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  • 6. PRINCIPLES OF FINANCE 6.1 About this Booklet Businesses are increasingly faced with a myriad of products and services available from financial institutions. Products and services have become more sophisticated and have greatly increased in number, making the right choices more difficult than they used to be. Also, banks today offer a great deal more than conventional finance. Many of their other products and services, if wisely selected and used, can greatly enhance your business through cost, time and productivity improvements. This booklet is aimed at helping you to select the products and services most suited to the individual requirements of your business, and to make the bank’s products work for your business. The booklet has a strong focus on the financial needs of the business, the sources of finance and how to establish the most appropriate financial mix for your business. Reference is also made to other products and services beneficial to businesses. These include electronic products, international services, insurance and assurance services. Booklets to read with this one: - Considering your own business - Your business and your bank - The business plan - Key issues in small business management - Tax and the small business - International trade 6.2 Financing your business Both businesses in the start-up phase and existing businesses that want to grow need to fund their business operations. However, before doing anything else they have to consider the following: - According to the business plan, what assets will have to be financed? - What is the appropriate term for the financing of these assets? - How can the cash be raised to finance these assets? - What is the most appropriate mix of finances? The answers to these questions will be covered in the pages that follow.
  • 2 6.3 Getting the term of the finance right It is essential that you match the term of the finance to the purpose for which it is to be used. For example, you cannot hope to finance long-term plans on a bank overdraft, which is a facility designed to cope with short-term financial needs. SMALL BUSINESS FINANCING Items financed Appropriate Term of Finance Type of product • Debtors Short term working capital Cheque overdraft • Stock (Less than 1 year) • Work in progress • Creditors Short term working capital Negotiate suitable terms (Less than 1 year) once you have established a track record • Vehicles and Medium term finance Asset finance equipment (Typically 1-5 years) • Installment sale • Plant and • Lease machinery • Sale and • Setting up a leaseback business or a • Rental franchise Medium term Loan • Renovation of premises • Land and buildings Long-term Commercial property (Typically 5 – 20 years) finance As a rule of thumb, the term of finance should match the useful life of the asset to be financed. That is, if an asset has a life expectancy of five years, the asset should be financed over a five-year term or shorter if possible. The table above lists assets that typically have to be financed by a business as well as the most appropriate term over which such assets should be financed. 6.4 Sources of finance Once you have established the short-, medium- and long-term financial needs of your business, you have to consider where you will find the money to take care of these needs. In broad terms, there are two major sources of finance available to a business: - Internal sources (financing the needs of the business from its cash flow) - External sources. One source of external finance is to take up debt (borrowing). Another is equity, i.e. the existing owners contribute capital to the business or they bring in outsiders to invest in the business. 6.5 Internal finance Before considering external sources of finance, you should consider how much cash you can squeeze out of your business. Even if you decide to use external sources of finance instead, you should, before you inject more money into the business, find out whether there is any unnecessary drainage on the cash flow of your business. You would not want the ‘top-up’ funds to leak away as well, would you? Many profitable businesses fail simply because they run out of cash and are therefore unable to meet their obligations.
  • 3 Cash flow is a function of the variables of cash (or bank overdraft), debtors, creditors and stock. The basic principle in improving cash flow is to slow down the cash flows leaving the business and to accelerate the cash flows entering the business. Much depends on the timing of cash flows - a business prefers to receive a cash inflow earlier rather than later and to allow a cash outflow later rather than earlier. How do you squeeze more cash out of your business? Below are some tips to improve the cash flow of your business. They will enable you to minimise the need for external financing: - Accelerate collections from debtors (your customers). You always have to reconcile the costs associated with funding credit to customers with the sales lost because of a stringent credit policy. Offer early settlement discounts, but carefully consider the cost of the discount and how it will impact on your gross profit. Improve collection on overdue accounts and reduce bad debts. - Bill your customers promptly. Invoice the same day the goods are shipped. - Accelerate the deposit of cheques and cash. Make deposits daily. - On major projects, ask the customer for a deposit/upfront payment and/or progress payments on completion of distinct phases of the project. - Negotiate extended credit terms with your creditors (suppliers). The ideal situation is to buy stock, to sell it and be paid for it before you have to settle your account with the supplier. The strength of your relationships with your suppliers will often determine their willingness to offer you credit - Minimise the money tied up in stock. Improve stockturn. Be wary of slow-moving stock. Departmentalise accounting so that slow-moving stock is easily identified. Have a sale to get rid of outdated and slow-moving stock. Keep a close eye on pilferage. Examine your reorder system and don’t hold more stock than is necessary. Distinguish gross profit margins on different stock items. If possible, reduce the number of lines you carry. Accelerate work-in-progress. - Finance assets over the correct term. For example, financing major machinery by means of an overdraft will put severe strain on your cash flow. - Create a cash windfall by selling unproductive assets, e.g. equipment that has fallen into disuse. Or lease out under-utilised assets, e.g. office space. Always remember that the objective of working capital management (cash, stock, debtors and creditors) is to have the right amount of cash available at the right time, that is, when the obligation to pay arises. This will minimise the dependence on outside sources of finance to fund the day-to-day requirements of the business. Moreover, it will ensure that every cent in the business is used as productively as possible. 6.6 External finance: making debt Debt finance can cater for the short-, medium- and long-term funding requirements of a business. Providers of debt finance risk the money they lend and often require that the entrepreneur risk some of his or her own money (‘own contribution’) and that he or she should provide collateral to secure the loan. 6.6.1 Short-term sources of debt finance The most common sources of short-term borrowing are:
  • 4 Bank overdraft A bank overdraft is a facility that allows the business to make payments beyond the amount of money in the cheque account of the business. The intention of a bank overdraft is to bridge the gap between cash inflows and cash outflows. It funds the business through its working capital cycle. Note: The utilisation of an overdraft should fluctuate depending on the stage of the working capital cycle. Typically, an overdraft should increase as the month goes by and be repaid when sales are made. An overdraft should not be permanently utilised or be allowed to develop a hard-core element which means that it never goes into credit. Overdrafts have specified limits that are normally reviewed and agreed to annually. They provide an immediate source of available working capital. The rate of interest is negotiable and is linked to the prime rate. The rate of interest depends on the borrower’s risk profile. Interest is calculated on the daily outstanding balance, which means that you only pay interest on the portion of the overdraft utilised at any particular time. This allows you to restrict interest payable to the minimum. Unlike other sources of finance a bank overdraft is repayable on demand. A bank overdraft is a flexible source of short-term finance and if used correctly it may be very cost-effective. Debtor finance Debtor finance consists of factoring and invoice discounting. Unlike the bank overdraft, debtor finance is strictly speaking not borrowing, i.e. it is not a loan secured by the book debts of the business. Instead, it involves the sale of debtors to a debtor finance company. Invoice discounting is the sale of existing debtors and future credit sales to a debtor finance company. It provides a cash injection to the business by releasing the working capital tied up in the debtors book. Credit sales are turned into ‘cash’ sales. Invoice discounting is confidential, that is, debtors are not advised of the arrangement between the business and the debtor finance company. Factoring is the same as invoice discounting, but goes one step further. In addition to turning credit sales into working capital, factoring also introduces a debtor administration and control function. Unlike invoice discounting, factoring is a disclosed service and debtors are therefore aware of the involvement of a debtor finance company. The specialist expertise of debtor finance companies enables them to place a much higher value on debtors than their banking colleagues. This source of short-term finance is therefore particularly suitable to rapidly expanding businesses that have outgrown their bank overdraft facilities. The debtor finance company will allow you to draw 70 per cent to 80 per cent of the money owed to you by existing debtors immediately (or later if you wish), with the balance becoming available once the debtors have settled their accounts. Typically, you will be charged one per cent above the prime rate on the money actually drawn or utilised. In addition, an administration fee is also normally levied. Bad debts will be for your own account.
  • 5 Not all businesses qualify for debtor finance. Typically, you will have to satisfy the following criteria: - The debt to be factored must be in the name of business entities, not individuals. - The business should primarily be involved in manufacturing and distribution. - Your business must have a high calibre of management a track record of success, good growth prospects and profitability, and first-class debtors. - Your business must not be too small. Debtor finance companies commonly only work with established businesses whose sales amount to more than a specified minimum turnover. Debtor finance is available from all the major banking groups and offers a flexible and continuous source of short-term finance that is directly linked to growth in sales. Credit card finance You may not consider credit and garage cards major sources of short-term finance, but they can help your business to limit the demands on its cash flow. They also improve administration of expenses and offer great convenience. Balances on cards have to be settled within 25 days of a statement being issued, allowing for interest-free finance of up to 55 days. 6.6.2 Medium-term sources of debt finance Typical sources of medium-term borrowing are asset finance and medium- term loans. Asset finance Asset finance is used to purchase movable assets, typically new and used vehicles and equipment. The most common types of asset finance are instalment sale, lease and rental. Asset finance allows you to acquire the use of an asset without having to outlay the full purchase price. It is particularly useful where a business expects to make profitable use of the asset immediately. A deposit may be required, with the balance owing being repaid in monthly, quarterly, half-yearly or annual instalments. The deposit required may vary depending on the asset being bought, the age of the asset and the credit rating of the borrower. For example, an item of specialised machinery not likely to be sold easily in the event of a liquidation would require a larger deposit than a machine which is in everyday use in many factories around the country. The term of finance is usually negotiable up to a maximum period of 60 months. A variable rate that fluctuates with prime is normally charged.
  • 6 Note that both the size of the deposit and the maximum term may vary according to the legislative requirements at the time of the transaction. Residuals, often referred to as balloon payments, are available on installment sale, leases and rentals, and require some explanation. A residual is a facility made available to the borrower which results in a portion of the capital of the asset not being paid off during the term of the agreement. Instead, there is a lump-sum payment (‘end or final payment') to make at the end of the agreement The residual, commonly expressed as a percentage, has the effect of lowering monthly installments, but interest remains payable on the full outstanding amount including the residual amount. Residuals should be considered carefully, as a large obligation to pay arises at the end of the agreement. Unless the market value of the asset at least equals the outstanding residual amount a shortfall may result. Residual percentages should therefore not be too large and should not be used for assets with a short lifespan. The various forms of asset finance are discussed in the paragraphs that follow with particular reference to the issues of ownership of assets, VAT and tax treatment. Instalment sale - Ownership of the assets being acquired vests in the bank until the final payment when full ownership passes to the borrower. - VAT is payable on the full purchase price at the beginning of the agreement with possible input credits that may be claimed, provided that the vendor is in possession of the required tax invoice. - Tax treatment - Subject to the assets being used in the production of income, the borrower is permitted to claim depreciation on the assets and the interest payable is allowed as a tax-deductible expense. Lease - Ownership - Lease differs from instalment sale in that the ownership of the asset does not pass to the lessee (the business paying for the use of the asset) at the end of the term of the lease. Upon expiry of the lease, the asset is returned to the lessor (the bank which owns the asset). However, the lessee may opt to purchase the asset or refinance it for a further period, subject to the contractual terms and conditions and negotiation with the bank. - Assets that are only required for a specific time period or assets that are expected to have no or little value at the end of the finance term should rather be leased than bought. - VAT - As with the instalment sale, Value Added Tax (VAT) is payable on the full purchase price at the beginning of the agreement with possible input credits that may be claimed. There are no VAT implications at the end of the lease except if the lessee acquires the asset for a further consideration. In this event, a tax invoice will be issued by the bank (on request) which the lessee may use for the purposes of obtaining an Input credit. - Tax treatment - Tax benefits allowed are based on the lease payments plus operating costs, provided that accurate records have been kept.
  • 7 An important difference between instalment sale and lease is that lease payments are made against income (profit) before tax, whereas instalment sale payments (the capital portion) are made out of after tax income. There are also tax implications should the lessee opt to acquire the asset upon expiry of the lease. Irrespective of the acquisition cost (which may be nominal), the deemed book value of the asset must be added to income for tax purposes. The reason for this treatment is that the full value of the asset and interest have already been claimed for tax purposes over the term of the lease. - Full maintenance lease - With full maintenance lease (FML), also referred to as full maintenance operating lease (FMOL), the expected cost of the maintenance of the asset is added to the lease at the outset and the lessee does not have to pay for maintenance. - Sale and leaseback - A business may require a capital injection, perhaps due to rapid growth. If there are assets that are fully paid for (‘unencumbered’), the business may negotiate with the bank to enter into a sale and leaseback agreement. The business sells the asset to the bank which in turn grants the business the right to use the asset. The term of the lease and what happens to the asset once the lease expires are negotiable. Rental - Ownership - As with the lease, the ownership of the asset does not pass to the renter (the business paying for the use of the asset) at the end of the term. End-of-term options are negotiable and include handing the asset back to the bank, refinancing the asset under a new agreement or buying the asset outright. - VAT and tax treatment - VAT is payable on each rental payment with possible input credits that may be claimed. The tax implications of lease and rental agreements are similar.
  • 8 Asset finance in summary The ownership, VAT and tax aspects of the three types of asset finance are summarised below. Content Instalment sale Lease Rental Vests in the bank Vests in the bank. Vests in the until final Upon expiry of the bank, as with payment, when lease, the asset is lease ownership passes returned to the agreements. Ownership to the client. bank. However, the client may End-of-term negotiate to buy the options are asset or to identical to refinance it. leases, i.e. return the asset buy it or refinance it. Payable on the As with installment Calculated and full purchase price sale, payable on payable on each VAT at the beginning the full purchase rental payment. of the agreement. price at the beginning of the agreement. Subject to the Lease payments As with leases, assets being used are allowed in full rental payments in the production as claims against are allowed in of income, pre-tax income, i.e. full as claims depreciation and they reduce the against pre-tax interest payable level of taxable income, i.e. they are allowed as income and reduce the level tax-deductible therefore tax. of taxable expenses, i.e. income and Tax they reduce the therefore tax. level of income on which tax will become payable. In contrast the capital portion of the repayment is made from after- tax income Medium-term loan A term loan is a finance facility granted for a fixed term of up to five years, and in some cases up to seven years, with a structured repayment pattern. Term loans are typically used when asset finance may not be suitable.
  • 9 Some of the uses of term loans are to finance: - the improvement or renovation of premises - the acquisition of a going concern or, an existing franchise business - the setting up of a business or franchise - large projects undertaken by an existing business - plant and heavy machinery that may fall outside the scope of normal asset finance facilities. Interest rates charged are usually variable and linked to the prime rate. Installments may be paid monthly, bimonthly, quarterly, half-yearly or annually. The term loan facility is continuously being enhanced and new innovative features are being added. Some of the recent additions include a drawdown facility, and access facility and a capital moratorium facility. The drawdown facility allows the borrower to take up the loan by way of a number of drawings over a set maximum period, say six months. Capital only becomes payable once the full amount of the loan has been taken up. The access facility allows the borrower to withdraw advance payments made on the term loan. This allows the borrower to access deposits to the term loan, that are over and above the agreed-to instalments. In some instances, the bank might agree to a capital moratorium being granted for a limited period. Such a moratorium will result in the borrower servicing only the interest on a loan for a set period, after which the repayment of capital will resume. Often repayments may also be structured to escalate over time. Initially, the capital repayments are low, but they are stepped up later when the purpose to which the loan has been put is generating sufficient income to meet the escalated payments. 6.6.3 Long-term sources of debt finance Common sources of long-term finance are: Commercial and industrial property loans A commercial and industrial property loan is a mortgage bond that may be used to finance business property. It may be applied to finance the acquisition of existing property or to develop new or existing property. Commercial and industrial property loans can be raised against the value of the property offered as security. Typically, it is possible to raise a commercial and industrial property loan amounting to 75 per cent of the valuation of the property for commercial and industrial properties. Usually such loans are repayable over periods of up to 20 years.
  • 10 Like residential mortgage bonds, commercial and industrial property loans are becoming increasingly innovative and flexible. Today, these loans offer an opportunity for tax-efficient saving by allowing the business borrower to make advance payments with the ability to access these excess payments later. Early settlement of the loan is also permitted without penalty. Participation mortgage bonds A participation mortgage bond provides the business with medium- to long- term finance to buy or build commercial and industrial property. The minimum loan is usually about R250 000, with the minimum repayment term being five years, with a maximum of 15 to 20 years. Under certain circumstances, there may be a capital moratorium, offering considerable cash flow advantages, for the first five years of the loan. In this case, only interest will be payable during this period. In terms of the Participation Bonds Act, loans may not exceed 75 per cent of the valuation of the property. The interest rate fluctuates with market trends and is indirectly linked to the prime overdraft rate. Historically, the interest rate has remained below the prime overdraft rate. 6.6.4 Collateral as a requirement for debt finance The provision of collateral is a common requirement to be satisfied for obtaining debt finance. This section takes a broad view and is aimed at enhancing your understanding of how financiers view collateral and what they accept as security for debt finance. What is collateral? What can you provide the bank as security for your loan. Do you have investments, policies or some value in you house over and above your mortgage loan? Should your business not succeed the bank can then realise the security to settle your loan account. Why is collateral required? The reason for taking collateral is two-fold: - To lessen the risk to the financier by providing a form of insurance against possible unforeseen events which could result in the borrower being unable to repay borrowings from other sources. - To ensure a greater commitment by the borrower to meet his obligations to the financier. Remember collateral can never be a substitute for the repayment ability of the borrower. Unless the business is able to service the debt a loan will not be granted, even if ample collateral is available. How is collateral assessed? A financier will usually consider collateral to be good if it satisfies the following criteria:
  • 11 - It must be stable and constant in value - It must be easy to realise or sell, that is, a reasonable market demand must exist for it - It must be valid in law, i.e. not subject to dispute - It must not depreciate rapidly. With some forms of security (e.g. listed shares), fluctuations might occur, but in such cases the financier would maintain a safe margin. Consequently, the security value provided would be less than the present market value. In most cases, the security value of the collateral will be less than the realistic market value. The reason for this treatment is threefold: - once finance charges are taken into account the settlement value of the loan may exceed the market value, - the market value of most assets is subject to some fluctuation and the financier must protect his or her interest by allowing a safety margin, - the value of assets is usually less in a forced sale situation. What constitutes collateral? Exactly what kind of collateral is acceptable to the bank and what security value is attached to such collateral will depend on the type of finance or loan selected and the policies and preferences of the institution providing such finance. Common sources of collateral are listed below, but note that they are not all rated equally: - Personal suretyships. This is where an individual undertakes to make good a specific loan if the borrower (the business) does not repay it when called upon to do so. - First or subsequent covering mortgage bonds over property. Usually first covering mortgage bonds are registered when property is acquired, but if the property has been paid for, subsequent covering bonds may be registered over the property as security for further loans. - Notarial bonds. This bond is by nature a covering bond and is registered over the movable assets of a business in order to secure a loan. This form of collateral is usually not favoured by financiers for normal borrowings. - Cession of investments. These investments may include, amongst others, listed shares, bank deposits and investments, and unit trusts. - Pledge of Kruger Rand coins, jewellery, paintings and other valuables. - Cession of assurance policies. Financiers are usually prepared to accept cession of policies, to the extent of the surrender value, as collateral to secure borrowings. - Cession of debtors. This means that if the business defaults on the loan, the debtors will be instructed to pay the financier instead. As a general rule, banks attach a low security value to debtors.
  • 12 6.7 External finance: equity Equity refers to the capital invested by the owners in the business. It remains a primary source of finance, particularly in starting a business. It can take four forms: - The capital invested by the owner(s) in the business - Loans made by the owner(s) to the business - The capital invested by outsiders, which in effect makes them co-owners - In the case of an existing business, retained earnings (reinvestment of the profits the business makes). 6.7.1 Own capital Always remember that you are more likely to attract financial backing from parties external to your business if you make an adequate financial contribution yourself. How can you expect other people to risk their money in your business when you, the ultimate beneficiary of its success, are unwilling to do so yourself? Your own contribution is viewed as a sign of your commitment to make the business work and will reduce the perceived risk to outsiders who may want to back you financially. When applying for loan finance from financial institutions you will find that an own contribution is an essential requirement for the loan to be granted. Generally, the more risky the purpose to which the finance will be applied, the higher the own contribution required. 6.7.2 Owners' loans Owners’ loans, often referred to as shareholder’s loans, refer to medium- to long-term loans made to the business by its owner(s). In the strictest sense, owners’ loans do not represent equity as they are net investments in the business (they have to be repaid), but are considered near-equity as they still represent entrepreneurial finance or owners’ funds. They may also arise when a proportion of remuneration is retained in the business to provide additional working capital. Owners’ loans are reflected as loan or capital accounts in the financial statements of the business. It is useful to bear in mind the following considerations relating to owners’ loans: - From the perspective of the business, owners’ loans can be a very flexible source of finance. Owners’ loans are often not interest-bearing. Even if they are, the repayment of capital and the servicing of interest need not represent a fixed monthly obligation. The owner might elect that the loan be repaid in a lump sum at a specific future date or when the business is adequately capitalised to allow for such an outflow. - Interest paid on the loan is allowed as a tax-deductable expense, from the perspective of the business. - Interest earned on a loan account is fully taxable in the hands of the owner, even if it has not actually been received, but has merely accrued to his or her loan account.
  • 13 - Unlike a loan from a lending institution, owners’ loans do not represent outside borrowings and therefore improve the ratio between own funding and outside borrowings. This ratio is important when the business attempts to raise finance from a lending institution at a future date. For the loan to be considered as ‘own funding’, lending institutions usually require a cession of the owner’s loan. - Owners’ loans are less flexible from the owner’s perspective. Firstly, the owner is unable to withdraw his capital unless the business has reached the stage where it no longer requires the loan. Secondly, if the loan account is not interest-bearing, inflation will significantly reduce the real value of the loan account over time. Banks, through their life assurance broking divisions, offer a product called Loan Account Assurance which entails investment policies to replace loans made by owners to the business. 6.7.3 Bringing in outsiders Having considered other sources of finance, you may still find that you have to increase the capital base of your business more than you can from your existing resources. As a result you have to look elsewhere. This means that you must consider the use of partners, co-members (in a close corporation) or shareholders (in a company) to generate the required capital for your business. Often outsiders are brought in as a matter of need. This occurs when gearing would be raised so high by additional loans that the risk would be unacceptable to lending institutions. Under such circumstances, the owner has to consider selling off part of his or her own stake to outsiders in order to generate new capital for the business. However, bringing in co-owners is about more than just raising capital. It may also mean sharing the control of the business as well as its profits, and perhaps joint decision-making on important matters. The advantages are obvious: Financially you are creating a broader capital base for future expansion, you may address the issue of succession should something happen to you, and the newcomer(s) may bring a fresh and experienced outlook to the business. Moreover, the newcomer(s) may relieve you of the burden of lonely decision-making, which weighs so heavily on the independent business owner. When looking for a co-owner, it is important to look beyond his or her money. Other important considerations are: - How active will the new co-owner be in the business? Will he or she be a sleeping partner, entrusting you with the full responsibility for the success of the business or will he or she dictate? How involved will he or she be in the day-to-day running of the business? - What skills, experience and business contacts can the co-owner bring to the business? Ideally they must complement rather than duplicate, your own.
  • 14 - Personal chemistry is important particularly if the new co-owner is going to be fairly active in the management of the business. - Does the new co-owner share your vision and goals for the business? - Is the new co-owner looking at a long-term relationship with your business, or is it likely that changing circumstances may cause him or her to sell the stake in the business? In taking on a new co-owner it is important to seek the right advice, particularly financial, tax and legal advice. For example, be sure to formalise a legal relationship in writing. 6.7.4 Retained earnings In newly established and fast growing businesses, the reinvestment of profits may be particularly important as a source of funding. Remember that what you do with profits has a direct effect on your cash flow. Should you decide to distribute profits to the owner(s), such payments will cause a ‘cash leak’ or cash outflow which may impact adversely on the running of your business. Depending on the tax ruling of the day, there might even be tax implications in the distribution of profits. Generally, the Receiver of Revenue looks more favourably upon reinvested profits than distributed profits, which may be taxed at a higher rate. The Receiver’s intention may be to encourage businesses to reinvest their profits in the hope that they will expand their operations. 6.8 Considerations in deciding on a source of finance Before examining these considerations, it is necessary to look more closely at business finance. The mix of external finance, debt and equity finance used in a business is commonly referred to as its capital structure. The proportion of debt to equity is referred to as the gearing or leverage of the business. The higher the debt finance, the higher the gearing. A further principle of finance is that there is always a trade-off between risk and return (the cost of finance). The higher the risk associated with your business, the higher the return expected by the provider of finance, that is, the more you will have to pay for the finance. In deciding on the most appropriate source of finance, you must consider various factors carefully. The most important considerations will be outlined in the paragraphs below. 6.8.1 Return (cost to your business) - Interest paid on debt is regarded as a cost of doing business. That makes interest a tax-deductible expense, which effectively reduces the level of taxable profits and therefore tax payable. In finance terms, debt offers a tax shield as the Receiver of Revenue ‘pays’ part of the interest by forgoing tax. That is, the effective cost of debt to the business is the interest charge, less the tax saved by the reduction of taxable profits through interest payments.
  • 15 Assuming a tax rate on business profits of 30%, then for every one rand the business pays out in interest it receives a tax saving of 30 cents. The effective rate of interest on a loan is therefore less (to the extent of the tax rate) than the nominal or quoted rate of interest. Remember that in reality a business can only deduct interest to the extent of profits. In contrast the return on equity (in the case of a company it is dividends) is not tax-deductible and therefore, unlike debt it brings no tax relief to the business. The effective and nominal costs of equity are the same. - Debt can increase the return on equity (the money invested in the business by its owners). Debt effectively levers the profits as the owners are using other people’s money to make more profits. In other words, the owners are increasing profits while their own investment in the business remains constant. 6.8.2 Risk - As we have seen, there are good arguments for taking up as much debt as possible. However, this is inconsistent with the real world. As the level of debt (gearing) increases so does the risk of financial distress (ultimately bankruptcy). - As a business becomes more highly geared, the market (including banks) will reassess the risk profile of the business, which in turn will raise the cost of finance. Providers of finance will become increasingly nervous as gearing increases and as compensation for the increased risk will demand a higher return on the capital they invest in the business. Gearing may reach such a high level that the business becomes saturated with debt (it is unable to raise any further debt finance). Remember, debt taken up now may take you closer to the point of saturation, which in turn may reduce your future borrowing capacity. - The cost of debt (interest) represents a fixed obligation that the business has to meet at a regular frequency, usually monthly, irrespective of whether or not the business is making a profit. During periods of high interest rates and economic recession, the cost of debt can become a high burden for a business. - Over and above interest, debt also requires capital repayment. These regular capital payments represent cash outflows and may therefore put a strain on the cash available in the business. - With equity, there is no fixed commitment and the owners are remunerated from profits, if any. 6.8.3 Control - The issue of giving up control of a business, even only partially, is a delicate one. The ability to control a business has value and should therefore not be given up easily.
  • 16 - Raising finance by means of equity dilutes the control that may be exercised by the existing owner(s). The exact impact will depend on the extent to which equity in the business is sold to outsiders and on the contents of any legal agreements that may be drawn up to govern the ownership and management of the business. - Debt is not an ownership stake in the business and therefore full control is retained by the owner(s). However, where a business has a high level of debt or where it is experiencing difficulties, financiers may become nervous and take a far greater interest in the business than would normally be the case. 6.8.4 Flexibility - It is important to select a source of finance that is sufficiently flexible to suit your specific needs and set of circumstances. Fortunately, most debt finance products are inherently flexible, making it possible to structure finance around the needs of your business. - An overdraft facility is a flexible source of short-term finance which supplies credit when needed (up to the agreed maximum limit) and you only pay for utilisation. Once the facility has been agreed to, there is no paperwork or time wasted in waiting for a decision. The money is available ‘on tap’. Debtor finance has the advantage of growing with your turnover. As you grow your sales, your debtor finance facility is increased. - When considering the flexibility of various sources, you also need to look at aspects such as the impact on your cash flow, tax implications, and how long it would take you to get the finance in relation to the urgency of your finance need. Remember to plan ahead, because the answer to applications made in a hurry is usually "no". 6.8.5 Capacity - In the case of debt finance you have to analyse the borrowing capacity of the business. Assess the value or net assets of the business and establish whether the flow of cash through the business will cater for the servicing and repayment of debt. - Your business may lack borrowing capacity and you may therefore have to look at equity finance. Equity also enhances the capacity of the business to make future borrowings. - You need to consider how your present choice of finance may affect your future ability to raise finance. 6.8.6 Business environment - Businesses with uncertain or irregular patterns of income are more likely to experience financial distress and will therefore probably use less debt finance. - Over and above economic conditions such as rising interest rates or a drop in the demand for your product due to recessionary conditions, there are several other factors that have to be considered.
  • 17 Some of them can create problems which may soon become financial difficulties. They include labour disruption, congested harbours and transport problems, a break in the supply of raw materials, and a sudden rise in the cost of key input material which you are unable to pass on to consumers. These hazards are not highlighted to discourage the use of debt finance. The danger lies in excessive levels of debt which leave little or no room for dealing with contingencies. Always be sure to have some reserve borrowing capacity which you can use to raise short-term finance to see your business through unforeseen eventualities.
  • 18 6.8.7 A summary of the considerations in deciding on a source of finance The factors that have to be considered in deciding on the most suitable source of finance and the mix between debt and equity finance are briefly summarised below: Considerations Debt finance Equity finance - Interest is tax-deductible Cost of equity, e.g. dividends, is not tax - Effective interest rate deductible Return/cost lower than nominal rate - Debt can increase return on equity by leveraging profits. - As level of debt - Higher levels of equity increases, so does the reduce the risk of risk of financial distress financial distress. Risk - Repayment of debt - No fixed obligation represents a fixed exists. obligation that must be met. - Debt does not represent - Control may be diluted Control an ownership stake in the if the business brings business the owner in co-owners. retains full control. - Debt finance can be - Equity finance is flexible, subject to the inherently flexible. finance need being Flexibility matched to the most appropriate type of finance. Some finance products are also more flexible than others. - Does the business have - Can the business the capacity to borrow? attract equity finance? Capacity Will the cash flow cater for the servicing and - Equity enhances the repayment of the debt? capacity to borrow. - High levels of debt - Equity (moderate increase vulnerability to levels of debt) Business volatility and unforeseen enhances the capacity management events in the business of the business to environment cope with hazards and eventualities in the business environment.
  • 19 6.9 Finding the right financial mix Sound business plans to buy, start or expand a business depend above all on a proper financial mix, i.e. matching the asset to be financed to the appropriate term and type of finance. In arriving at this financial mix, the factors of cost risk, control, flexibility, capacity and the business environment have to be considered in order to fine-tune the financial mix for the unique requirements and preferences of your business. ASSETS TO BE APPROPRIATE FACTORS TO FINANCED APPROPRIATE TERM FINANCIAL MIX CONSIDER Debtors Stock Short-term(less - Internal finance - Cost Work-in-progress than 1 year) - Bank overdraft - Risk - Debtor finance - Control - Flexibility - Capacity - Business environment - Vehicles and Medium-term - Instalment sale equipment (typically 1-5 years, - Lease - Plant and but up to 7 years) - Rental machinery - Medium-term loans - Buying a - Equity business or franchise - Setting up a business or franchise - Renovation of premises - Land and Long-term - Commercial and buildings (in excess of 5 industrial property - Goodwill* years, up to 20 loans years) - Participation Bonds - Equity *Note: Equity rather than debt is considered the most appropriate source to finance goodwill. Usually banks will not entertain any applications for the finance of goodwill. The table above provides a useful summary of the content of the booklet thus far and concludes the discussion on financing your business and its operations. 6.10 Making other banking products work for you 6.10.1 The business cheque account The business cheque account is the foundation of all your business banking requirements. This account not only caters extensively for the transactional requirements of your business, but it also provides for an integrated approach to managing your banking requirements through links with other important banking services.
  • 20 Some of the many features of this essential product are: - Access to short-term finance by means of an overdraft - Payment of third parties by cheque, debit or stop orders - Cheques can reflect the corporate identity or logo of your business - Detailed banking statements, providing a record of all transactions - Linkage to electronic banking services, allowing transactions to be made from a remote location such as your office - Linkage with card products such as garage and credit cards. 6.10.2 Electronic banking services Technology is the way the world of business is moving. Rapid advances have been made with electronic banking and these are likely to continue at an even faster rate. Businesses can ill afford to distance themselves from these advances and may stand to benefit greatly from the use of such electronic products. Essentially, electronic banking products enable business clients to perform functions such as the transfer of funds between accounts, accessing account and historical information, payroll administration, creditor payments and debtor collection. This is facilitated by using a personal computer which is linked to the bank’s mainframe computer by means of a modem or internet facilities. These electronic products make it possible to conduct the banking activities of the business from the business premises. Electronic products provide for good security and increasingly they are becoming ‘friendlier’ to use. 6.10.3 International banking services South African businesses are increasingly exposed to international markets and business practices. While the prospect of international trade is exciting, it is also intimidating, as it is fraught with uncertainty and risk, particularly for the uninitiated exporter or importer. If you are involved in international trade, you are best advised to seek assistance from the international banking experts at your bank and to use international banking services that facilitate trade and limit risk. These services may broadly be classified into settlement services, finance in foreign currency, hedging services, shipping guarantees and airway releases, and advisory services. Settlement services One of the major risks associated with international trade is that of default. Settlement services, such as documentary credits and documentary collections, offer a degree of protection to both the importer and the exporter. Other less sophisticated settlement services include bank drafts (foreign cheques) and electronic transfers.
  • 21 A documentary credit, also known as a letter of credit or L/C, is issued by the importer’s bank and guarantees payment to the exporter, as long as the exporter conforms to the terms as prescribed by the importer in the documentary credit. The exporter has to submit documentation, e.g. proof of shipment to the effect that he or she has satisfied the conditions of the credit before the importer’s bank will make payment. It is advisable to keep the terms of the documentary credit as simple as possible. Non-conformity with complicated clauses and conditions may cause unnecessary delays and prove costly to both importer and exporter. If, as an exporter, you are uncertain about the standing of the foreign bank issuing the documentary credit (the importer’s bank), or uneasy about the country to which you are exporting, you may ask your own bank for written confirmation. This is known as a confirmed letter of credit. A documentary credit is the ideal instrument when dealing with a buyer (importer) known only by name to the seller (exporter) as it provides, by means of the backing of the importer’s bank, for payment security. A documentary collection, also known as a foreign bill for collection (FBC), offers less protection than documentary credit and is therefore ideally suited to cases where trading partners are known to each other and where a basis of mutual trust already exists. With a documentary collection, the exporter ships the goods and presents his or her own bank with commercial and/or financial documents to be forwarded to the importer’s bank for payment. The exporter retains control over the goods as ownership only passes to the importer upon either payment or acceptance of (usually) a bill of exchange. A documentary collection does not guarantee payment, as the importer may not accept the documents or bill of exchange. However, it offers substantially greater security than settlement on an open account basis. Finance in foreign currency (offshore finance) Sophisticated mechanisms are available to finance the import and export of goods, capital imports and working capital. Foreign currency trade financing provides short-term finance to importers and exporters in a foreign currency. This may offer several advantages, including lower financing costs, but should not be undertaken without the expert advice of your bankers. Capital import financing is available from some countries that offer subsidised medium- to long-term facilities to promote the export of their capital goods. Working capital financing involves the raising of short-term loans in a foreign currency to meet normal working capital requirements. Ask your bank’s international banking experts for advice on these financing mechanisms.
  • 22 Hedging services Any business involved in international transactions has to consider the risk of exchange rate fluctuations. The most commonly known and used hedging mechanism is the forward exchange contract (FEC). These contracts provide protection against loss as a result of exchange rate fluctuations. An importer can fix the rand value of his or her foreign currency obligation, payable at a later date, at the time the FEC is drawn up, thus enabling the business to determine its profit margin. Similarly, an exporter who only receives payment after shipment can determine and lock in the exact rand value of the future receipt at the time of entering into the FEC. Shipping guarantees and airway releases These guarantees and releases are required for the release of imported goods that arrived before the relevant documentation. They cater for late arrival and non-arrival of documentation. Goods retained at the port of entry, awaiting documentation, may make the importer liable for demurrage (‘holding’) costs for the period of retention. Shipping guarantees and airport releases avoid these costs and allow the importer to clear the goods immediately on arrival. This is possible because the bank indemnifies the shipping company in respect of any claims that may follow the release of the goods. Advisory services Banks offer a range of advisory services to existing and prospective international traders. The services available include advice on exchange control matters and investment opportunities, trade promotion, exchange rate movements, and bank reports on foreign institutions, businesses and individuals. 6.10.4 Credit card services A complete range of facilities are available to enable merchants and vendors to accept credit cards such as Visa, MasterCard, Diners Club and American Express, as well as garage, petrol and fleet cards for payments from their customers. The introduction of point of sale (POS) card terminals has enhanced the service available to merchants. These terminals capture transactions at point of sale and forward the data via the bank’s mainframe to your local branch on the same day. The POS card terminals offer many advantages, including great convenience to both merchant and cardholder, cheque verification, automatic control of fraudulent card transactions, improved processing speed at point of sale and reduced risk arising from cash holdings. Business, garage, petrol and fleet cards make for great convenience while enhancing the administration of expenses. Business cards enable staff to pay for accommodation and travel expenses, and garage, petrol and fleet cards can be used to pay for fuel, oil and maintenance.
  • 23 Fleet management services are attractive to fleet-owning businesses as they simplify the administration of fleets, enhance control of vehicle expenses and provide valuable management information. Like electronic banking, card-based services are subject to technological innovation and you are best advised to contact your local branch for an update on the services available. 6.10.5 Assurance and insurance services Any business and its owner(s) are continuously exposed to various forms of risk. Unless the business takes the necessary steps to safeguard its interests against risk, such events may seriously harm, if not ruin, the enterprise. Cover against risk is available from the broking divisions of most banking groups today. In addition, they will often also assist businesses with the establishment and management of pension funds, provident funds, group life schemes and medical aid schemes. Life assurance Key-person assurance People are often the most important assets in a business, yet they are never reflected as such on the balance sheet of the business. How would the business cope should it lose one of these assets (a staff member key to the continued success of the business)? Such a loss is normally a very unsettling experience for any business. The business may lose momentum and creditworthiness and it may take time and money to find a suitable successor. While no form of assurance can replace a valuable member of staff lost through death or disability, the proceeds from a key-person assurance policy can ensure the financial continuity of the business by minimising the financial impact of such a loss on the business. Partnership/shareholders’/members’ assurance The death or disability of a partner in a partnership, a member in a close corporation or a shareholder in a company may put the continuity of a business at risk. For example, In the event of death, the heirs may want to sell their stake in the business, which may put the other owner(s) in the business in a serious predicament. They have to find the money to buy the deceased owner’s stake from his or her heirs. This kind of assurance policy provides the cash required to acquire a deceased or disabled co-owner’s stake in the business in a tax-efficient way. Other assurance policies - Capital funds assurance may be used to provide for the specific future capital needs of a business (for example, replacement of fixed assets or expansion).
  • 24 - Loan account assurance entails investment policies to replace loans made by the owner(s) to the business. On maturity, the proceeds of the policy settle the loan and the balance of the proceeds are paid to the investor. - Sureties or contingent liability assurance policies provide life and disability cover for those co-owners bound as sureties for the loans and overdraft facilities of the business. The policy releases the deceased estate or disabled co-owner from liabilities. This means that personal assets cannot be attached by creditors of the business, and the business can continue without any undue claims. Short-term insurance Every business needs protection against short-term risks such as fire, theft accidents and other insurable risks. Insurance cover is usually a condition of financing agreements in respect of property, vehicles, plant equipment and other assets. Banks are in a position to arrange such cover at favourable terms with leading insurers. This broking and risk management service is available at no extra cost. Businesses that sell to local or foreign organisations on credit terms may also avail themselves of credit insurance for debtors. The cession of a credit insurance policy provides added security to the bank, which may provide larger finance facilities than would be the case without the insurance (and perhaps at more favourable interest rates). Staff benefit schemes To attract and keep good staff, a business must pay attention to the short- and long-term well-being of both owner(s) and staff. Staff benefit schemes assist the business with this important task by providing for illness (medical aid), death and disability (group life assurance), and retirement (pension and provident funds). You are best advised to seek the advice and guidance of the staff benefits specialist at your bank to formulate a flexible scheme that will best meet the needs of both the staff and the business. 6.11 Disclaimer Absa or any of its agents, contractors, assignees or employees, does not accept liability of any nature whatsoever for any loss sustained by any person (whether natural or juristic) who/which makes use of the information contained herein and any person who uses it, does so entirely at his/her own risk. This booklet is a basic guideline only. Most issues will require professional assistance.