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Making sense of the numbers
Top 8 most important considerations with commercial financing
Often you are so busy running the day to day of your business you don’t have time to really delve into the numbers. Despite this, taking on additional funding for your business can have significant financial and legal implications both for your business and even you personally.
To help you better understand these factors, we have compiled the top 8 most important financial related items to consider.
Interest rates cover how much you are charged for the funding provided to your business. While this may seem straightforward, not all interest rates are created equal, so you need to appreciate exactly what the specific interest rate you are supplied with refers to. In addition, it is often important to adjust the interest rate to reflect all fees and charges associated with the loan (this is usually referred to as the Comparison Rate).
Most important is understanding the period over which the interest rate is calculated (for example 10% per month is a lot more expensive than 10% per annum).
Repayments includes both interest payments (the cost of the financing) and principal repayments (this is the amount actually borrowed and what the interest is calculated against). Different loans have different schedules as to when the principal and interest must be paid, so you need to understand when these obligations fall due.
Particularly in the case of interest only loans, the interest only period repayment obligations are not significant, but at the expiry of the loan the repayment of the principal can become challenging for those borrowers who have not planned ahead for this event.
When assessing the cost of financing, it is important that you consider all costs associated with the arrangement. Often finance providers will quote an interest rate and then include additional fees and charges which are not incorporated into the rate given. These fees and charges can include things such as setup, administration, legal and establishment expenses, which in total can frequently add up to thousands of additional dollars. These amounts are typically charged on an upfront basis when the loan is made.
You should therefore check with your provider to ensure that all fees and charges are transparent and that you have included these in the total assessment of the financing you are obtaining (essentially that you understand the “real rate” or “total rate” of interest to be paid).
Certain types of finance, particularly the shorter term unsecured variety, can incorporate specific interest rate or fee penalties. These higher interest rate or fee penalties can be triggered by such things as a borrower failing to make a regular payment or other types of breaches of the original finance contract.
These penalties are designed to motivate the borrower to maintain their original obligations and if they are breached to rectify the situation as soon as possible. Their punitive nature means they can become significant relatively quickly and you therefore need to appreciate the potential ramifications of any such penalty clauses in your finance contract.
Obtaining finance for your business is one thing, however you need to take responsibility for being able to service that finance. Serviceability refers to the capacity of your business to satisfy the repayment obligations of any finance obtained. So you need to have a firm grasp of the cashflow or profitability of your business and how much of this can be allocated to take on additional finance.
Understanding the serviceability levels finance providers generally look for can also be useful when applying for finance, as it often leads to more successful outcomes.
An amortising loan is one whereby the principal (amount borrowed) is repaid over the life of the loan. Typically this will follow a regular amortisation schedule, so you as the borrower are responsible for periodic payments that are always the same over the life of the loan.
In certain situations the loan can follow a varying amortisation schedule, so you need to ensure you are aware of this variability in payments and have the cashflow or profitability in your business to accommodate such changes. In addition, finance providers can also include their fees into the amortisation amount of the loan, therefore spreading their fees evenly over the life of the loan (however this means you effectively pay interest on these original fees and charges).
Obtaining finance for your business is only worthwhile if the purpose you will be using the funds for can generate a return greater than your total cost of financing. If you cannot generate a return on investment greater than your cost of capital, then you will be losing money on any such activity.
This illustrates that it is important to have a firm grasp on what type of returns your business is generating, in order to make appropriate financing decisions. For example, if a business sells an item that generates a net profit margin of 20% before finance costs and the total cost of financing that sale is 12%, then the business will still make a net profit of 8% (this business should therefore likely obtain finance if it is going to help generate the sale).
In assessing the total risks associated with any financing, it is important to understand any security or collateral that is being pledged, as part of your overall risk management assessment. Specifically, how much of your assets are at risk relative to the size of the financing you are obtaining. In instances where a general guarantee is given this can be difficult to determine, however when specific assets or securities are pledged the process is a lot easier.
You need to be clear with your finance provider to ensure you understand precisely what security has been provided and balance the size or risks associated with this versus the total dollar amount of finance being requested.
An experts tips
Tips to Find the right finance
Good organisation of your business information and financials can be instrumental when it comes to assessing and obtaining the right finance. Ideally you should be “finance ready” at all times, this way you will always be able to take advantage of any opportunities that come along.
Being “finance ready” means maintaining up to date financial and tax reporting for your business, that includes all of the information required internally and by external stakeholders. Working with a good professional accountant can help keep your business stay organised.
Plan for Rainy Days
For the health of your business, we like to say “obtain finance when you can, not when you have to”.
What this means is securing finance for your business can be a detailed and lengthy process, particularly if you are after the optimal solution available. This process is therefore not a last minute exercise (otherwise the costs can be significantly higher), instead it is something that should be appropriately planned.
Furthermore, when it comes to the size of any finance, make sure you have built in enough contingency into your forecasts that you are able to weather any negative variability or decline in operating conditions for your business.