Professional Documents
Culture Documents
PRINCIPLES OF FINANCE
6.1
6.2
International trade
The answers to these questions will be covered in the pages that follow.
2
6.3
Items financed
Debtors
Stock
Work in progress
Creditors
Vehicles and
equipment
Plant and
machinery
Setting up a
business or a
franchise
Renovation of
premises
Land and buildings
Long-term
(Typically 5 20 years)
Type of product
Cheque overdraft
Commercial property
finance
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.
6.4
Sources of finance
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:
6.5
Internal sources (financing the needs of the business from its cash flow)
Internal finance
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.
3
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.
6.6
4
Bank overdraft
A bank overdraft is a facility that allows the business to make payments
beyond the amount of money in the cheque account of the business. The
intention of a bank overdraft is to bridge the gap between cash inflows and
cash outflows. It funds the business through its working capital cycle.
Note:
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 borrowers 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.
Unlike other sources of finance a bank overdraft is repayable on demand.
A bank overdraft is a flexible source of short-term finance and if used
correctly it may be very cost-effective.
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 specialist expertise of debtor finance companies enables them to place a
much higher value on debtors than their banking colleagues. This source of
short-term finance is therefore particularly suitable to rapidly expanding
businesses that have outgrown their bank overdraft facilities.
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.
5
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.
Credit card finance
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.
Balances on cards have to be settled within 25 days of a statement being
issued, allowing for interest-free finance of up to 55 days.
6.6.2
6
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.
Residuals, often referred to as balloon payments, are available on installment
sale, leases and rentals, and require some explanation.
A residual is a facility made available to the borrower which results in a
portion of the capital of the asset not being paid off during the term of the
agreement.
Instead, there is a lump-sum payment (end or final payment') to make at the
end of the agreement The residual, commonly expressed as a percentage,
has the effect of lowering monthly installments, but interest remains payable
on the full outstanding amount including the residual amount.
Residuals should be considered carefully, as a large obligation to pay arises
at the end of the agreement. Unless the market value of the asset at least
equals the outstanding residual amount a shortfall may result. Residual
percentages should therefore not be too large and should not be used for
assets with a short lifespan. The various forms of asset finance are
discussed in the paragraphs that follow with particular reference to the issues
of ownership of assets, VAT and tax treatment.
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.
7
An important difference between instalment sale and lease is that
lease payments are made against income (profit) before tax, whereas
instalment sale payments (the capital portion) are made out of after tax
income.
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.
-
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.
8
Asset finance in summary
The ownership, VAT and tax aspects of the three types of asset finance are
summarised below.
Content
Instalment sale
Lease
Rental
Vests in the
bank, as with
lease
agreements.
Ownership
Payable on the
full purchase price
at the beginning
of the agreement.
As with installment
sale, payable on
the full purchase
price
at
the
beginning of the
agreement.
Calculated and
payable on each
rental payment.
Subject to the
assets being used
in the production
of
income,
depreciation and
interest payable
are allowed as
tax-deductible
expenses,
i.e.
they reduce the
level of income on
which tax will
become payable.
Lease
payments
are allowed in full
as claims against
pre-tax income, i.e.
they reduce the
level of taxable
income
and
therefore tax.
As with leases,
rental payments
are allowed in
full as claims
against pre-tax
income, i.e. they
reduce the level
of
taxable
income
and
therefore tax.
VAT
Tax
End-of-term
options
are
identical
to
leases,
i.e.
return the asset
buy
it
or
refinance it.
In contrast the
capital portion of
the repayment is
made from aftertax 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.
9
Some of the uses of term loans are to finance:
-
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.
In some instances, the bank might agree to a capital moratorium being
granted for a limited period. Such a moratorium will result in the borrower
servicing only the interest on a loan for a set period, after which the
repayment of capital will resume.
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.
6.6.3
10
Like residential mortgage bonds, commercial and industrial property loans
are becoming increasingly innovative and flexible. Today, these loans offer
an opportunity for tax-efficient saving by allowing the business borrower to
make advance payments with the ability to access these excess payments
later. Early settlement of the loan is also permitted without penalty.
Participation mortgage bonds
A participation mortgage bond provides the business with medium- to longterm finance to buy or build commercial and industrial property.
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.
6.6.4
11
-
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,
12
6.7
6.7.1
Own capital
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.
6.7.2
Owners' loans
Owners loans, often referred to as shareholders loans, refer to medium- to
long-term loans made to the business by its owner(s). In the strictest sense,
owners loans do not represent equity as they are net investments in the
business (they have to be repaid), but are considered near-equity as they still
represent entrepreneurial finance or owners funds. They may also arise
when a proportion of remuneration is retained in the business to provide
additional working capital. Owners loans are reflected as loan or capital
accounts in the financial statements of the business.
It is useful to bear in mind the following considerations relating to
owners loans:
-
13
Owners loans are less flexible from the owners 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.
6.7.3
Bringing in outsiders
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.
When looking for a co-owner, it is important to look beyond his or her
money. Other important considerations are:
-
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.
14
-
Does the new co-owner share your vision and goals for the business?
Retained earnings
In newly established and fast growing businesses, the reinvestment of profits
may be particularly important as a source of funding. Remember that what
you do with profits has a direct effect on your cash flow. Should you decide to
distribute profits to the owner(s), such payments will cause a cash leak or
cash outflow which may impact adversely on the running of your 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 Receivers intention may be to encourage
businesses to reinvest their profits in the hope that they will expand their
operations.
6.8
15
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.
In contrast the return on equity (in the case of a company it is
dividends) is not tax-deductible and therefore, unlike debt it brings no
tax relief to the business. The effective and nominal costs of equity are
the same.
-
6.8.2
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 peoples money to make more profits. In other
words, the owners are increasing profits while their own investment in
the business remains constant.
Risk
-
6.8.3
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.
Control
-
16
6.8.4
6.8.5
6.8.6
Flexibility
-
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.
Business environment
-
17
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.
18
6.8.7
Return/cost
Debt finance
Equity finance
- Interest is tax-deductible
- Repayment
of
debt
represents
a
fixed
obligation that must be
met.
- No fixed
exists.
- Equity
finance
inherently flexible.
- Equity
(moderate
levels
of
debt)
enhances the capacity
of the business to
cope with hazards and
eventualities in the
business environment.
Risk
Control
Flexibility
Capacity
Business
management
obligation
is
19
6.9
APPROPRIATE
FINANCIAL MIX
APPROPRIATE TERM
Debtors Stock
Work-in-progress
Short-term(less
than 1 year)
- Internal finance
- Bank overdraft
- Debtor finance
- Vehicles
and
equipment
- Plant
and
machinery
- Buying
a
business
or
franchise
- Setting up a
business
or
franchise
- Renovation of
premises
Medium-term
(typically 1-5 years,
but up to 7 years)
- Land
buildings
- Goodwill*
Long-term
(in excess of 5
years, up to 20
years)
- Commercial
and
industrial property
loans
- Participation Bonds
- Equity
*Note:
and
FACTORS TO
CONSIDER
Cost
Risk
Control
Flexibility
Capacity
Business
environment
Instalment sale
Lease
Rental
Medium-term loans
Equity
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.
6.10
20
Some of the many features of this essential product are:
6.10.2
6.10.3
21
A documentary credit, also known as a letter of credit or L/C, is issued by the
importers bank and guarantees payment to the exporter, as long as the
exporter conforms to the terms as prescribed by the importer in the
documentary credit. The exporter has to submit documentation, e.g. proof of
shipment to the effect that he or she has satisfied the conditions of the credit
before the importers bank will make payment.
It is advisable to keep the terms of the documentary credit as simple as
possible. Non-conformity with complicated clauses and conditions may cause
unnecessary delays and prove costly to both importer and exporter.
If, as an exporter, you are uncertain about the standing of the foreign bank
issuing the documentary credit (the importers 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.
A documentary credit is the ideal instrument when dealing with a buyer
(importer) known only by name to the seller (exporter) as it provides, by
means of the backing of the importers bank, for payment security.
A documentary collection, also known as a foreign bill for collection (FBC),
offers less protection than documentary credit and is therefore ideally suited
to cases where trading partners are known to each other and where a basis
of mutual trust already exists.
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 importers 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.
A documentary collection does not guarantee payment, as the importer may
not accept the documents or bill of exchange. However, it offers substantially
greater security than settlement on an open account basis.
Finance in foreign currency (offshore finance)
Sophisticated mechanisms are available to finance the import and export of
goods, capital imports and working capital.
Foreign currency trade financing provides short-term finance to importers and
exporters in a foreign currency. This may offer several advantages, including
lower financing costs, but should not be undertaken without the expert advice
of your bankers.
Capital import financing is available from some countries that offer subsidised
medium- to long-term facilities to promote the export of their capital goods.
Working capital financing involves the raising of short-term loans in a foreign
currency to meet normal working capital requirements. Ask your banks
international banking experts for advice on these financing mechanisms.
22
Hedging services
Any business involved in international transactions has to consider the risk of
exchange rate fluctuations. The most commonly known and used hedging
mechanism is the forward exchange contract (FEC). These contracts provide
protection against loss as a result of exchange rate fluctuations.
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.
Similarly, an exporter who only receives payment after shipment can
determine and lock in the exact rand value of the future receipt at the time of
entering into the FEC.
Shipping guarantees and airway releases
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
Banks offer a range of advisory services to existing and prospective
international traders. The services available include advice on exchange
control matters and investment opportunities, trade promotion, exchange rate
movements, and bank reports on foreign institutions, businesses and
individuals.
6.10.4
23
Fleet management services are attractive to fleet-owning businesses as they
simplify the administration of fleets, enhance control of vehicle expenses and
provide valuable management information.
Like electronic banking, card-based services are subject to technological
innovation and you are best advised to contact your local branch for an
update on the services available.
6.10.5
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).
24
-
Short-term insurance
Every business needs protection against short-term risks such as fire, theft
accidents and other insurable risks.
Insurance cover is usually a condition of financing agreements in respect of
property, vehicles, plant equipment and other assets. Banks are in a position
to arrange such cover at favourable terms with leading insurers. This broking
and risk management service is available at no extra cost.
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).
Staff benefit schemes
To attract and keep good staff, a business must pay attention to the shortand 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.