FOOD FOR THOUGHT

What is the true cost of external finance?

Posted by Matt Bellingham on May 26, 2016

Taking on external finance is a necessity for most growing businesses. However, business owners should have a robust understanding of the pros and cons of external finance before entering into an agreement, and have a repayment strategy in place from the beginning.

 

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Sometimes in order to get ahead, we have to take a step backwards – and in business this often involves taking on debt. Scaling a business is challenging and requires capital, but it’s important to be aware of the risks associated with external finance. Here are some tips to help you navigate this decision.

 

Not all finance is created equal

There is good debt and there is bad debt – before you apply for finance, you need to be certain that the debt you will take on is ‘good’, in that it will help your business grow and ultimately become more successful. ‘Bad’ debt is debt that funds working capital shortfalls due to financial mismanagement (for example, GST or PAYE arrears). The irony is, the worst time to take on debt is usually when you are in financial trouble – even though this is often the time you feel you need it most. If you are experiencing cash flow challenges, it’s better to work with your accountant to resolve these issues before considering external finance.

 

Read more: Aligning financial and non-financial KPIs to boost your business

 

Be prepared to negotiate

Finance will be lent to your business against the security of one or several of your assets. You need to have an understanding of the value (both tangible and intangible) of the assets you are providing security against, as this will ensure you are best placed to negotiate the terms and cost of debt (for example, interest rates).

 

Security arrangements are a significant aspect of debt negotiations, and unfortunately it’s common for lenders to take security of an excess value over the debt being drawn. To ensure the arrangement is fair, use your accountant to help you understand the exact level of debt required. Your accountant will be able to provide advice surrounding the cash flow required to repay the cost of debt, and the cash flow generated from the debt (e.g. a new asset), and match these against the security being offered to the lender.

 

Be aware of the opportunity cost

Accepting external finance may limit some of your decision-making power throughout the course of the arrangement. For example, if some of your assets are bound by a security arrangement, the sale of these assets may be subject to the restriction of the lenders. Again, an accountant can help you manage these potential limitations.

 

Pay attention to early warning signs

Once you take on external finance, you need to be extremely proactive about managing your financial situation. Lenders are always focused on what their exit will be should the funding arrangement become negative. Often this means that if the lender sees the value of the security as being lower than the value of the outstanding debt, the lender will look for ways in which they can control the security being offered. This can be very distressing as it puts the lender in the ‘driver’s seat’ on key business decisions.

 

Business owners (and equity holders) can manage this by working with their accountant to actively monitor financial performance. By proactively reporting financial information and understanding early warning signs, you can remain at the forefront of business decisions. It’s also worth noting that lenders view the involvement of an accountant favourably, because they trust the accountant has a good understanding of the business’ financial performance to enable successful outcomes.

 

Have a clear business plan

Lastly, make sure you have a clear and concise business plan. This will speed up the application process, as the lender will be able to quickly understand your business and assess the value of security required to support the level of debt needed. It will also allow you to make financial decisions more easily, as the implications of borrowing (both short-term and long-term) will be clearly understood.

 


 

Many people think that financial pressures or issues are isolated incidents, but they are all connected. Our Cause and Effect Navigator is an excellent tool for highlighting the interdependent nature of business and it works for all sizes of businesses – from the corner dairy to Vodafone! 

 

Cause and Effect Navigator Infographic

Topics: Financial Management, Raising Capital