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Here at The Office, we pride ourselves in the provision of state-of-the-art shared spaces, meeting rooms, serviced offices and support services that make running your business a little easier. And we recently launched this blog to share answers to some of the most interesting business questions.
This week, we bring you the third installment of a five part series on business finance. It’s about debt financing as an external source of funding and continues from our last post on bootstrapping.
So what is debt financing?
Simply put, it means the injection of borrowed money into a business with the promise of paying back at a predetermined future date. Depending on the source of debt, the repayment may also include an agreed interest component and the pledge of collateral for the duration of the loan. However, once repayment is completed, the business has no further commitment to the lender and collateral pledged must be returned.
And what are these sources?
For small businesses at the start-up phase, the major external source of finance is family and friends. While being a one-time source, it is the cheapest form of leverage, usually requires no collateral and minimum agreements if any. And because of the personal relationship with the funding source, the appraisal is not always based on a convincing business plan or market realities. Rather, it is an investment in the business owner. It is important to note though, that the absence of drawn agreements and a defined repayment plan has resulted in lots of problems with family loans, especially during future refinancing stages of the business.
The second and most popular source of debt finance is a bank loan. For starters, banks are sustained by the income they make from the money they lend. They therefore require proof of capacity to repay the principal and in most cases, an interest component. They may also require the pledge of collateral as a second way out and are likely to base lending decisions on the proven character and integrity of the principal officers. As such, business history or realistic and provable financial projections are necessary. It is for these reasons that bank loans are very difficult to obtain during the start-up phase but get progressively easier as the business grows. But that’s not totally a bad thing. These demands serve to make businesses better by exposing details of feasibility, profitability and most importantly, cash flow; which ultimately determines if the business will succeed or not.
Another source of debt finance is private companies. These are usually unofficial, short term and high interest lenders that provide quick access to funds and do not demand some of the conditions provided by banks. They however require personal guarantees and are based on referrals from trusted existing or former customers.
So how do you decide on debt financing or the source to pick?
Any decision on debt finance must be based on what is to be financed, cash flow realities, interest rates offered and the availability of collateral. Loans from family and friends are usually finite and one-off. As such, they finance the early stages. They also allow extra cash to run the business by eliminating interest payments and the need for collateral.
Bank loans on the other hand are dependent on an appraisal of cash flow, prevailing interest rates, and collateral. Cash flow depends on terms of payments between you, your supplies and buyers. The most favourable terms of payment should allow you get supplies and pay later while also collecting money from your buyers in advance; the least, being a situation where you pay suppliers in advance and sell on credit. These situations will determine your capacity to make timely loan repayments and will affect the bank’s decision to lend. And even if these are satisfactory, an understanding of the part of the business to be financed is critical to the successful repayment of loans.
Care must be taken to understand the difference between financing for fixed assets/costs and variable ones. For example, a loan to construct a warehouse, factory or purchase furniture will not be the same as one to run daily activities such as shortfalls in fueling costs, or raw materials. While the former will finance a process during which the business does not generate any extra money, the latter can start being recouped from daily operations. The basic rule of thumb is to finance fixed costs with long term loans that allow moratoriums where possible, and finance variable costs with lines of credit. But other types of loans may even provide extra flexibility.
Okay, Okay! What is a moratorium? A moratorium is a period of time when loan repayments are suspended to allow for the construction or installation of an asset to be completed. In some cases, moratoriums are granted on principal only. For example, a loan of one million may, after six months, still have a principal component of a million while interest on the one million is charged each month. In other cases, both principal and interest are capitalized for the period of the moratorium. In this case, a loan of one million may, based on a six-month moratorium, start charging repayments on a principal component of say one million and one hundred thousand (principal of one million plus six month interest of one hundred thousand) in the seventh month.
A line of credit (e.g. an overdraft) is an amount that can be drawn on an account when it is unfunded, but attracts interest on only the specific amount used. For example, if a business with a line of credit of one million uses two hundred thousand in March, repays and then uses one hundred thousand in April, interest will only be charged on two hundred thousand in March and on one hundred thousand in April. Moratoriums and lines of credit allow for reduced burdens on repayment obligations while freeing cash to run the business.
Essentially, debt allows you retain full ownership of the business and schedule expenses based on a defined repayment plan, with the added benefit that the lender’s claim expires once the loan is fully repaid. The key is however to remember that it has to be repaid, with interest, may erode cash flow, the ability to grow and result in loss of assets pledged as collateral. But don’t fret! Even if these aren’t favourable to your business, other funding options exist and will be discussed in the next two posts. So just follow our social media page(s) and get notified.
For now, please share the ways you have used debt to fund your business so far?
Abubakar Abdullahi is Managing Principal at the The Front Office NG, where they help businesses, individuals and non-profits achieve sustainable growth through outsourcing and continuous improvement. He tweets @ab_bakr