Evaluating what best suits your business needs
If you are a business owner or manager then you will typically need cash to purchase stock, plant and equipment, repay the bank or shareholders, or fund losses if things aren’t going so well. Where this cash is sourced from can have a significant impact on the financial stability of your business and put the assets of the business at risk if not structured properly.
There are a number of options available for sourcing cash for your business. These include the reasonably common approach of leveraging the company’s balance sheet or your personal assets (such as your family home) to raise bank finance. There are also the less common alternatives of seeking equity investment or factoring specific assets of the business through the use of invoice finance.
There is also the frequently used option to release cash from your business’s trading cycle by turning over stock faster, requiring debtors to pay sooner and/or stretching out payments to creditors.
Each source has its pros and cons, and each carries business risk.
Talk with your bank
Talking to your bank manager is tough at the best of times but there’s real benefit in having a strong and established relationship with the person holding the purse strings. If your business is rocketing along and making a good annual profit with a strong positive cash flow, then raising debt finance is likely to be relatively straightforward.
If things aren’t going so well or your business is at an early stage of its growth cycle then the conversation may be a little trickier.
Banks are low risk lenders, offering fairly cheap interest rates and, in turn, expect a loan to be well secured and repaid in full and on time.
It’s unclear at present just what impact the new loan to value ratio (LVR) restrictions on bank funding will have on small businesses and their ability to raise finance. A significant number of owners raise seed and growth capital against the equity in their homes and LVR caps may limit their ability to do this.
The chances are that if your business needs to raise serious cash from the bank, then your business will need to be a proven performer and have access to a strong asset base to stand behind it. Either that or you are going to have to have a pretty good relationship with the person at the other end of the phone.
Find an investor
If the bank doesn’t come to the party or you’re looking at alternatives to raise debt finance, you may choose to issue new ‘preferred’ or ‘ordinary’ shares to raise capital.
Investors tend to be attracted to businesses that either pay a dividend or are in a high growth phase and are therefore likely to realise a significant capital gain over a reasonably short period of time.
By issuing ‘preferred’ shares you can retain control of the company’s operations by limiting voting rights. This does tend to come at a price, however, as you may be required to pay a higher coupon rate (or fixed dividend rate). Preferential shareholders also rank ahead of ordinary shareholders if the business runs into trouble and needs to be wound up.
Selling ‘ordinary’ shares comes with more strings attached and could lead to real difficulties down the line if appropriate shareholder arrangements aren’t put in place at the outset. If you’re thinking of taking on an equity investor (whether in a passive or active capacity), we would strongly recommend that you talk with us to ensure the consequences of such a move are clearly understood.
It’s also important to understand that introducing investors into your business raises a number of personal, as well as financial, considerations and should not be done lightly. Remember ‘if you lie down with dogs you’re sure to get up with fleas’.
Factor in a factor
Debt factoring is a quite common practice overseas (the UK and the US in particular) but doesn’t seem to hold as much appeal for New Zealand business owners.
Factoring is a transaction in which a business sells its accounts receivable to a factoring agent at a discount. The business gets cash quickly and doesn’t have to collect the debt. The factoring agent collects the debt and makes a profit by paying less cash than the face value of the invoice (typically around 90-95%).
Different factoring agents will have different policies and may prefer to purchase your entire debtor book, invoices relating to certain periods, amounts owing by specific customers or even a single invoice. They will generally seek to take a specific security interest (registered on the Personal Property Securities Register) over the invoices to be purchased and collected or, if available, a general security interest over all the assets and undertakings of your business.
Care should be taken here as entering into an agreement that grants a security interest will usually be an event requiring consent of your bank. Banks and other finance providers may also view factoring arrangements as a sign of financial stress on your business. This will, however, ultimately depend on the circumstances and the reasons for seeking finance in the first place.
In reality, running a successful business is all about managing cash flow and a factoring arrangement can help to speed up your cash conversion cycle by reducing the length of time that your working capital is tied up in the production and sales process before being converted to cash through collected sales. This in turn can help provide the short-term funding required for business growth.
Where businesses tend to get into trouble is where factoring arrangements are used to collect revenue early and repay overdue accounts; this can contribute to a downward spiral. If the basic fundamentals of earn more than you spend are not supported, then factoring is not going to be a
viable long term solution. It will only delay the inevitable.
Work the business harder
As an alternative to debt factoring, you may wish to focus on your business’s internal efficiencies to ease the working capital requirement.
As a simple example, if your business needs $300,000 of working capital to fund $1 million of sales this could potentially cost you $45,000/year in interest (applying a 15% bank overdraft interest rate).
This cost may be significantly reduced by focussing on your business’s cash conversion cycle. Gains can be achieved by increasing stock turnover and reducing the total amount held on the balance sheet, negotiating more favourable terms with suppliers and/or proactively chasing debtors to reduce payment timeframes.
Using the earlier example, if you were to achieve a 20% efficiency gain then it could theoretically reduce your external borrowing requirement by $60,000 and save $9,000/year in interest costs. This could also ease pressure on funding limits and help improve your working relationship with the bank.
Your customers and suppliers are your cheapest source of finance and shouldn’t be underestimated as a way of freeing up short term working capital. You don’t want to push them too far, however, and finding the right commercial balance between getting what you want on the trade side and keeping your customers and suppliers happy is crucial. As the old saying goes ’a business with no customers is no business at all’.
The right funding for the right purpose
Ultimately, there are a number of ways in which your business can source funding. Critical to the success of any arrangement is your ability to access the right funding source for the right purpose.
It doesn’t make a lot of sense, for example, to draw down a fixed two year term loan to provide bridging finance for a short term working capital requirement. You should also avoid using an expensive bank overdraft facility to purchase long term, income generating assets such as machinery, plant or other equipment.
If you are unsure about which type of funding best suits your business requirements, do talk to your business advisors. Your bank manager or accountant should be able to assess and advise you on the most efficient source of funding to use. And also remember to talk to us about the best way to structure the arrangements to minimise your downside risk. Better yet, talk to all three at the same time.