Cash flow to grow. The best sources of working capital for SMEs

Cash flow to grow. The best sources of working capital for SMEs

Content: Introduction Why is it difficult for SMEs to seek working capital? Information asymmetry Lack of collateral High cost to entry Short term focus What s the alternative? How to get a lender to swipe right on your business? Stating your business case Getting your books in order Upskilling and training your staff Choosing the right source of finance Credit card Private equity investment Bank overdraft facility Factoring or invoice finance Trade finance

78 % of SMEs say cash flow is the most important to business. Introduction. In September 2016, Australian SME magazine, My Business, surveyed its readers and asked them about growth, profitability, and funding for the current financial year. When asked which areas of finance are most important to their business, 78 per cent of SMEs said cash flow.

SMEs face serious cash flow issues. Australia s 2 million SMEs account for close to 70 per cent of all industry employment and 56% of the output of the private sector. Despite being such drivers of growth and innovation in the country, SMEs face serious cash flow issues, largely due to delayed payments by debtors and difficulty in accessing bank finance. If a business is seeking funding for growth or to finance a sales contract, there can quite often be a lengthy approval process for a bank loan. This delay often means a lost opportunity for the business. 26.5 % of Australian Businesses seek finance for survival. -Australian Bureau of Statistics (ABS) 2015-16 Business Characteristics Survey However, when we consider the Australian Bureau of Statistics (ABS) 2015-16 Business Characteristics Survey findings that 26.1% of Australian businesses seek finance to ensure survival of the business, the lack of access to finance becomes devastating.

01 Information Assemetry See how credit assessment models put SMEs at a disadvantage. 04 Short Term Focus Borrowing from lenders at high interest rates can hurt your business in the long run. WHY DO SMEs STRUGGLE TO GET LOANS? Understand the disadvantages of putting up your family home as security for a business loan. Collateral Understand the disadvantages of putting up your family home as security for a business loan. 02 Costs See how the higher costs and risks associated with lending to SMEs are a barrier to entry. 03

Information Asymmetry. Increased consolidation in the banking sector has led to credit assessment using algorithmic models. While these are cost-efficient for the bank, it has put SMEs at a distinct disadvantage. By using these models, the banks treat SMEs as one homogenous segment Rather than looking at them as heterogenous businesses with varying risk profiles. This may cause them to reduce lending to any business under the SME umbrella. These models are unable to calculate the potential of a business or the capability of its owner. This is bad news for both, the business who may not get a loan approved, and the lender who may wrongly calculate capability and end up with a defaulting business on their hands. An algorithm can t replace a traditional relationship With the latter one can really understand the business. On paper, a company may appear to be insolvent because they have few assets and low liquidity, when it may just be a young, high-growth firm.

Collateral. In the last few years, the cost of housing relative to income in Australia has reached historic highs and, consequently, home ownership amongst younger Australians has declined. Young business owners are less likely to have a home as collateral. Despite this, banks and many lenders won t touch a business that can t offer property as security.

Costs. There are higher costs and risks associated with lending to SMEs as compared to large businesses. This is mainly due to most SMEs shorter financial history. Another major factor is the lack of documentation. Since smaller companies tend to rely on internal and personal funding, they are not diligent about recording and documenting their finances. So lenders have to work harder and spend more to get the information to make accurate credit assessments. They factor this cost into the loans.

Short term focus. The lack of access to affordable credit often pushes companies to resort to short-term stopgap measures instead of the strategic long-term borrowing that is required for a business to thrive and grow. In such situations companies are tempted to borrow from lenders at high interest rates for a short term. SMEs typically have more volatile and seasonal revenue streams, making it more likely that they will default. Once a default has occurred, it becomes even harder to source credit.

What s the solution? Looking at these factors, it seems clear that the solution is to seek unsecured finance from a lender that takes the time to understand your business while also providing long-term support for your business goals. Okay. Now we re getting somewhere. There are reputable lenders that do just that. The question is, are you the customer they re looking for?

How to Get a Lender to Swipe Right on Your Business According to the Reserve Bank of Australia, around 20% of small business loan applications are rejected by banks. Additionally, 1 in 3 businesses expect that obtaining funding will be difficult or very difficult. Companies can make the process much easier for themselves. Most businesses don t do the necessary housekeeping before approaching lenders. 20 % To be considered for a business loan, it s important that a company gets its management accounts in order. of small business loans applications are rejected by the banks.

State your business case. 1. Do your homework It s essential to have a business plan, including succession planning, to give a lender the confidence of dealing with your business. In fact, don t wait until you need a loan to create a business plan. 2. Get the right data from your management accounting systems Have you made a profit in each of the last three years? Do your earnings before interest and depreciation cover your interest bill by more than two times? Arm yourself with the right information. 3. Get trained in how to read and interpret accounting data When a business is small, owners often have to stretch their skills across multiple areas of the business. As a small business grows, owners struggle with the increasing complexity of doing this. With technical areas such as accounting, it s best to get the right training, or the right employee to handle it.

Get your books in order. 1. Look at your Profit and Loss statement AND your Balance Sheet Most small business managers don t understand that they need to look at both in unison and are taken by surprise when they face a cash flow problem. Profits and cash flow are not the same thing. Especially in seasonal industries, a profitable business may not have a dollar in the bank. 3. Always be across how much you owe and how much you re owed Dun and Bradstreet estimate that a staggering $19 billion annually is locked away from businesses beyond the widely accepted 30 day payment term. Considering Australia s late payments culture, chances are you are owed money, or owe someone money. Keep a diligent record of both. 2. Tell the right financial story Your book of accounts is your story book get it in order. Unless this is your core strength, you may have to invest in the services of a professional accountant to do this.

Upskill and train your accounting staff a. Grow skills to manage and nurture growth You need working capital to grow, but you also need the skills to manage and nurture that growth. Have the foresight to budget for/ hire the right person for the job, so that you can free up your time to focus on your core strength of growing the business. b. Ensure technology and skills keep up with your stage of growth Your bookkeeper/ accountant may not be able to keep up with the growing volume of business, and the increasing sophistication of the technology you re using to manage it. Inculcate an environment of consistent learning and upskilling so that you re not constantly playing catch-up with your growing business. c. Working capital is not the sole mandate of your accounting team. Educate from the top-down so that every person in the business understands effective working capital and what their roles and responsibilities are around it.

CREDIT CARD PRIVATE EQUITY INVESTMENT OVERDRAFT FACILITY Find the Right Source of Finance. FACTORING & INVOICE FINANCE Once you re able to properly present your business and tell the right accounting story, you will find lenders far more willing to extend a line of credit for your cash flow needs. TRADE FINANCE There are a number of viable sources of finance available for a company seeking working capital to grow.

ADVANTAGES Credit cards. For a business struggling to find funding, borrowing against your existing credit card is an attractive option. Easy access to unsecured credit No need to go through a lengthy loan application process Earn reward points on business expenditures Save on costly credit and high interest rates if you repay in time It is an often underutilized source of funding that is good for much more than travel and entertainment. However, it is important to read the terms and conditions of your credit card to find out how to spread your liability and minimize risk. DISADVANTAGES If you fall behind on your credit card payments, your personal credit rating and your personal ability to borrow can be affected. In case of a default on payments, your personal assets may be at risk

ADVANTAGES Unsecured source of finance Investors might bring skills and expertise into a business, not just cash Investors see ROI only when the business is doing well No need to keep up with the costs of servicing bank loan or debt finance Investors typically spread their portfolio across a wide range of businesses, as opposed to venture capital firms which are more focussed on finding and funding the next big thing. DISADVANTAGES Raising equity finance is time-consuming, costly and demanding Private Equity Investment Equity finance is a form of investment in the business by the owner, a partner, or other people willing to take a portion of ownership of the business. Examples include trust funds, issued shares, owner s capital, partnership capital, and accumulated profits. While equity finance can sometimes be the most appropriate source of funds, it does place a different set of demands on your business. Depending on the investor, you may lose a certain amount of ownership and decisionmaking power in your business You will have to invest time and effort to document and provide regular information to the investor

DISADVANTAGES Your bank could charge you if you exceed your overdraft limit without prior authorization. If you ask to extend your overdraft, you usually have to pay a fee. The bank has the right to ask for repayment at any time. ADVANTAGES It is a flexible source of working capital you can borrow exactly how much you need at the time It can be arranged quickly and does not involve a lengthy application process The borrower is charged interest only on the proportion of funds used. To get an overdraft, you must have an account with that specific bank. With variable interest rates, and a variety of charges and fees, it is very difficult to calculate your borrowing costs. Overdrafts may be secured against business assets and/ or bricks and mortar You may have to pay a fee on unutilised funds of the facility Bank Overdraft Facility An overdraft is a temporary facility extended by a bank, that allows the facility holder to withdraw money in excess of their actual account balance. They are most useful for day-to-day expenses, and for the shortterm needs of seasonal businesses or those with fluctuating cash flow.

Factoring or Invoice Finance. Here, a business may sell or assign its right to their accounts receivable to a financial institution. There are several types of facilities available, which include invoice discounting and factoring. Invoice discounting is typically an undisclosed facility where the debtor is unaware that a financing arrangement is in place with a financial institution. This way, businesses can continue to handle collections. Factoring is a disclosed facility where debtors are informed of the presence of the financial institution and they pay the financial institution directly. DISADVANTAGES Can be more expensive than a bank loan due to the administrative and transactional work taken on by the receivable finance company. ADVANTAGES Unlocks open account terms. Businesses don t need to wait until a debtor makes a payment in order to access a significant portion of the invoice value upfront. Access to larger amounts of cash than many other types of finance most debtor financing firms will give an advance of approximately 80% of receivables which can be drawn as cash into the business bank account. Facility grows with your business the more receivables that are provided, the more the business is able to draw down upon. Debtor finance firms may verify invoices with your customers. Just as the facility expands with a growing business, it shrinks with downward fluctuations in revenue, since the less accounts receivables uploaded, the less there is to draw down upon.

ADVANTAGES The business does not need to have funds upfront in order to pay their suppliers May be available in an unsecured format which is more desirable to the purchaser Suppliers may provide a discount on their order for being paid upfront, this can then be applied as an offset to the costs of the transaction Enhances relationship between buyer and supplier given that payment can be made quickly Simplifies logistics around foreign exchange requirements as the trade financier pays the overseas suppliers direct in the currency required Trade Finance. Here, businesses provide documentation in relation to an order from their suppliers for goods or services to a financial institution. The financial institution will then validate the order and make a payment directly to the supplier on behalf of the business, thereby establishing a loan. The business will then enter into an arrangement to repay the financial institution for both the principal and fee components over a period of time. This is a typical funding mechanism for importing. DISADVANTAGES Businesses are not able to draw down on the available funds to use as cash in their business. Instead it is specifically used to pay a particular invoice from a supplier directly Once you have utilised your available funds, you will have to make repayments before making another transaction Businesses may have to wait for approval from their financial institution before funds are released to the supplier

In Conclusion. Now that you re armed with knowledge that will help you choose the best finance option, don t forget to pick the right lender. In addition to industry expertise and experience, you want someone that will look at your business individually rather than group it under a generic SME umbrella. Invest the time and research necessary to find a lender that your business can grow with.

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