6. PRINCIPLES OF FINANCE
6.1 About this Booklet
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
Reference is also made to other products and services beneficial to businesses. These
include electronic products, international services, insurance and assurance services.
Booklets to read with this one:
- Considering your own business
- Your business and your bank
- The business plan
- Key issues in small business management
- Tax and the small business
- International trade
6.2 Financing your business
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:
- According to the business plan, what assets will have to be financed?
- What is the appropriate term for the financing of these assets?
- How can the cash be raised to finance these assets?
- What is the most appropriate mix of finances?
The answers to these questions will be covered in the pages that follow.
6.3 Getting the term of the finance right
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.
SMALL BUSINESS FINANCING
Items financed Appropriate Term of Finance Type of product
• Debtors Short term working capital Cheque overdraft
• Stock (Less than 1 year)
• Work in progress
• Creditors Short term working capital Negotiate suitable terms
(Less than 1 year) once you have
established a track
• Vehicles and Medium term finance Asset finance
equipment (Typically 1-5 years) • Installment sale
• Plant and • Lease
machinery • Sale and
• Setting up a leaseback
business or a • Rental
franchise Medium term Loan
• Renovation of
• Land and buildings Long-term Commercial property
(Typically 5 – 20 years) 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:
- Internal sources (financing the needs of the business from its cash flow)
- External sources. One source of external finance is to take up debt (borrowing).
Another is equity, i.e. the existing owners contribute capital to the business or
they bring in outsiders to invest in the business.
6.5 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.
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
- Accelerate collections from debtors (your customers). You always have to
reconcile the costs associated with funding credit to customers with the sales
lost because of a stringent credit policy. Offer early settlement discounts, but
carefully consider the cost of the discount and how it will impact on your gross
profit. Improve collection on overdue accounts and reduce bad debts.
- Bill your customers promptly. Invoice the same day the goods are shipped.
- Accelerate the deposit of cheques and cash. Make deposits daily.
- On major projects, ask the customer for a deposit/upfront payment and/or
progress payments on completion of distinct phases of the project.
- 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
- Minimise the money tied up in stock. Improve stockturn. Be wary of slow-moving
stock. Departmentalise accounting so that slow-moving stock is easily identified.
Have a sale to get rid of outdated and slow-moving stock. Keep a close eye on
pilferage. Examine your reorder system and don’t hold more stock than is
necessary. Distinguish gross profit margins on different stock items. If possible,
reduce the number of lines you carry. Accelerate work-in-progress.
- 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 External finance: making debt
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.
6.6.1 Short-term sources of debt finance
The most common sources of short-term borrowing are:
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: The utilisation of an overdraft should fluctuate depending on the
stage of the working capital cycle. Typically, an overdraft should
increase as the month goes by and be repaid when sales are
made. An overdraft should not be permanently utilised or be
allowed to develop a hard-core element which means that it never
goes into credit.
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.
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 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
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.
Not all businesses qualify for debtor finance. Typically, you will have to
satisfy the following criteria:
- The debt to be factored must be in the name of business entities, not
- The business should primarily be involved in manufacturing and
- Your business must have a high calibre of management a track record
of success, good growth prospects and profitability, and first-class
- Your business must not be too small. Debtor finance companies
commonly only work with established businesses whose sales amount
to more than a specified minimum turnover.
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
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 Medium-term sources of debt finance
Typical sources of medium-term borrowing are asset finance and medium-
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.
The term of finance is usually negotiable up to a maximum period of 60
months. A variable rate that fluctuates with prime is normally charged.
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
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.
- Ownership of the assets being acquired vests in the bank until the final
payment when full ownership passes to the borrower.
- VAT is payable on the full purchase price at the beginning of the
agreement with possible input credits that may be claimed, provided
that the vendor is in possession of the required tax invoice.
- Tax treatment - Subject to the assets being used in the production of
income, the borrower is permitted to claim depreciation on the assets
and the interest payable is allowed as a tax-deductible expense.
- Ownership - Lease differs from instalment sale in that the ownership of
the asset does not pass to the lessee (the business paying for the use
of the asset) at the end of the term of the lease. Upon expiry of the
lease, the asset is returned to the lessor (the bank which owns the
asset). However, the lessee may opt to purchase the asset or
refinance it for a further period, subject to the contractual terms and
conditions and negotiation with the bank.
- 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.
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
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.
- Full maintenance lease - With full maintenance lease (FML), also
referred to as full maintenance operating lease (FMOL), the expected
cost of the maintenance of the asset is added to the lease at the outset
and the lessee does not have to pay for maintenance.
- Sale and leaseback - A business may require a capital injection,
perhaps due to rapid growth. If there are assets that are fully paid for
(‘unencumbered’), the business may negotiate with the bank to enter
into a sale and leaseback agreement.
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.
- 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.
Asset finance in summary
The ownership, VAT and tax aspects of the three types of asset finance are
Content Instalment sale Lease Rental
Vests in the bank Vests in the bank. Vests in the
until final Upon expiry of the bank, as with
payment, when lease, the asset is lease
ownership passes returned to the agreements.
Ownership to the client. bank. However, the
client may End-of-term
negotiate to buy the options are
asset or to identical to
refinance it. leases, i.e.
return the asset
buy it or
Payable on the As with installment Calculated and
full purchase price sale, payable on payable on each
VAT at the beginning the full purchase rental payment.
of the agreement. price at the
beginning of the
Subject to the Lease payments As with leases,
assets being used are allowed in full rental payments
in the production as claims against are allowed in
of income, pre-tax income, i.e. full as claims
depreciation and they reduce the against pre-tax
interest payable level of taxable income, i.e. they
are allowed as income and reduce the level
tax-deductible therefore tax. of taxable
expenses, i.e. income and
Tax they reduce the therefore tax.
level of income on
which tax will
In contrast the
capital portion of
the repayment is
made from after-
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.
Some of the uses of term loans are to finance:
- the improvement or renovation of premises
- the acquisition of a going concern or, an existing franchise business
- the setting up of a business or franchise
- large projects undertaken by an existing business
- 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
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
6.6.3 Long-term sources of debt finance
Common sources of long-term finance are:
Commercial and industrial property loans
A commercial and industrial property loan is a mortgage bond that may be
used to finance business property. It may be applied to finance the
acquisition of existing property or to develop new or existing property.
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.
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 long-
term 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 Collateral as a requirement for debt finance
The provision of collateral is a common requirement to be satisfied for
obtaining debt finance. This section takes a broad view and is aimed at
enhancing your understanding of how financiers view collateral and what
they accept as security for debt finance.
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
Should your business not succeed the bank can then realise the security to
settle your loan account.
Why is collateral required?
The reason for taking collateral is two-fold:
- To lessen the risk to the financier by providing a form of insurance
against possible unforeseen events which could result in the borrower
being unable to repay borrowings from other sources.
- To ensure a greater commitment by the borrower to meet his
obligations to the financier.
Remember collateral can never be a substitute for the repayment ability of
the borrower. Unless the business is able to service the debt a loan will not
be granted, even if ample collateral is available.
How is collateral assessed?
A financier will usually consider collateral to be good if it satisfies the
- It must be stable and constant in value
- It must be easy to realise or sell, that is, a reasonable market demand
must exist for it
- It must be valid in law, i.e. not subject to dispute
- 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,
- the value of assets is usually less in a forced sale situation.
What constitutes collateral?
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
Common sources of collateral are listed below, but note that they are
not all rated equally:
- Personal suretyships. This is where an individual undertakes to make
good a specific loan if the borrower (the business) does not repay it
when called upon to do so.
- First or subsequent covering mortgage bonds over property. Usually
first covering mortgage bonds are registered when property is
acquired, but if the property has been paid for, subsequent covering
bonds may be registered over the property as security for further
- Notarial bonds. This bond is by nature a covering bond and is
registered over the movable assets of a business in order to secure a
loan. This form of collateral is usually not favoured by financiers for
- Cession of investments. These investments may include, amongst
others, listed shares, bank deposits and investments, and unit trusts.
- Pledge of Kruger Rand coins, jewellery, paintings and other valuables.
- Cession of assurance policies. Financiers are usually prepared to
accept cession of policies, to the extent of the surrender value, as
collateral to secure borrowings.
- Cession of debtors. This means that if the business defaults on the
loan, the debtors will be instructed to pay the financier instead. As a
general rule, banks attach a low security value to debtors.
6.7 External finance: equity
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:
- The capital invested by the owner(s) in the business
- Loans made by the owner(s) to the business
- The capital invested by outsiders, which in effect makes them co-owners
- In the case of an existing business, retained earnings (reinvestment of the
profits the business makes).
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 shareholder’s 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
- From the perspective of the business, owners’ loans can be a very
flexible source of finance. Owners’ loans are often not interest-bearing.
Even if they are, the repayment of capital and the servicing of interest
need not represent a fixed monthly obligation. The owner might elect
that the loan be repaid in a lump sum at a specific future date or when
the business is adequately capitalised to allow for such an outflow.
- Interest paid on the loan is allowed as a tax-deductable expense, from
the perspective of the business.
- Interest earned on a loan account is fully taxable in the hands of the
owner, even if it has not actually been received, but has merely
accrued to his or her loan account.
- Unlike a loan from a lending institution, owners’ loans do not represent
outside borrowings and therefore improve the ratio between own
funding and outside borrowings. This ratio is important when the
business attempts to raise finance from a lending institution at a future
date. For the loan to be considered as ‘own funding’, lending
institutions usually require a cession of the owner’s loan.
- 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.
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
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,
- Personal chemistry is important particularly if the new co-owner is
going to be fairly active in the management of the business.
- Does the new co-owner share your vision and goals for the business?
- Is the new co-owner looking at a long-term relationship with your
business, or is it likely that changing circumstances may cause him or
her to sell the stake in the business?
In taking on a new co-owner it is important to seek the right advice,
particularly financial, tax and legal advice. For example, be sure to formalise
a legal relationship in writing.
6.7.4 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 Receiver’s intention may be to encourage
businesses to reinvest their profits in the hope that they will expand their
6.8 Considerations in deciding on a source of finance
Before examining these considerations, it is necessary to look more closely at
business finance. The mix of external finance, debt and equity finance used in a
business is commonly referred to as its capital structure. The proportion of debt to
equity is referred to as the gearing or leverage of the business. The higher the debt
finance, the higher the gearing.
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
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
6.8.1 Return (cost to your business)
- Interest paid on debt is regarded as a cost of doing business. That
makes interest a tax-deductible expense, which effectively reduces the
level of taxable profits and therefore tax payable. In finance terms,
debt offers a tax shield as the Receiver of Revenue ‘pays’ part of the
interest by forgoing tax. That is, the effective cost of debt to the
business is the interest charge, less the tax saved by the reduction of
taxable profits through interest payments.
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
- 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.
- As we have seen, there are good arguments for taking up as much
debt as possible. However, this is inconsistent with the real world. As
the level of debt (gearing) increases so does the risk of financial
distress (ultimately bankruptcy).
- As a business becomes more highly geared, the market (including
banks) will reassess the risk profile of the business, which in turn will
raise the cost of finance. Providers of finance will become increasingly
nervous as gearing increases and as compensation for the increased
risk will demand a higher return on the capital they invest in the
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.
- The cost of debt (interest) represents a fixed obligation that the
business has to meet at a regular frequency, usually monthly,
irrespective of whether or not the business is making a profit. During
periods of high interest rates and economic recession, the cost of debt
can become a high burden for a business.
- 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.
- With equity, there is no fixed commitment and the owners are
remunerated from profits, if any.
- The issue of giving up control of a business, even only partially, is a
delicate one. The ability to control a business has value and should
therefore not be given up easily.
- Raising finance by means of equity dilutes the control that may be
exercised by the existing owner(s). The exact impact will depend on
the extent to which equity in the business is sold to outsiders and on
the contents of any legal agreements that may be drawn up to govern
the ownership and management of the business.
- Debt is not an ownership stake in the business and therefore full
control is retained by the owner(s). However, where a business has a
high level of debt or where it is experiencing difficulties, financiers may
become nervous and take a far greater interest in the business than
would normally be the case.
- It is important to select a source of finance that is sufficiently flexible to
suit your specific needs and set of circumstances. Fortunately, most
debt finance products are inherently flexible, making it possible to
structure finance around the needs of your business.
- An overdraft facility is a flexible source of short-term finance which
supplies credit when needed (up to the agreed maximum limit) and
you only pay for utilisation. Once the facility has been agreed to, there
is no paperwork or time wasted in waiting for a decision. The money is
available ‘on tap’. Debtor finance has the advantage of growing with
your turnover. As you grow your sales, your debtor finance facility is
- When considering the flexibility of various sources, you also need to
look at aspects such as the impact on your cash flow, tax implications,
and how long it would take you to get the finance in relation to the
urgency of your finance need. Remember to plan ahead, because the
answer to applications made in a hurry is usually "no".
- 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.
6.8.6 Business environment
- Businesses with uncertain or irregular patterns of income are more
likely to experience financial distress and will therefore probably use
less debt finance.
- Over and above economic conditions such as rising interest rates or a
drop in the demand for your product due to recessionary conditions,
there are several other factors that have to be considered.
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.
6.8.7 A summary of the considerations in deciding on a source of finance
The factors that have to be considered in deciding on the most suitable
source of finance and the mix between debt and equity finance are briefly
Considerations Debt finance Equity finance
- Interest is tax-deductible Cost of equity, e.g.
dividends, is not tax
- Effective interest rate deductible
Return/cost lower than nominal rate
- Debt can increase return
on equity by leveraging
- As level of debt - Higher levels of equity
increases, so does the reduce the risk of
risk of financial distress financial distress.
- Repayment of debt - No fixed obligation
represents a fixed exists.
obligation that must be
- Debt does not represent - Control may be diluted
Control an ownership stake in the if the business brings
business the owner in co-owners.
retains full control.
- Debt finance can be - Equity finance is
flexible, subject to the inherently flexible.
finance need being
Flexibility matched to the most
appropriate type of
finance. Some finance
products are also more
flexible than others.
- Does the business have - Can the business
the capacity to borrow? attract equity finance?
Capacity Will the cash flow cater
for the servicing and - Equity enhances the
repayment of the debt? capacity to borrow.
- High levels of debt - Equity (moderate
increase vulnerability to levels of debt)
Business volatility and unforeseen enhances the capacity
management events in the business of the business to
environment cope with hazards and
eventualities in the
6.9 Finding the right financial mix
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.
ASSETS TO BE APPROPRIATE FACTORS TO
FINANCED APPROPRIATE TERM FINANCIAL MIX CONSIDER
Debtors Stock Short-term(less - Internal finance - Cost
Work-in-progress than 1 year) - Bank overdraft - Risk
- Debtor finance - Control
- Vehicles and Medium-term - Instalment sale
equipment (typically 1-5 years, - Lease
- Plant and but up to 7 years) - Rental
machinery - Medium-term loans
- Buying a - Equity
- Setting up a
- Renovation of
- Land and Long-term - Commercial and
buildings (in excess of 5 industrial property
- Goodwill* years, up to 20 loans
years) - Participation Bonds
*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
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 Making other banking products work for you
6.10.1 The business cheque account
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.
Some of the many features of this essential product are:
- Access to short-term finance by means of an overdraft
- Payment of third parties by cheque, debit or stop orders
- Cheques can reflect the corporate identity or logo of your business
- Detailed banking statements, providing a record of all transactions
- Linkage to electronic banking services, allowing transactions to be
made from a remote location such as your office
- Linkage with card products such as garage and credit cards.
6.10.2 Electronic banking services
Technology is the way the world of business is moving. Rapid advances
have been made with electronic banking and these are likely to continue at
an even faster rate. Businesses can ill afford to distance themselves from
these advances and may stand to benefit greatly from the use of such
Essentially, electronic banking products enable business clients to perform
functions such as the transfer of funds between accounts, accessing account
and historical information, payroll administration, creditor payments and
debtor collection. This is facilitated by using a personal computer which is
linked to the bank’s mainframe computer by means of a modem or internet
facilities. These electronic products make it possible to conduct the banking
activities of the business from the business premises.
Electronic products provide for good security and increasingly they are
becoming ‘friendlier’ to use.
6.10.3 International banking services
South African businesses are increasingly exposed to international markets
and business practices. While the prospect of international trade is exciting, it
is also intimidating, as it is fraught with uncertainty and risk, particularly for
the uninitiated exporter or importer. If you are involved in international trade,
you are best advised to seek assistance from the international banking
experts at your bank and to use international banking services that facilitate
trade and limit risk. These services may broadly be classified into settlement
services, finance in foreign currency, hedging services, shipping guarantees
and airway releases, and advisory 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.
A documentary credit, also known as a letter of credit or L/C, is issued by the
importer’s 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 importer’s 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 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.
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 importer’s 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 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.
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 bank’s
international banking experts for advice on these financing mechanisms.
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.
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
6.10.4 Credit card services
A complete range of facilities are available to enable merchants and vendors
to accept credit cards such as Visa, MasterCard, Diners Club and American
Express, as well as garage, petrol and fleet cards for payments from their
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.
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 Assurance and insurance services
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.
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.
While no form of assurance can replace a valuable member of staff lost
through death or disability, the proceeds from a key-person assurance policy
can ensure the financial continuity of the business by minimising the financial
impact of such a loss on the business.
The death or disability of a partner in a partnership, a member in a close
corporation or a shareholder in a company may put the continuity of a
business at risk.
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.
This kind of assurance policy provides the cash required to acquire a
deceased or disabled co-owner’s stake in the business in a tax-efficient way.
Other assurance policies
- Capital funds assurance may be used to provide for the specific future
capital needs of a business (for example, replacement of fixed assets
- Loan account assurance entails investment policies to replace loans
made by the owner(s) to the business. On maturity, the proceeds of
the policy settle the loan and the balance of the proceeds are paid to
- Sureties or contingent liability assurance policies provide life and
disability cover for those co-owners bound as sureties for the loans
and overdraft facilities of the business. The policy releases the
deceased estate or disabled co-owner from liabilities. This means that
personal assets cannot be attached by creditors of the business, and
the business can continue without any undue claims.
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 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.
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.