Knowledge Centre: News and know-how for your business

1.1 Decide what gearing you want (what proportion of your financing you want to be in the form of debt). This will depend on:

• What your cost of capital is and what returns your business expects to achieve.
• How much cashflow you generate.
• How risky your business is.
• What financial risk profile you want.
• How much security you can offer lenders.

1.2 Establish the most appropriate mix between overdraft facility and loans according to the 'matching principle'.

• Use an overdraft facility to finance cashflow fluctuations and to provide contingency financing.
• Use loans to provide fixed-term financing.

1.3 Make sure you have enough finance.

Arrange all your financing at once and allow for unexpected cashflow 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 your overdraft limit, you will pay additional bank charges and higher interest rates.
• If you run short of cash and then fail to make a payment on a loan, you will be technically 'in default'.

2.1 Overdrafts have two clear advantages.

• An overdraft is a simple, flexible way of financing changing cashflow requirements.
• You pay interest only on the amount you are overdrawn each day.

2.2 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.

2.3 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.
• Large overdrafts may incur additional charges similar to loans (see 3.3).
• You will pay higher fees for an 'informal' overdraft (eg where you go overdrawn without agreeing it in advance with your bank) than you would for a pre-arranged, or 'formal', overdraft.

2.4 The effective interest you pay may be boosted by other charges.

• You pay a fixed margin over base rate.
• You can try to negotiate a narrower margin.
• Larger overdraft facilities may carry a non-utilisation fee on the amount of the facility you are not using.
• You may also have to pay for regular (typically quarterly) reviews.

3.1 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 secure for the life of the loan (unless you fail to make payments or breach any covenants - see 3.2).
• You can match the term of a loan to the life of an asset you want to purchase.
• You may be able to tailor the loan to match the cashflow of the project you are using the loan to finance.
• You can usually fix the loan interest rate.

3.2 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, the bank may insist you keep your overall gearing below a certain level.
• 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 (see 5).

3.3 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.
• 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.

3.4 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 one to three per cent is typical, depending on your credit score (see 4.1).
• 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.

4.1 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 (see 5).
• How low your gearing is and how strong your balance sheet is.
• What your cashflow projections are.
• Your past banking record.
• Your business' past financial performance.
• How professional your business plan is.
• How expensive the financing will be for the bank to administer.

4.2 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).

4.3 Shop around. Then negotiate for a lower interest rate and lower charges (even if you have only received one offer of finance).

• A bank is usually more willing to improve its offer if you have other quotes. 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.

4.4 Build a relationship with your bank manager, so the bank will be more supportive if you need additional financein the future.

5.1 Freehold or long-leasehold property is often the most valuable security you can provide.

A bank will usually lend up to about 50 to 80 per cent of the value of a property, although other specialist lenders may advance as much as 90 per cent.

• 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.

5.2 A bank may lend up to 50 to 60 per cent of the value of your outstanding debtors (sales invoices). The bank will check:

• How likely the invoices are to be paid.
• How much it costs to collect the debts.

5.3 Equipment, stock and work in progress will only be valued at their resale price - usually what they would fetch at auction.

• Specialised equipment which is difficultto sell, and equipment which becomes obsolete quickly, such as computers, provides little security.

5.4 Directors of limited companies are often asked to provide personal guarantees. (Sole traders and partners are automatically liable for all the business debts.)

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.
• Ask to limit the duration of the guarantee.
• You may want to renegotiate any guarantees whenever you take out a new loan or overdraft facility.
• If any friends or relatives offer third-party guarantees, the same risks apply to them.

5.5 You may want to consider pledging other assets, rather than giving a guarantee or putting a charge on your home.

• For example, life insurance policies, shares and other investments.