One of the biggest challenges business owners face is successfully managing cash flow – and your borrowings can have a serious impact on your financial position if not arranged carefully.
Borrowing to buy assets is common for most businesses. But it’s very important that you arrange the terms of your borrowings so that the revenue you generate from the asset matches your loan repayment obligations.
Any loan funding you take out to buy an asset must be repaid by the time you retire it – or at least from the residual proceeds when you sell the asset. Hopefully, your asset will generate income for your business for a long time, but these days there is no guarantee of that. Ideally you should try to cover your repayments over a shorter period, because technology is evolving so fast that plant and equipment can become obsolete during its working lifetime, leaving you with an asset with little or no value.
Short-term assets such as stock and debtors would not normally be financed by long-term funding facilities, so these are not discussed in this article. However, you can find guidance on how to manage your stock levels and debtors in other articles.
Long-term financing options
There are many forms of finance available and there is no ‘right’ or ‘wrong’ method. The cost of funding will vary depending upon the form of loan you take out – but remember that what appears to be the ‘cheapest’ option may not ultimately the best choice for your business.
The most common forms of long-term asset financing include:
- Principal and interest (P&I) term loans
With this type of finance, the period of the loan and the rate of interest will be set at the start of the loan and you’ll make regular principal and interest payments over the term of the loan.
Payments are generally monthly but, for seasonal businesses such as agriculture or viticulture, you may be able to match the timing of your payments to the times when your business generates its cash flows.
A P&I loan will usually be secured over either the asset you are acquiring, or your other business or personal assets.
- Asset purchase loans (also known as ‘hire purchase loans’ or ‘asset lease purchase loans’)
These are similar to P&I Loans, but are always secured against the asset you are acquiring. Unlike P&I loans, asset purchase loans can have lower regular monthly payments, with a lump sum, or ‘residual’ payable at the end of the loan. Interest rates are fixed for the term of the contract.
If you opt for this type of finance, it’s important to make sure that the final residual payment isn’t likely to exceed the estimated value of the item at that time. For example, if the residual payment due is $20,000, but the market or trade-in value of the asset is only $10,000, then you’ll have to find a lump sum of $10,000 to cover the shortfall – which may not be an easy feat.
With lease finance, your lender will buy the asset and lease it back to you for a fixed period, in exchange for regular (usually monthly) lease payments. At the end of the term of the lease your business will then buy the asset for an agreed amount (usually called the ‘lease residual’).
Your lender will calculate your monthly lease payments using a fixed interest rate, which is likely to be similar to the rate you’d pay on an asset purchase loan.
Even though your lender will legally own the equipment during the term of the lease, you will usually be obliged to buy the item at the end of the lease for the agreed residual. If you fail to make this final payment for any reason, the lender can sell the asset – and if the sale proceeds don’t cover the residual they can recover any shortfall from you.
Just as with an asset purchase loan, it’s important that you make sure the final residual payment isn’t likely to be more than the estimated value of the asset at that the end of the lease.
- Banking facility
If your business needs substantial, ongoing finance for asset purchases, you may want to consider arranging a facility loan with your bankers.
This is a flexible funding facility, with a set limit on how much you can borrow, for a fixed period of time – at which point you may be able to renew it, if you can show your business can still service your repayments.
This type of facility enables you to buy assets as you need them, without constantly having to enter into new finance agreements. You will be expected to provide adequate security for the loan, of course, and to provide regular financial reports to the bank.
Your lender may ask you to provide certain ‘covenants’, for example that your business makes sufficient profits to cover the interest payable on your loan over the period of a year. A typical covenant may be that your adjusted annual profit (before any charge for income tax or interest), must be at least, say, 2.5 times the annual interest cost of your loans. (The lender will decide what this multiple will be, based on their assessment of how much risk is involved in lending to you).
This type of facility is usually suitable for well-established businesses that continually invest in plant and equipment.
Interest rates on your banking facility may be fixed, or variable, or a combination of both.
Overdrafts are not recommended as a form of funding for long-term assets because they are a short-term facility that can usually be withdrawn by your lender at any time.
There are many types of loan that can be used for financing long-term assets, and the most suitable source of funding for you will depend on your business, the asset you are buying and your circumstances at that time. Terms and interest rates can vary widely between lenders, too, so it’s a good idea to shop around for options and seek advice from your accountant before taking out any form of financing.