Rising interest rates and falling property prices could cut loans to
SMEs that are attempting to grow. I looked at the borrowing
options and how the money lenders measure up … for In The Black.
One of the eternal problems for start-up businesses or growing SMEs is getting access to credit.
Susan Campbell, finance policy adviser at CPA Australia and principal consultant at Argyll Financial Consulting, says that often small businesses use family homes or investment properties as asset backing, creating an easy, cheap source of credit.
The Commonwealth Bank’s Steve Morgan – regional executive manager, business banking – says that the backbone of the Australian economy are sole traders or small partnerships, who typically secure lending on the home. Some have regular mortgages, others are lines of credits, overdrafts or loans. A typical debt structure would be some sort of term loan for the core of the debt, working overdraft and a business credit card.
Campbell says the changing property market is having an impact on SMEs: ‘When you need more money at a time when house prices are going up you can say ‘I’ll keep increasing my loan’. But when your house price starts going down, you can’t go and increase your loan.’
She says the problems are exacerbated for fast growing businesses or companies that don’t understand the profit and cash flow of their business.
‘Some businesses have had the luxury during the last few years of easy access to money. But that could well be drying up and could dry up quite rapidly during 2004.’
Usually banks will lend between 70 and 80 per cent of value of the house. Campbell says that the banks are usually interested in where the money is going and how the all-important business plan is shaping up. Many mortgage brokers, however, aren’t so interested in where the money is going. She warns that people involved with such brokers risk being forced to sell their house should the business implode.
Keith Rodwell, managing director of GE Commercial Finance, says that a lot of asset-backed bank facilities are a five-year term but with annual review points. Under bank regulations facilities less than 12 months require less equity.
He says that in the eyes of the banks the 12-month loan is lower risk and as a result it can be priced cheaper. Rodwell says: ‘The risk though is then passed to the customer because now they don’t have a five-year commitment. It is probably a less known issue at the moment because we have gone through such a long period of economic strength.
‘If you go back to the early 1990s you will see that this happened significantly. This is an issue for companies today. They need to think about what they would do if they had to pay back more of their facilities.
‘How would they handle that?’
CPA Australia’s Campbell says that although the prospect of a severe fall in house prices may be some way off, companies should be thinking now about reviewing their property-backed borrowing facilities.
‘It’s now the time to do it – not when the crunch has come and you are panicking.
‘If you want to go sourcing for funds you want to do it from a position of power,’ she explains.
She adds that it is not easy to find alternative sources of finance. ‘People don’t always want to have partners involved in their business or other potential investors who may take the idea or kick them out.’
Alternatives are venture capitalists and business angels, where the options are few and far between. Many people as a last resort look to family and friends. But Campbell warns to shy away from handshake deals and to ensure that investors understand the details and that the terms are put into writing.
‘I’ve seen examples when people have borrowed from family or friends who thought they were actually investing in the firm and sharing in the capital growth. But the people who owned the firm just thought it was a loan,’ she says.
GE’s Rodwell says that SMEs inevitably reach the point where directors want to separate personal assets and business assets.
‘If you’ve been running your business for 10 or 20 years at some point you feel like you deserve to release your home,’ he says.
‘A lot of the business lending is effectively home-loan lending. Again, short-term in nature and secured by your home. And some point the business needs to stand on its own two feet.’
One of the problems for SMEs is having the clout and expertise to negotiate with banks in addition to identifying the best deal structures and deals on finance.
Andrew Nicholls, director, NCS Nicholls Corporate Services, had over 20 years experience as a senior strategist and adviser at the National. He says that as small business grow into larger, more profitable ones, their finance requirements and structures need to change. He says that borrowing at the smaller end of the market is very difficult.
‘The general banking market is not tolerant of new business unless they’ve got the bricks and mortar to support them.’
He says that as the banks have segmented their market many clients have found they are being ostracised and pushed onto telephone platforms.
‘They were, and still are, screaming out to have that bank manager as the confidante to the business. But unless a company makes a lot of money for the bank, nowadays relationship banking is a thing of the past down at the smaller end.
‘Even at the larger SME level, while there are relationship managers in place, obviously they are pushing their own bank’s products.’
What Nicholls does is not only help find new funding for companies but also restructures their existing arrangements. The advice goes beyond debt funding to including transactional cash management advice as well as risk management on interest rates and foreign exchange.
The main concern for established businesses or mature businesses is that the directors often want to split their personal assets away from the business assets.
Nicholls says: ‘Nowadays there are ways where businesses can finance their operations purely on the balance sheet.’
One method is debt finance, a form of factoring but invisible to the customer. ‘It doesn’t have the traditional ramifications,’ Nicholls explains.
Traditional factoring is known as ‘lender of last resort’ when a company is running into trouble. Nowadays the twist on factoring is that invoices can be mortgaged to the bank, which provides 80 per cent of finance.
The company, rather than the bank, invoices the client direct. This finance, however, is for companies with a financial track record of two to three years, a turnover of at least $1m to $2m, and a debt requirement from a few hundred thousand dollars upwards.
Nicholls says another source of finance is leasing. But he cautions businesses to be careful of the cost of this option. For example, the high depreciation of IT equipment means that the lease costs are higher than, for instance, a car. ‘But it suits people and certainly protects company’s and individual’s cash flows,’ he points out.
Many businesses survive on overdrafts and credit cards but these are costly ways to finance a business.
Nicholls says: ‘Most businesses are unaware how expensive it actually is to run an overdraft. The premiums are enormous. They are a fantastic facility for come-and-go requirements for companies that are cash-strapped over a few months.
‘The whole reason for having an overdraft is to cover those peaks and troughs in cash requirements.
‘What a lot of companies tend to do is have it become their easy form of long-term finance. And what they need to understand is that they are paying enormous margins on it.’
Some banks specialise under $2m. Both the Commonwealth and St George are targeting small business.
The Commonwealth’s Morgan says that the bank focuses on cash flow and the track record of the people running the business more than asset backing in its relationships.
He says that the prospects of changing economic conditions and falling house prices aren’t causing concern in the bank’s risk management.
‘It’s probably from our point of view business as normal,’ he says. ‘There’s always going to be cycles in most markets.
‘When we are making a lending decision it’s not so much on the ups and downs of the market but the underlying cash flow of the business.
‘The vast majority of what we do is based on the fundamentals – the track record of the business, the cash flow of the business and perhaps the collateral that’s gone in there.
‘The security is only a fall-back position.
‘Obviously banks aren’t in the business of trying to sell assets and wind up loans. That’s not good for either party.’
Bob Greves, executive manager, small business at the Commonwealth, says that SMEs looking for finance should put a great deal of effort into their business plans.
‘No one is going to come near you unless you spend a lot of time on the viability of the business going forward,’ he stresses.
‘You’ve got to show some sort of track record. Even venture capitalists – they’ll look at the business plan but they will also look at the individuals that are running it and how they have gone in the past.’
Morgan says that typically a bank will want to review three years of financial records. Many decisions are made after visiting a company’s offices.
‘Typically,’ he says, ‘you get a good sense of how a business is travelling when you walk through the premises.’
Further reading – Funding issues for small business start-ups
‘Banked up’ by John Kavanagh, BRW, 20 November, 2003
‘Cash for the asking’ by Jacqui Walker, BRW, 8 April, 2004
Driving small business by Noel Whittaker and Des Knight, Simon & Shuster, 2002
Financial freedom for your business, Morris Kaplan, Hardie Grant, 2003
You’ve got a business idea: start me up: now make it happen, Toney Fitzgerald, Simon & Schuster, 2002