Understanding debt finance for small businesses

Debt finance is a common source of finance for both start-ups and established businesses. Most debt finance takes the form of a loan that you repay to the lender, along with fees or interest. You'll often have to provide personal guarantees, which can put your personal finances at risk.

There are many lenders, banks and financial institutions in London that provide debt financing deals for small businesses. In this blog, we explore the different types of debt finance and the potential risks you need to look out for.

What are the different types of debt finance?

Bank loans

Bank loans are one of the most common forms of debt finance. Often called "term loans", you pay them back over a set period.

Typically, you'll use a business asset or one of your personal assets as security for a bank loan. This gives the lender some security if you don't make your loan repayments in full. Lenders charge interest on the full amount of the loan, so it's important to borrow only the money you need.

When looking for a bank loan, shop around to see what deals are available from both online and high-street banks. Compare their different interest rates, loan terms and agreements, and whether you can manage the repayments.

It's also worth checking whether the bank offers any extra incentives, such as an initial repayment holiday, reduced initial interest rate or lower set-up fees.

Commercial mortgages

Commercial mortgages are loans you use to buy, refinance or develop business property. Typically, you repay them over a period of 10 to 20 years or, in some cases, even longer. However, some commercial mortgages have repayment periods as short as three years.

Mortgages are secured on your property, which will be at risk if you fail to keep up with your repayments.

Most banks and building societies provide commercial mortgages, and all will investigate your business' current position, outlook and credit history before accepting your application. Some banks might also check your personal credit history.

Overdrafts

An overdraft is a simple, flexible way to finance your business with a limit set by the lender. You'll only pay interest on the amount that is overdrawn. The interest rate is usually higher than on a loan, but interest is calculated daily, so it often works out cheaper.

Overdrafts are typically for short-term boosts to cash flow rather than buying capital items (such as tools, machinery, vehicles, computers and so on). You pay them back when the lender demands, and the lender will usually need some form of security.

As with bank loans, you'll probably have to pay set-up fees when you take out an overdraft.

Credit cards

A business credit card is a convenient form of finance that lets you make purchases up to an agreed credit limit, which you then pay for later.

At the end of each month, you'll receive a bill for all the purchases you've made. You don't have to repay the whole amount you owe, but you'll be charged interest on any outstanding balance.

Interest rates are usually higher for credit cards than overdrafts and loans, so it can be an expensive way of financing your business purchases. You may be able to take out a 0% interest credit card, which will offer an initial interest-free period.

Factoring and invoice discounting

Factoring and invoice discounting allows your business to "sell" some or part of your invoices to a factoring company. They then pay you an advance on your invoice, so you don't have to wait what can be between 30 and 90 days.

Factors advance a certain percentage of the value of approved invoices (usually 70% to 85%). You still raise the invoices and send them to your customers, but the factor collects the payments. You'll then receive the balancing payment, minus the factor's fee and interest.

Invoice discounting is similar to factoring except that the responsibility for collecting payments from customers remains with your business. This means the customers never need to know that you're using an invoice discounting service. Invoice discounters charge a monthly fee plus interest on the net amount of cash they advance you.

Asset finance

Asset finance is where a lender provides you with finance so you can buy capital equipment (such as machinery or tools) for your business. The loan is secured on the asset that you buy.

There are two types of asset financing: leasing and hire purchase.

• With leasing, you return the asset to the lender at the end of the lease period.

• With hire purchase, you take ownership of the asset at the end of the agreement and once you've paid back the full amount you borrowed.

Choosing the most appropriate debt finance

When deciding which type of debt finance to use, you should consider the following factors:

• How much you need to borrow.

• How you'll use the money.

• The period of the loan.

• The security the lender asks for.

• The repayments you can afford.

• The level of risk you're comfortable taking.

For example, you could resolve a short-term cash flow problem with an overdraft. However, if you need to buy expensive equipment, a longer-term bank loan or asset finance may be more appropriate.

Deciding how much to borrow

Deciding how much debt finance to borrow is a relatively simple equation. You just need to estimate the total cost of your plans.

However, you should also prepare a detailed cash-flow forecast and include the repayments, interest and any fees associated with the debt. This will help you decide if you can manage the repayments.

Providing information for lenders

You'll need to provide information to help lenders decide whether to approve your application. This typically includes:

• Business bank statements.

• Accounts for the last two years.

• Budgets and cash-flow forecasts.

• Details about customers.

• Details about business assets for security.

Risks of debt finance

The ultimate risk of debt finance is being unable to make the necessary repayments.

To pay off the remaining debt, the lender could seize and sell any business assets you provide as security. If the debt was secured under a personal guarantee, the person or people who gave the guarantee would have to pay the debt.

If you get into any financial difficulties, it's important to tell the lender as soon as possible so they can help resolve any issues. Putting things off, or trying to deceive lenders, will only create bigger problems in the long run.

Debt finance hints and tips

• Plan ahead – it can take time to secure the right form of debt finance.

• Prepare detailed forecasts that you can provide to potential lenders. These will increase your chances of securing finance by showing you're serious and that you're capable of repaying on time.

• Consider the different types of debt finance available to your business and discuss them with an accountant or other business adviser.

• Work out how much your business actually needs to borrow. Be realistic: if your business doesn't borrow enough, it might be tricky to go back to lenders for more. If you borrow too much, you'll have to repay money you didn't need.

Your cultural and community space toolkit

If you're reading this guide as part of the toolkit for opening, running and growing a cultural or community space, next look at step 15: understanding angel investment.

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