Introduction
Businesses can access debt from a variety of sources. This is a simple guide to various business debt options which will help you understand and navigate the choices available to organisations requiring debt financing.
Why does your business need Debt?
It is important to be clear why you require debt financing in your business. Do you need short term cashflow cover or funds for longer term investment or for a purchase of equipment? It's also essential to carefully evaluate your business needs and financial situation before selecting the most suitable option. For example, you will have to consider the ability of your organisation to pay back the debt over a period of time, and understand what level of interest repayments the business can afford. Careful planning and forecasting is required, not only to manage the debt, but in many cases to give the lender assurance in order to grant your business the required facility.
Short term debt for working capital requirements
Bank overdraft
An overdraft lets you borrow extra money through your business current account, where you are able to spend more than the cash balance currently held in your account. An overdraft must be agreed in advance, with a specified overdraft limit, and interest will be charged on overdrawn amounts.
This is the most straightforward option and has the benefit of having virtually no administrative burden. Banks will monitor your usage of such a facility and don’t like the money being spent on capital purchases. Rather, they want you to use this facility to help you manage short term cash requirements.
Before granting an overdraft, banks will consider many factors around the business, including risk, credit rating, the debtor book, bad debts, customer contracts and general working capital requirement.
Invoice discounting/factoring
This is when the lender uses an unpaid invoice as security for funding, giving you quick access to a percentage of that invoice's value quickly. This can be for all or some of your invoices over an agreed period of time. The lender gets repaid when the customer pays the invoice into a specially set up trust account.
This type of facility is very administratively heavy, requiring good systems, processes and staff to monitor and control the flow of transactions.
Trade Finance
This is an import loan or a domestic import loan facility agreed with a lender. The loan can be used to pay overseas or UK suppliers and can often include VAT import duty. This type of arrangement is good for upfront working capital for businesses that are trading in tangible goods and supplies.
Trade finance can work well hand in hand with invoice discounting. The lender may require a PO from a longstanding/reputable customer. If considering this option, it is worth looking at the General Export Finance Scheme which is a government guarantee used to help firms gain better financial deals. This need to be looked at carefully as certain eligibility criteria will need to be met.
Non working capital financing
Loans
A loan in its simplest form is a lump sum of money borrowed from a lender with an associated interest charge. The loan will need to be paid over an agree term, with interest payments on top.
A loan can be secured (ie a lender will need something as security in case the business can't repay the loan) or unsecured. Do note that unsecured loans are generally granted by lenders for less than £50k, with personal guarantee still required. A personal guarantee is an individual's legal promise to repay credit issued to a business for which they serve as an executive or partner. As you would expect, business owners are generally not motivated to offer personal guarantees, and prefer to secure a business loan on the assets of the business where possible.
Large loan facilities will have comprehensive legal agreements and may involve robust covenant testing by the lender – these are conditions which need to be meet at certain points during the loan term, which the borrower must adhere to. These conditions must be monitored closely by the business and the lender.
Asset finance
This is credit offered to businesses by way of leasing equipment, machinery, vehicles or other assets required. This is a great way for businesses to access new equipment but avoid large capital up front payments.
The lender provides finance against the value of each asset, and fixed monthly repayments (which of course include an interest charge element) aid cashflow management.
Recovery Loan Scheme
The Recovery Loan Scheme (RLS) is a government-backed loan scheme designed to support access to finance for UK businesses as they look to invest and grow. It is essentially a CBILS/BBL (COVID related financial support schemes) replacement scheme whereby there is a 70% government guarantee.
The scheme actually covers not just term loans, but also overdrafts, asset finance and invoice finance facilities. It can support facility sizes of up to £2 million for borrowers.
There is strict eligibility criteria and there will be a requirement for the business to demonstrate that it is viable. Please also note that this scheme is currently due to be closed in mid 2024.
Lender considerations
Potential lenders to your business will consider many factors when determining whether to provide funding. They will look at the history of the business and it’s banking current account to assess viability. They will want to know about prior loan history and whether there have been any issues with repayments in the past. Credit checks will be made on both the business and its Directors.
Existing business liabilities will be taken into account – for example, are there other outstanding debts held by the business and are all tax liabilities paid up to date?
As mentioned earlier, there will be an evaluation of the reason for business funding, and potentially a requirement for a contribution from the business or its directors in terms of cash or personal guarantees.
Lenders nowadays are more focused on affordability than security offered.
Factors which may assist the obtaining credit finance include having up to date management accounts, having a Finance Director in place, being able to meet stress tests, and ownership of assets which debt can be secured against.
Summary
There are many options available to businesses when it comes to credit financing.
It is imperative that Management consider which options are the most suitable and then improve the chances of obtaining financing by being prepared and understanding what lenders will look for as part of the application process.