Overdrafts and bank loans are the most common form of external financing available to businesses. Used properly, they provide a simple and effective way of financing the growth of your business.
Using the right mix reduces the risks to your business and helps you minimise the cost of financing. You may be required to provide the bank with security.
1. The right finance
Decide how much of your financing should be in the form of borrowing
This will depend on:
- What your cost of capital is and what returns your business expects to achieve.
- How much cash flow you generate. Your debts will spiral out of control unless you generate the cash to pay the interest and repayments on loans and overdrafts.
- How risky your business is. High gearing (a high proportion of borrowing) is less appropriate if you cannot confidently predict future cash flow.
- What financial risk profile you want. If you (and other investors in your business) are prepared to accept higher risks in the expectation of higher returns, you will want higher gearing.
- How much security you can offer lenders. The amount of debt banks are prepared to offer you, and the interest rates they charge, will partly depend on how well secured the debt is.
Establish the most appropriate mix between overdraft facility and loans
- Match the type of borrowing to what you are using the financing for.
- Use an overdraft facility to finance cash flow fluctuations and to provide contingency financing. For example, to cover seasonal troughs in cash flow, long payment delays and to cope with sudden cash flow demands.
- Use loans to provide fixed-term financing. For example, to cover development and start-up losses, to buy fixed assets such as plant and equipment, and to fund the fixed portion of your working capital requirements.
Make sure you have enough finance
- Arrange all your financing at once and allow for unexpected cash flow shortfalls. Do not try to manage with less than you need in return for a lower interest rate.
- If you arrange too small an overdraft facility, and then exceed that limit, you will pay additional bank charges and higher interest rates. The bank may also bounce payments you make, damaging your credit with suppliers and leaving you short of working capital.
- If you run short of cash and then fail to make a payment on a loan, you will be technically ‘in default’. The bank may let you miss a payment, but may impose higher costs as a result. Alternatively, the bank may call in the loan and security.
2. Overdraft facilities
Overdrafts have two clear advantages
- An overdraft is a simple, flexible way of financing changing cash flow requirements.
- You pay interest only on the amount you are overdrawn each day.
There are also substantial disadvantages
- In most circumstances, the bank can demand repayment at any time.
- The overdraft has to be regularly renegotiated, depending on how long it is needed for. The bank will want to check your creditworthiness has not deteriorated.
The bank will charge you setting-up costs as well as interest
- You are usually charged an arrangement or commitment fee whenever you set up or renew an overdraft facility. A typical fee for a £5,000 facility might include a set up charge of £100.
- You pay interest at a fixed margin over base rate. 5-10% is typical. In general, the larger the facility and the better your credit score (see minimising costs), the lower the margin will be.
- You can try to negotiate a narrower margin. There is less room for negotiation on facilities of £100,000 or less.
- Large overdrafts may incur additional charges similar to loans.
- You will pay higher fees for an ‘informal’ overdraft (where you go overdrawn without agreeing it in advance with your bank) than you would for a pre-arranged, or ‘formal’, overdraft.
The effective interest you pay may be boosted by other charges
- Larger overdraft facilities may carry a non-utilisation fee on the amount of the facility you are not using. A typical charge is 1.5%.
- You may also have to pay for regular (typically quarterly) reviews.
The biggest advantage of a loan is the fact that you can bank on having the money
- Once you have arranged a loan, the financing is usually secure for the life of the loan (unless you fail to make payments or breach any other conditions).
- You can match the term of a loan to the life of an asset you want to purchase. For example, you can finance the purchase of a machine which will have a working life of five years using a five-year (or shorter) loan. By the time the machine is obsolete, the loan will have been paid off.
- You may be able to tailor a loan to match the cash flow of the project you are using the loan to finance.
- You can usually fix the loan interest rate.
The disadvantages of a loan may include a lack of flexibility
- You pay interest on the full amount of the outstanding loan.
- The bank often imposes legally binding covenants before agreeing to a loan. For example, it may insist you keep your overall gearing below a certain level. If you breach these conditions, the bank will be entitled to immediate repayment.
- You do not have access to the portion of a loan which you have repaid, unless you apply for a new loan.
- The bank will usually require a fixed charge or some other form of security.
The setting-up costs for a loan may be just as high as for an overdraft
- You are usually charged an initial arrangement or commitment fee. A typical fee might be 1.75% for a £30,000 loan, falling to 0.25% for a loan of £1 million or more.
- You might be required to take out insurance, such as key man cover.
- You may be charged for the bank’s other costs. For example, for an assessment of the value of the security you are offering or to manage exceptionally complicated loans.
As well as interest, you will have to pay other charges
- You usually pay a fixed margin over base rate for floating rate loans of less than £100,000. A margin of 1-3% is typical, depending on your credit score.
- For larger amounts, you can choose to negotiate a fixed rate loan. This makes it easier to budget for interest payments.
- If you want to repay a loan early, you may be charged a pre-payment fee. A typical charge is 1% plus a charge to compensate the bank for its interest costs.
You can control your exchange rate risks
- For example, if you expect to generate income in another currency you might borrow in the same currency.
You may be able to use sophisticated financing techniques
For larger loans (typically £1 million to £5 million or more) your choices may include:
- caps, which limit the interest rate you pay on a floating rate loan, no matter how much interest rates rise;
- floors, where you agree always to pay at least the floor rate of interest, no matter how much interest rates fall;
- collars, which combine a cap and a floor;
- swaps, which reduce your costs through advanced financial engineering.
Make sure you understand the costs, benefits and risks of any arrangement
- Seek independent, expert advice.
4. Minimising costs
Do what you can to improve your credit score
Most banks evaluate businesses using a process of credit-scoring. While each bank’s system is different, they tend to focus on:
- How good your security is.
- How low your gearing is and how strong your balance sheet is. Putting more share capital (or unsecured director’s loans) into the business may reduce the interest rate margin demanded by the bank.
- What your cash flow projections are. Your cash flow projections should be credible and should demonstrate that you can comfortably meet interest payments and loan repayments.
- Your past banking record. For example, whether there have been problems with previous loans or overdrafts (including your personal banking or other businesses you are associated with).
- Your business’ past financial performance.
- How professional your business plan is. This includes credible commercial plans, not just profit and cash flow forecasts.
- How expensive the financing will be for the bank to administer. It may be cheaper to consolidate all your borrowings with one bank.
Ask the bank to calculate and itemise the total cost of any overdraft or loan offer
- The total amount you will pay over the life of the financing provides a rough guide.
- For a loan, the total cost of interest and all charges can usually be expressed as an annual percentage rate (APR).
- These figures make it easier to compare different offers.
Negotiate for a lower interest rate and lower charges
- Shop around. A bank is usually more willing to improve its offer if you have other quotes.
- It is worth negotiating even if you have only received one offer of finance. Your negotiations are more likely to succeed if you have a good credit score or have a good relationship with your bank.
- Most banks will only provide a quote once you have completed a full application for finance and they have assessed its viability.
Build a relationship with your bank manager
- Provide periodic management and financial information. Notify the bank of any major business decisions.
- The bank will be more supportive if you need additional finance in the future.
5. Security for borrowings
A bank usually wants security to ensure that it is repaid if things go wrong. The bank puts a legal charge over your business or personal assets, which can be sold if you default.
Freehold or long-leasehold property is often the most valuable security you can provide
- A bank will usually lend up to about 50-80% of the value of a property. Specialist premises may be valued at less than you spent on them.
- For smaller businesses, taking a mortgage on personal property (and then lending the money to the business) can pay off.
- Mortgage rates are below business loan rates and there are no ongoing arrangement fees. Some mortgages have flexible repayment arrangements, reducing your risk of defaulting.
- Using personal finance to expand your business may be the best option if you would otherwise risk your house anyway.
A bank may lend up to 50-60% of the value of your outstanding debtors (sales invoices)
- The bank will check how likely the invoices are to be paid and how much it costs to collect the debts.
- A typical charge is 1% plus a charge to compensate the bank for its interest costs.
Equipment, stock and work in progress will only be valued at their resale price
- This is usually what they would fetch at auction.
- Specialised equipment which is difficult to sell, and equipment which becomes obsolete quickly, such as computers, provides little security.
Directors of limited companies are often asked to provide personal guarantees
- Giving a personal guarantee exposes you to serious financial risk, as your personal assets are at risk if the business fails.
- Ask to limit the scope of the guarantee. For example, the bank might agree to a guarantee which is less than the total amount of the loan or overdraft facility.
- Ask to limit the duration of the guarantee. For example, the bank might agree to release you from your guarantee after a set period of time, or once cash flow reaches an agreed target.
- You may want to renegotiate any guarantees whenever you take out a new loan or overdraft facility.
- You may be charged for any legal fees and negotiations.
- If any friends or relatives offer third-party guarantees, the same risks apply to them.
- Sole traders and partners are automatically liable for all the business debts.
You may want to offer other assets as security
- For example, you might consider life insurance policies, shares and other investments rather than giving a guarantee or putting a charge on your home.
- Alternatively, you may use these as security for a larger and less expensive personal loan and lend the money to the business.
Charges as security
Most bank loans are secured with a fixed charge
- You may be asked to sign a debenture agreement to provide the bank with a fixed charge.
- Typical fixed charges are over a property (for example, a mortgage on a house), fixed plant and machinery, or debtors.
Some debts may be covered by a floating charge
- The charge floats on some or all of a company’s assets, even though these assets come and go in the ordinary course of doing business. It can cover stock, work in progress, furniture and equipment, and also goodwill and other unspecified assets.
"Small businesses seem to be using overdrafts rather less than they did. This could be because they’re being asked for more stringent security guarantees, or are considering (often with bank encouragement) alternative forms of providing working capital, such as factoring or invoice discounting." - Richard Holloway, management consultant
"If you are a business with significant intangible assets — like strong brands or intellectual property — you may want to show their value on the balance sheet or your gearing may appear to be too high. Be aware that banks are likely to discount such assets unless you have a strong justification for their value." - Richard Holloway, management consultant