| Introduction
Are you starting a new business? Or thinking about expanding your present operation? Perhaps you have just experienced the effects of a protracted drought? If that is so, you will probably find - unless you have a surplus of ready cash - that you will need to obtain some extra finance.
Extra finance could be required for a number of reasons: Maybe you are starting a new line and need new machinery or equipment; or you need to replace old machinery which has worn out; perhaps you need to purchase extra stock, buy land or cover extra credit sales; or maybe you just need to supplement your cash flow to keep you going during the sort of seasonal fluctuations that can bedevil this industry.
Whatever the reason (and there are many more than those that have been listed here), it is important for managers to know how to judge whether extra cash is needed and, if it is, how to raise it.
A couple of years ago you could have found financial institutions fighting each other for the right to lend you the money. Since then what began as the “US Sub-Prime Mortgage Problem” has become “The Global Credit Crisis”. Things will not be as easy as they were.
For the majority of small businesses, the most common source of additional finance is by way of borrowing, from trading banks, finance companies or other institutional lenders.
However, many business owners fail in their attempts to borrow money from these lenders, not because they are not credit-worthy but because their applications for loans are not clearly presented.
This article aims to assist you to prepare your application for finance, and while the emphasis is on borrowed finance, similar preparation is necessary should you consider seeking equity investment from an outside investor.
Types of Loan Finance
Before approaching any lender, you should be aware of the types of loan the lender makes available and the purposes for which the loans are made. Just as a consumer seeking a loan to purchase a home will approach those institutions dealing in mortgage finance, and when seeking a loan to buy a car will seek a personal loan (lease provider or hire purchase finance), so must you as a business owner/manager always seek the loan, and the lender, best suited to your needs.
Loan finance can be divided into three broad categories:
Short-term finance (usually under three years)
Medium-term finance (3-10 years
Long-term finance (10+ years)
Short-term loans
The most popular short-term loan is a trading bank overdraft. Overdrafts are usually issued for periods of less than 12-months and are intended to finance short-term needs such as:
Purchase of stock
Supplementary cash flow
Personal needs
However, many small businesses regard overdrafts as medium-term finance and use their overdrafts to finance the purchase of some items of equipment. This can be dangerous, because if a “credit squeeze” occurs (as has been the case recently), you may be asked to reduce your overdraft limit at quite short notice. While this does not often happen, when it does, it can create serious problems for any firm, which has used overdraft loans to finance medium-term to long-term assets.
Bridging loans are another form of short-term loan. Available from trading banks and finance companies, bridging are provided as an interim facility to cover a short-term finance gap; they are usually secured to land or buildings.
Some personal loans from trading banks or finance companies and certain hire purchase contracts are also short-term.
Medium-term loans
The main medium-term loans are trading bank term loans, fixed-term advances and facilities such as Commonwealth Development Bank (CDB) development loans. These loans are usually granted to finance the purchase of plant and equipment and are secured by the item being financed, often supported by other acceptable security. In today’s financial climate expect to be asked to provide a Director’s guarantee. Banks are being very cautious.
Some personal loans are also granted for the medium-term. Most hire purchase contracts for capital equipment can be regarded as medium-term finance.
Long-term loans
Long-term loans are not as readily available as short and medium-term loans. They are used for the purchase of land and buildings, and some items of plant and equipment, which have a long usable life. Generally, loans beyond 10-years would not be available from trading banks or finance companies. However, insurance companies, trustee companies, friendly societies and solicitor's trust funds are potential sources for long-term loans in the form of mortgages usually secured by a first charge on land and buildings.
Should you apply for a short-term, medium-term or long-term loan? To decide this, you should first give some careful thought to what you need the money for.
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Identifying your needs
There are a number of questions to be answered before you begin to think about loans:
Is additional finance really needed?
If it is, will sufficient profit be generated?
Could money be saved by better use of resources or by reducing waste, damage or misuse of material?
Are funds being tied up in excess stock?
Could cash flow be increased by selling under-utilised assets and leasing or hiring their replacements as required?
Are clients paying promptly, or is 30-days being stretched to 90 and beyond?
If you keep clients to the terms of their credit arrangements, could you release funds for other uses?
If additional finance is needed should you be considering avenues other than loans such as leasing, factoring or even looking for a partner to provide equity.
Will sufficient income be generated by the extra finance to service the borrowing and still provide you with a reasonable margin?
Once you have decided that you do in fact need to borrow money, you have to consider whether short-, medium- or long-term finance will be most suitable for your needs. This is not always obvious at first glance, as the following example will show.
Let's examine the case of Mike and Kay, partners in a small Dealership, whose business has quickly grown beyond their original expectations. To satisfy their rising demand and imporive efficiency they have to increase their workshop capacity by installing some additional machinery. They also have to increase their purchases of spare parts to attain the increased productivity level required. They check out the question of waste in their operation and find they cannot save money that way.
They do some calculations and figure that the machinery needed will cost $10,000 and the increased carrying cost of parts inventory will be $5,000 for the first 6-months of operation, a total cost of $15,000.
Further calculations show that they can afford to repay a $15,000 loan over 5-years from the increased profit generated by the additional workshop business. They therefore intend to apply to their local bank for a $15,000 loan over 5-years.
At this stage they discuss the matter with Newell, their accountant. "Not so fast!" is his admonition. He suggests that they look again at what their financial needs really are.
The $10,000 for machinery is a medium-term need to be repaid out of the increased profit generated by the machinery, but the $5,000 for parts is a short-term need to be repaid as the parts are converted into repaired product (and thus cash).
The partners should therefore split their loan application into two parts: One medium-term loan for the machinery and possibly an overdraft, or an increase in their present facility, to cover their increased carrying cost of spare parts inventory.
The important point is that they match the terms of the loan to the purpose for which the finance is being used.
Decide
To sum up, you have to decide:
Whether you need to borrow at all
Whether increased income will cover the cost of borrowing
If you do need a loan, how much it should be
When it is required
Whether you need short-, medium- or long-term finance, or a combination of any of these.
Having identified your needs and decided on the type of loan you are seeking, you now have to consider what information the potential lender will require.
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