Getting the most out of debt finance

As long as your business can service the level of debt and has enough security to support the funding, debt finance can be a viable way to fund business operations.

You will benefit by retaining ownership in respect of the growth and profitability of the business. Why give it away if you can afford not to?

There have been many businesses that have benefited from the use of debt financing as it has enabled them to grow, arguably, more than what they might have without it.

Consider one of my clients, who operates a business from an office warehouse that he used to lease for an annual rental amount of $66,000. The lease agreement had annual four per cent rent increases built in, which was a benefit to the landlord who was not only receiving more rent each year, but was also increasing the value of his property given commercial value is generally based on yield (or the percentage return on investment). In the first couple of years, it suited my client to rent given his personal circumstances, and the rent expense was fully tax deductible.

After a couple of years, he decided to buy the property he was renting as it suited his business requirements and had potential for some expansion. He successfully acquired the property for $1.35 million at a rate of 3.8 per cent, which meant his interest cost on the full loan amount was $51,300 per annum ($14,700 less than his rental payments). Beyond the annual cost savings, a secondary benefit was that he now had an asset that was increasing in capital value year on year.

As you can see, taking on the debt of the mortgage was a sensible business decision.

If you decide that debt financing is your best option then it is important to review a range of finance products from different lenders, as there are many options out there in today’s market and you need to find the best option for your needs.

Not only are there various lenders, there are also various finance types, such as a bank overdraft, line of credit, credit card, cash flow lending, debtor finance, fully drawn advance, mortgage loan, interest only loan, lease and hire purchase and chattel mortgage, just to name a few.

The important thing here is to make sure you match the type of finance with the reason for the finance. That is, you want to match the term of the loan with the life of the asset you are funding.

Let’s look at an example.

You need to upgrade the motor vehicle you use for your business, be it your ute, van or truck. Having made the decision to purchase the vehicle, the next decision is how you will pay for it. Let’s assume paying it all up front is not an option, so you need to finance. Your options include a hire purchase agreement, a chattel mortgage, a line of credit or a personal loan.

Motor vehicles have an effective business life. In an ideal scenario, you would want to use that vehicle for a period of time where you are receiving the maximum benefit, both operationally and financially. Typically, that period is between three and seven years, depending on the type of vehicle, the kilometres you will drive and how it will be used (will you be carrying building materials in it or a regular basis or not?).

The most popular finance options for vehicles are hire purchase agreements and chattel mortgages. They are both taken out for a defined period of time (in years) and have the option of a balloon payment at the end of the period, meaning an amount you need to pay to buy it outright and pay back the finance. The balloon payment can be anywhere from zero to 50 per cent, depending on the length of the finance period and how the vehicle will be used. As a general rule, the shorter the period, the higher the balloon. The more the vehicle is driven, the lower the value of the vehicle and hence the lower the balloon.

The fundamental difference between a hire purchase and a chattel mortgage is that with the hire purchase you do not legally own the vehicle until the finance is paid out, whereas with the chattel mortgage you own the vehicle from day one. Other than that distinction, they both have very similar attributes from a financial perspective.

A line of credit, which is used solely for tax deductible business costs, could be a cheaper option as the interest rates are generally lower. If you have a line of credit already in place, it has the added advantage of no extra application process or fees. If the line of credit is not in the name of business, then you will need to apportion costs and allocate accordingly. For example, you may have a line of credit for an investment in another entity name, such as a trust, and the vehicle you are acquiring is for the business in the trading company. Therefore, you need to work out the amount of interest apportioned to the vehicle and account for that in the business company accounts so you get the full benefit of the tax deduction. This option is not ideal from the point of matching the finance to the asset and has the added complexity of one loan applying to various entities. While the line of credit is an option, from a trading business perspective it is generally used to manage working capital, not for motor vehicle purchases, as it is available on a long-term basis and generally secured against your property.

The other finance option for the vehicle is a personal loan. I would suggest this as a last resort due to the higher interest rates that are attached to such loans. It is very unlikely you would be in a position to have to use such a facility and I would not recommend it, other than in extreme circumstances.

In summary, this example shows that a hire purchase or chattel mortgage fits best, as its purpose is solely for the vehicle.

When dealing with banks and other lenders, you need to understand that they tend to be a little conservative regarding your business potential, especially when compared to your own thoughts. Of course, you know how well your business will perform with some additional funds; however, the banks need a little more persuasion and then there is that frustrating issue of red tape that they may force you to try and break through to get anything achieved.

What are banks looking for? Your bank wants to know as much about you and your business as possible so they can assess whether you are suitable for a loan. Some of the things the bank will want to see include:

  • A description of your business, including and a brief history and where you are now.
  • Your personal financial information, including personal assets and existing loans.
  • Historical business financial information, including your profit and loss reports, balance sheets and tax returns (likely for a minimum of two years).
  • Projected financial information, including cash flow forecasts and/or business plans.
  • Details of what you require the loan for and why.
  • If you have business partners, their personal information.

Providing all the above information in a complete and timely manner is the first step to showing the bank that you are well prepared and on top of your finances.

The bank will review this information to establish whether you will be able to support the loan with the required level of security, and service the loan with the required level of profits and cash flow. Therefore, the stronger your application, the more likely the bank will approve the loan. Keep in mind that your historical information is just that – historical – so you cannot do much there. Your cash flow forecast and business plan, on the other hand, are where you can really make a difference.

Finally, remember that numbers are just one aspect – don’t forget the words that should go with them to demonstrate that you know exactly what is required and where you are headed. The level of confidence you have in your business and yourself will help increase the level of confidence the bank has in you and your business.

If you are faced with your loan application being denied, rather than getting angry, turn your energy towards finding out why. The better informed you are regarding this, the better prepared you will be to either seek alternative funding or review your strategy and prepare for when you are ready to make your next application.

Armed with this information, you could approach other lenders that may wish to deal with you, as their offering may be better aligned to your requirements.

You need to make sure you exhaust all options before giving up on the loan. I have had a number of clients who have not been successful on the first attempt, but then secured the loan they wanted from another lender. There are many lenders in the market and you should keep your options open. Start with the ‘Big 4’ banks and, if not successful, approach the second-tier financial institutions. There is an option is almost every situation.

Another alternative is to review your loan requirements and establish whether you may be able to reduce the funding amount required to achieve your goals. While this is not ideal, you may find that a lower funding amount may allow you to work towards your ultimate goal as servicing the loan is more manageable. Again, it will come down to your specific circumstances and requirements.

Assuming you do successfully get funding, you can be assured that your bank will require you to undergo reviews. At a minimum, this would be annually and, depending on the level of funding and your business situation, it could be as regularly as quarterly. Being well prepared for these reviews will show the bank that you understand their requirements and demonstrates that you have good internal management practices.

Keeping the lines of communication open with your banker will ensure they are ready to respond to any request you may have. The more you give, the more they do. If you do not provide information and respond to requests, then they will feel that there might be a problem with your business and will therefore become guarded and reserved in future dealings.

If you need any assistance with any finance requirements it would like to simply bounce some ideas off us, please do not hesitate in getting in touch.

You will see the impact these changes have on your profit margin, your asset turnover and ultimately your return on assets.

Now you’re starting to really see where your business is financially and what you need to do to get you to where you want to be.

Are you in need of finance or funding to help grow your business? Do you clearly understand the cost of money? Contact us for a free 30 min strategy consultation. Click here to get started

Let us review your business and funding requirements to help you grow your business and achieve your business goals – big and small.

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Tony Dimitriadis
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