get profitable as fast as possible.
Most lenders must see at least one year of profitable financial statements before they will consider lending funds based on the strength of the business. Before short term profitability is demonstrated, business financing is based primary on personal credit and net worth.
For existing businesses, historical results need to show profitability to acquire additional capital. The measurement of this ability to repay is based on the net income recorded for the business by a third party accredited accountant.
In many cases, businesses work with their accountants to reduce business tax as much as possible but also destroy or restrict their ability to borrow in the process when the business net income is insufficient to service any additional debt.
No Financing Strategy
A proper financing strategy creates
- the financing required to support the present and future cash flows of the business,
- the debt repayment schedule that the cash flow can service, and
- the contingency funding necessary to address unplanned or unique business needs.
This sounds good in principle, but does not tend to be well practiced. It seems once everything else is figured out, then a business will try to locate financing.
There are many reasons for this including: entrepreneurs are more marketing oriented, people believe financing is easy to secure when they need it, the short term impact of putting off financial issues are not as immediate as other things, and so on. Regardless of the reason, the lack of a workable financing strategy is indeed a mistake.
However, a meaningful financing strategy is not likely to exist if one or more of the other mistakes are present. This reinforces the point that all mistakes listed are intertwined and when more than one is made, the effect of the negative result can become compounded.
There are a few basic finance terms that every small business owner should understand. They represent the core of understanding how business development works across all stages in the life of a venture, so it's important you understand their meaning. Here's a quick review of the terms you need to know:
- Return on investment (ROI): The only way to think about your business is with an ROI perspective. The entrepreneur has committed capital investment into a certain combination of assets, from which the company generates sales. Those sales cover the costs of operations and hopefully produce a profit. That profit, divided by the total funds invested in the company (the assets), equals the ROI to the entrepreneur. Think of it this way: Would you work all those hours and take on all that responsibility if your ROI was only 6 percent annually? The stronger the profit picture compared to the total funds employed in the enterprise, the higher the ROI.
- Internal rate of return (IRR): Every decision enacted by the entrepreneur must be viewed in terms of its internally generated return to the company. Unlike the simple division used to find the ROI, the IRR compares the net expected returns over the useful life of a project being reviewed by management to the funds spent on that decision (or project). All projects must meet a certain IRR in order to be acceptable for investment by the company. If a project cannot meet a minimum IRR, then don't invest in it.
- Fixed asset base: This is the long-term base of the company's operation strategy, represented by all the equipment, machinery, vehicles, facilities, IT infrastructure and long-term contracts the firm has invested in to conduct business. From a finance perspective, these assets are the revenue generators. When the entrepreneur decides to invest in a certain fixed asset configuration, that becomes the base from which the company functions week in and week out, doing business and servicing its customers.
- Working capital: Current assets are those short-term funds represented by cash in the bank, funds parked in near-term instruments earning interest, funds tied up in inventory, and all those accounts receivable waiting to be collected. Subtracting the company's current liabilities from these current assets shows how much working capital (your firm's truest measure of liquidity) is on hand and its ability to pay for decisions in the short-term. For example, if the firm has $500,000 in current assets and $350,000 in current liabilities, then $150,000 is free and clear as working capital, available for spending on new things as needed by the company.
- Cost of capital: This is the true cost of securing the funds that the business uses to pay for its asset base. Some funds are from debt (less risky to the creditors, so it has a lower cost of capital to the firm), and some funds come from equity (more risky to the investors, so these have a higher cost of capital). The combination of lower-cost debt capital with higher-cost equity capital produces the next item in this list.
- Weighted average (between debt and equity) cost of capital (WACC): This is the firm's true annual cost to obtain and hold onto the combination of debt and equity that pays for the fixed asset base. Every time the owners contemplate investing in a new project, the IRR for that project must be at least equal to the WACC of the funds used to do that project, otherwise it makes no sense taking on that new project, because its return cannot even cover the cost of the capital employed to make the project happen.
- Risk premium: Entrepreneurs must understand that every decision they consider has an inherent level of risk associated with it. If project A is far riskier than project B, there should be a clear risk premium that could accrue to the firm if project A is enacted. But with that risk premium return, there will also be a risk premium cost to the company for the use of the funds. Business owners always have to decide whether the risk premium of additional potential return is commensurate with the additional risk costs that come with doing that investment project.
- Systematic risk: Some risks facing the company are not unique to that business in that market, but are faced by all firms operating in the broader, general marketplace. These so-called "systematic" risks (such as changes in interest rate levels, the performance and direction of the economy or the availability of certain types of skilled labor) cannot be avoided.
- Nonsystematic risk: The risks that are entirely unique to your company, products, buyers, promotional programs, billing, pricing, IT system and so on are nonsystematic risks specific to your firm. Although there's little you can do to avoid or mitigate exposure to systematic risk, it is possible to use various diversification strategies to offset risks that are unique to your business. When working with risk premium, systematic risk and nonsystematic risk, the rule is that the expected return on the business operations will always be directly related to the amount of risk taken on: Lower risk decisions come with lower expected returns, and higher risk decisions come with higher expected returns.
- Option premium: A "call" is an option to buy something at a future date; a "put" is an option to sell something at a future date. On virtually every partnership contract, vendor deal, distributor arrangement, equipment lease or financing, personnel hire and investment decision, there will likely be some kind of option offered to one party by the other. Entrepreneurs must always place a dollar value on any option premium they offer or have offered to them in these various deals. The value of having an option to either buy or sell, agree or disagree, accept certain terms or let them expire, should always be determined prior to signing any deal or contract or term sheet, and that value should always be treated as a tangible benefit when negotiating decisions with parties inside and outside the firm.
A Great Business does not just happen
It is financed properly!
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