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PRINCIPLES OF FINANCE
Businesses are increasingly faced with a myriad of products and services available
from financial institutions. Products and services have become more sophisticated and
have greatly increased in number, making the right choices more difficult than they
used to be. Also, banks today offer a great deal more than conventional finance. Many
of their other products and services, if wisely selected and used, can greatly enhance
your business through cost, time and productivity improvements.
This booklet is aimed at helping you to select the products and services most suited to
the individual requirements of your business, and to make the bank’s products work for
your business. The booklet has a strong focus on the financial needs of the business,
the sources of finance and how to establish the most appropriate financial mix for your
business.
Reference is also made to other products and services beneficial to businesses. These
include electronic products, international services, insurance and assurance services.
- International trade
Both businesses in the start-up phase and existing businesses that want to grow need
to fund their business operations. However, before doing anything else they have to
consider the following:
The answers to these questions will be covered in the pages that follow.
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It is essential that you match the term of the finance to the purpose for which it is to be
used. For example, you cannot hope to finance long-term plans on a bank overdraft,
which is a facility designed to cope with short-term financial needs.
As a rule of thumb, the term of finance should match the useful life of the asset to be
financed. That is, if an asset has a life expectancy of five years, the asset should be
financed over a five-year term or shorter if possible.
The table above lists assets that typically have to be financed by a business as well as
the most appropriate term over which such assets should be financed.
Once you have established the short-, medium- and long-term financial needs of your
business, you have to consider where you will find the money to take care of these
needs. In broad terms, there are two major sources of finance available to a business:
- Internal sources (financing the needs of the business from its cash flow)
Before considering external sources of finance, you should consider how much cash
you can squeeze out of your business. Even if you decide to use external sources of
finance instead, you should, before you inject more money into the business, find out
whether there is any unnecessary drainage on the cash flow of your business. You
would not want the ‘top-up’ funds to leak away as well, would you?
Many profitable businesses fail simply because they run out of cash and are therefore
unable to meet their obligations.
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Cash flow is a function of the variables of cash (or bank overdraft), debtors, creditors
and stock. The basic principle in improving cash flow is to slow down the cash flows
leaving the business and to accelerate the cash flows entering the business. Much
depends on the timing of cash flows - a business prefers to receive a cash inflow
earlier rather than later and to allow a cash outflow later rather than earlier.
How do you squeeze more cash out of your business? Below are some tips to improve
the cash flow of your business. They will enable you to minimise the need for external
financing:
- Bill your customers promptly. Invoice the same day the goods are shipped.
- Negotiate extended credit terms with your creditors (suppliers). The ideal
situation is to buy stock, to sell it and be paid for it before you have to settle your
account with the supplier. The strength of your relationships with your suppliers
will often determine their willingness to offer you credit
- Finance assets over the correct term. For example, financing major machinery
by means of an overdraft will put severe strain on your cash flow.
- Create a cash windfall by selling unproductive assets, e.g. equipment that has
fallen into disuse. Or lease out under-utilised assets, e.g. office space.
Always remember that the objective of working capital management (cash, stock,
debtors and creditors) is to have the right amount of cash available at the right time,
that is, when the obligation to pay arises. This will minimise the dependence on outside
sources of finance to fund the day-to-day requirements of the business. Moreover, it
will ensure that every cent in the business is used as productively as possible.
Debt finance can cater for the short-, medium- and long-term funding requirements of a
business. Providers of debt finance risk the money they lend and often require that the
entrepreneur risk some of his or her own money (‘own contribution’) and that he or she
should provide collateral to secure the loan.
Bank overdraft
Overdrafts have specified limits that are normally reviewed and agreed to
annually. They provide an immediate source of available working capital. The
rate of interest is negotiable and is linked to the prime rate. The rate of
interest depends on the borrower’s risk profile. Interest is calculated on the
daily outstanding balance, which means that you only pay interest on the
portion of the overdraft utilised at any particular time. This allows you to
restrict interest payable to the minimum.
Debtor finance
Debtor finance consists of factoring and invoice discounting. Unlike the bank
overdraft, debtor finance is strictly speaking not borrowing, i.e. it is not a loan
secured by the book debts of the business. Instead, it involves the sale of
debtors to a debtor finance company.
Invoice discounting is the sale of existing debtors and future credit sales to a
debtor finance company. It provides a cash injection to the business by
releasing the working capital tied up in the debtors book. Credit sales are
turned into ‘cash’ sales. Invoice discounting is confidential, that is, debtors
are not advised of the arrangement between the business and the debtor
finance company.
Factoring is the same as invoice discounting, but goes one step further. In
addition to turning credit sales into working capital, factoring also introduces
a debtor administration and control function. Unlike invoice discounting,
factoring is a disclosed service and debtors are therefore aware of the
involvement of a debtor finance company.
The debtor finance company will allow you to draw 70 per cent to 80 per cent
of the money owed to you by existing debtors immediately (or later if you
wish), with the balance becoming available once the debtors have settled
their accounts. Typically, you will be charged one per cent above the prime
rate on the money actually drawn or utilised. In addition, an administration
fee is also normally levied. Bad debts will be for your own account.
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Not all businesses qualify for debtor finance. Typically, you will have to
satisfy the following criteria:
Debtor finance is available from all the major banking groups and offers a
flexible and continuous source of short-term finance that is directly linked to
growth in sales.
You may not consider credit and garage cards major sources of short-term
finance, but they can help your business to limit the demands on its cash
flow. They also improve administration of expenses and offer great
convenience.
Asset finance
Asset finance is used to purchase movable assets, typically new and used
vehicles and equipment. The most common types of asset finance are
instalment sale, lease and rental.
Asset finance allows you to acquire the use of an asset without having to
outlay the full purchase price. It is particularly useful where a business
expects to make profitable use of the asset immediately.
A deposit may be required, with the balance owing being repaid in monthly,
quarterly, half-yearly or annual instalments.
The deposit required may vary depending on the asset being bought, the age
of the asset and the credit rating of the borrower. For example, an item of
specialised machinery not likely to be sold easily in the event of a liquidation
would require a larger deposit than a machine which is in everyday use in
many factories around the country.
Note that both the size of the deposit and the maximum term may vary
according to the legislative requirements at the time of the transaction.
Instalment sale
- Ownership of the assets being acquired vests in the bank until the final
payment when full ownership passes to the borrower.
Lease
- Assets that are only required for a specific time period or assets that
are expected to have no or little value at the end of the finance term
should rather be leased than bought.
- VAT - As with the instalment sale, Value Added Tax (VAT) is payable
on the full purchase price at the beginning of the agreement with
possible input credits that may be claimed. There are no VAT
implications at the end of the lease except if the lessee acquires the
asset for a further consideration. In this event, a tax invoice will be
issued by the bank (on request) which the lessee may use for the
purposes of obtaining an Input credit.
- Tax treatment - Tax benefits allowed are based on the lease payments
plus operating costs, provided that accurate records have been kept.
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There are also tax implications should the lessee opt to acquire the
asset upon expiry of the lease. Irrespective of the acquisition cost
(which may be nominal), the deemed book value of the asset must be
added to income for tax purposes. The reason for this treatment is that
the full value of the asset and interest have already been claimed for
tax purposes over the term of the lease.
The business sells the asset to the bank which in turn grants the
business the right to use the asset. The term of the lease and what
happens to the asset once the lease expires are negotiable.
Rental
- Ownership - As with the lease, the ownership of the asset does not
pass to the renter (the business paying for the use of the asset) at the
end of the term. End-of-term options are negotiable and include
handing the asset back to the bank, refinancing the asset under a new
agreement or buying the asset outright.
- VAT and tax treatment - VAT is payable on each rental payment with
possible input credits that may be claimed. The tax implications of
lease and rental agreements are similar.
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The ownership, VAT and tax aspects of the three types of asset finance are
summarised below.
In contrast the
capital portion of
the repayment is
made from after-
tax income
Medium-term loan
A term loan is a finance facility granted for a fixed term of up to five years,
and in some cases up to seven years, with a structured repayment pattern.
Term loans are typically used when asset finance may not be suitable.
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- plant and heavy machinery that may fall outside the scope of normal
asset finance facilities.
Interest rates charged are usually variable and linked to the prime rate.
Installments may be paid monthly, bimonthly, quarterly, half-yearly or
annually.
The term loan facility is continuously being enhanced and new innovative
features are being added. Some of the recent additions include a drawdown
facility, and access facility and a capital moratorium facility.
The drawdown facility allows the borrower to take up the loan by way of a
number of drawings over a set maximum period, say six months. Capital only
becomes payable once the full amount of the loan has been taken up.
The access facility allows the borrower to withdraw advance payments made
on the term loan. This allows the borrower to access deposits to the term
loan, that are over and above the agreed-to instalments.
Often repayments may also be structured to escalate over time. Initially, the
capital repayments are low, but they are stepped up later when the purpose
to which the loan has been put is generating sufficient income to meet the
escalated payments.
Commercial and industrial property loans can be raised against the value of
the property offered as security. Typically, it is possible to raise a commercial
and industrial property loan amounting to 75 per cent of the valuation of the
property for commercial and industrial properties. Usually such loans are
repayable over periods of up to 20 years.
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The minimum loan is usually about R250 000, with the minimum repayment
term being five years, with a maximum of 15 to 20 years. Under certain
circumstances, there may be a capital moratorium, offering considerable
cash flow advantages, for the first five years of the loan. In this case, only
interest will be payable during this period.
In terms of the Participation Bonds Act, loans may not exceed 75 per cent of
the valuation of the property. The interest rate fluctuates with market trends
and is indirectly linked to the prime overdraft rate. Historically, the interest
rate has remained below the prime overdraft rate.
What is collateral?
What can you provide the bank as security for your loan. Do you have
investments, policies or some value in you house over and above your
mortgage loan?
Should your business not succeed the bank can then realise the security to
settle your loan account.
- It must not depreciate rapidly. With some forms of security (e.g. listed
shares), fluctuations might occur, but in such cases the financier would
maintain a safe margin. Consequently, the security value provided
would be less than the present market value.
In most cases, the security value of the collateral will be less than the
realistic market value. The reason for this treatment is threefold:
- once finance charges are taken into account the settlement value of
the loan may exceed the market value,
- the market value of most assets is subject to some fluctuation and the
financier must protect his or her interest by allowing a safety margin,
Exactly what kind of collateral is acceptable to the bank and what security
value is attached to such collateral will depend on the type of finance or loan
selected and the policies and preferences of the institution providing such
finance.
Common sources of collateral are listed below, but note that they are
not all rated equally:
Equity refers to the capital invested by the owners in the business. It remains a primary
source of finance, particularly in starting a business. It can take four forms:
Always remember that you are more likely to attract financial backing from
parties external to your business if you make an adequate financial
contribution yourself. How can you expect other people to risk their money in
your business when you, the ultimate beneficiary of its success, are unwilling
to do so yourself? Your own contribution is viewed as a sign of your
commitment to make the business work and will reduce the perceived risk to
outsiders who may want to back you financially.
When applying for loan finance from financial institutions you will find that an
own contribution is an essential requirement for the loan to be granted.
Generally, the more risky the purpose to which the finance will be applied,
the higher the own contribution required.
- Owners’ loans are less flexible from the owner’s perspective. Firstly,
the owner is unable to withdraw his capital unless the business has
reached the stage where it no longer requires the loan. Secondly, if the
loan account is not interest-bearing, inflation will significantly reduce
the real value of the loan account over time.
Banks, through their life assurance broking divisions, offer a product called
Loan Account Assurance which entails investment policies to replace loans
made by owners to the business.
Having considered other sources of finance, you may still find that you have
to increase the capital base of your business more than you can from your
existing resources. As a result you have to look elsewhere. This means that
you must consider the use of partners, co-members (in a close corporation)
or shareholders (in a company) to generate the required capital for your
business.
Often outsiders are brought in as a matter of need. This occurs when gearing
would be raised so high by additional loans that the risk would be
unacceptable to lending institutions. Under such circumstances, the owner
has to consider selling off part of his or her own stake to outsiders in order to
generate new capital for the business.
However, bringing in co-owners is about more than just raising capital. It may
also mean sharing the control of the business as well as its profits, and
perhaps joint decision-making on important matters.
The advantages are obvious: Financially you are creating a broader capital
base for future expansion, you may address the issue of succession should
something happen to you, and the newcomer(s) may bring a fresh and
experienced outlook to the business. Moreover, the newcomer(s) may relieve
you of the burden of lonely decision-making, which weighs so heavily on the
independent business owner.
- How active will the new co-owner be in the business? Will he or she be
a sleeping partner, entrusting you with the full responsibility for the
success of the business or will he or she dictate? How involved will he
or she be in the day-to-day running of the business?
- What skills, experience and business contacts can the co-owner bring
to the business? Ideally they must complement rather than duplicate,
your own.
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- Does the new co-owner share your vision and goals for the business?
Depending on the tax ruling of the day, there might even be tax implications
in the distribution of profits. Generally, the Receiver of Revenue looks more
favourably upon reinvested profits than distributed profits, which may be
taxed at a higher rate. The Receiver’s intention may be to encourage
businesses to reinvest their profits in the hope that they will expand their
operations.
A further principle of finance is that there is always a trade-off between risk and return
(the cost of finance). The higher the risk associated with your business, the higher the
return expected by the provider of finance, that is, the more you will have to pay for the
finance.
In deciding on the most appropriate source of finance, you must consider various
factors carefully. The most important considerations will be outlined in the paragraphs
below.
Assuming a tax rate on business profits of 30%, then for every one
rand the business pays out in interest it receives a tax saving of 30
cents. The effective rate of interest on a loan is therefore less (to the
extent of the tax rate) than the nominal or quoted rate of interest.
Remember that in reality a business can only deduct interest to the
extent of profits.
- Debt can increase the return on equity (the money invested in the
business by its owners). Debt effectively levers the profits as the
owners are using other people’s money to make more profits. In other
words, the owners are increasing profits while their own investment in
the business remains constant.
6.8.2 Risk
Gearing may reach such a high level that the business becomes
saturated with debt (it is unable to raise any further debt finance).
Remember, debt taken up now may take you closer to the point of
saturation, which in turn may reduce your future borrowing capacity.
- Over and above interest, debt also requires capital repayment. These
regular capital payments represent cash outflows and may therefore
put a strain on the cash available in the business.
6.8.3 Control
6.8.4 Flexibility
6.8.5 Capacity
- In the case of debt finance you have to analyse the borrowing capacity
of the business. Assess the value or net assets of the business and
establish whether the flow of cash through the business will cater for
the servicing and repayment of debt.
- Your business may lack borrowing capacity and you may therefore
have to look at equity finance. Equity also enhances the capacity of
the business to make future borrowings.
- You need to consider how your present choice of finance may affect
your future ability to raise finance.
Some of them can create problems which may soon become financial
difficulties. They include labour disruption, congested harbours and transport
problems, a break in the supply of raw materials, and a sudden rise in the
cost of key input material which you are unable to pass on to consumers.
These hazards are not highlighted to discourage the use of debt finance. The
danger lies in excessive levels of debt which leave little or no room for
dealing with contingencies. Always be sure to have some reserve borrowing
capacity which you can use to raise short-term finance to see your business
through unforeseen eventualities.
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Sound business plans to buy, start or expand a business depend above all on a proper
financial mix, i.e. matching the asset to be financed to the appropriate term and type of
finance. In arriving at this financial mix, the factors of cost risk, control, flexibility,
capacity and the business environment have to be considered in order to fine-tune the
financial mix for the unique requirements and preferences of your business.
*Note: Equity rather than debt is considered the most appropriate source to finance
goodwill. Usually banks will not entertain any applications for the finance of
goodwill.
The table above provides a useful summary of the content of the booklet thus far and
concludes the discussion on financing your business and its operations.
The business cheque account is the foundation of all your business banking
requirements. This account not only caters extensively for the transactional
requirements of your business, but it also provides for an integrated
approach to managing your banking requirements through links with other
important banking services.
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Electronic products provide for good security and increasingly they are
becoming ‘friendlier’ to use.
Settlement services
One of the major risks associated with international trade is that of default.
Settlement services, such as documentary credits and documentary
collections, offer a degree of protection to both the importer and the exporter.
Other less sophisticated settlement services include bank drafts (foreign
cheques) and electronic transfers.
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If, as an exporter, you are uncertain about the standing of the foreign bank
issuing the documentary credit (the importer’s bank), or uneasy about the
country to which you are exporting, you may ask your own bank for written
confirmation. This is known as a confirmed letter of credit.
With a documentary collection, the exporter ships the goods and presents his
or her own bank with commercial and/or financial documents to be forwarded
to the importer’s bank for payment. The exporter retains control over the
goods as ownership only passes to the importer upon either payment or
acceptance of (usually) a bill of exchange.
Capital import financing is available from some countries that offer subsidised
medium- to long-term facilities to promote the export of their capital goods.
Hedging services
An importer can fix the rand value of his or her foreign currency obligation,
payable at a later date, at the time the FEC is drawn up, thus enabling the
business to determine its profit margin.
These guarantees and releases are required for the release of imported
goods that arrived before the relevant documentation. They cater for late
arrival and non-arrival of documentation.
Goods retained at the port of entry, awaiting documentation, may make the
importer liable for demurrage (‘holding’) costs for the period of retention.
Shipping guarantees and airport releases avoid these costs and allow the
importer to clear the goods immediately on arrival. This is possible because
the bank indemnifies the shipping company in respect of any claims that may
follow the release of the goods.
Advisory services
The introduction of point of sale (POS) card terminals has enhanced the
service available to merchants. These terminals capture transactions at point
of sale and forward the data via the bank’s mainframe to your local branch on
the same day. The POS card terminals offer many advantages, including
great convenience to both merchant and cardholder, cheque verification,
automatic control of fraudulent card transactions, improved processing speed
at point of sale and reduced risk arising from cash holdings.
Business, garage, petrol and fleet cards make for great convenience while
enhancing the administration of expenses. Business cards enable staff to
pay for accommodation and travel expenses, and garage, petrol and fleet
cards can be used to pay for fuel, oil and maintenance.
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Any business and its owner(s) are continuously exposed to various forms of
risk. Unless the business takes the necessary steps to safeguard its interests
against risk, such events may seriously harm, if not ruin, the enterprise.
Cover against risk is available from the broking divisions of most banking
groups today. In addition, they will often also assist businesses with the
establishment and management of pension funds, provident funds, group life
schemes and medical aid schemes.
Life assurance
Key-person assurance
People are often the most important assets in a business, yet they are never
reflected as such on the balance sheet of the business. How would the
business cope should it lose one of these assets (a staff member key to the
continued success of the business)?
Such a loss is normally a very unsettling experience for any business. The
business may lose momentum and creditworthiness and it may take time and
money to find a suitable successor.
Partnership/shareholders’/members’ assurance
For example, In the event of death, the heirs may want to sell their stake in
the business, which may put the other owner(s) in the business in a serious
predicament. They have to find the money to buy the deceased owner’s
stake from his or her heirs.
- Capital funds assurance may be used to provide for the specific future
capital needs of a business (for example, replacement of fixed assets
or expansion).
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Short-term insurance
Every business needs protection against short-term risks such as fire, theft
accidents and other insurable risks.
Businesses that sell to local or foreign organisations on credit terms may also
avail themselves of credit insurance for debtors. The cession of a credit
insurance policy provides added security to the bank, which may provide
larger finance facilities than would be the case without the insurance (and
perhaps at more favourable interest rates).
To attract and keep good staff, a business must pay attention to the short-
and long-term well-being of both owner(s) and staff.
Staff benefit schemes assist the business with this important task by
providing for illness (medical aid), death and disability (group life assurance),
and retirement (pension and provident funds).
You are best advised to seek the advice and guidance of the staff benefits
specialist at your bank to formulate a flexible scheme that will best meet the
needs of both the staff and the business.
6.11 Disclaimer
Absa or any of its agents, contractors, assignees or employees, does not accept
liability of any nature whatsoever for any loss sustained by any person (whether
natural or juristic) who/which makes use of the information contained herein and any
person who uses it, does so entirely at his/her own risk. This booklet is a basic
guideline only. Most issues will require professional assistance.