Debt finance refers to the use of overdrafts and/or loans to fund the business. They are far the most popular forms of business finance, but their appropriateness is seldom questioned. In this section we cover the pros and cons of each:

What are overdrafts?

Overdraft facilities, supplied by banks or building societies, are primarily designed to cover short-term fluctuations in cashflow. There is a set overdraft limit, not usually beyond a few thousand pounds, and interest is paid on the value overdrawn. If businesses go beyond their overdraft limits they will face hefty charges.

The advantages of the overdraft

You only pay interest at the times when you are overdrawn and you can use it when cashflow becomes a problem.

The disadvantages of the overdraft

The overdraft is usually reviewed every 6-12 months (for which you pay a fee) and can be cancelled at any time. There can be a whole range of fees and costs that may only become fully apparent when you take up the service. E.g. opening costs, renewal costs and even non-utilisation costs. So check the small print!

The advantages of the loan

You can pay for a big purchase, such as a piece of equipment, in chunks, over the life of that equipment

• Some loans are quite flexible. Repayments and interest charges can be deferred if the business is experiencing short-term problems. These are referred to as ‘capital holidays’
  
  
• The rate of interest is fixed making cashflow forecasting easier

However…

If you attempt to cancel them after you have started you will face a heavy fine.

Some loans maybe flexible but this is not always the case others.

In exchange banks can arrange special ‘covenants’ dictating the way you run your business. For example they could stipulate what your gearing should be.

Loans can come with extra costs: banks can charge for checking the security you’re offering; there can be prepayment fees for paying loans back too early, not forgeting arrangement fees, commitment fees, and insurance fees.

Smaller loans can carry a floating rate, usually 1 or 2% above base rate. This can be favourable when interest rates are low; when high they can cripple your business.

Is debt finance easy to obtain?

It all depends on the inter-relationship between the amount of money you’re asking for, the riskiness of your business, your credit-worthiness and the security you can offer. The more you go for, the more it will cost in terms of interest and charges

‘Risky’ business ventures usually need high inputs for high returns. And, if you can’t easily predict cashflow over a temporary period, you’ll need more debt finance than the average business.

So what security can you offer? If you’re a freeholder or own a long leasehold on a property, a lender would be willing to loan you 50-70% of that property’s value.

Small business owners can usually borrow up to 90% of the value of their personal property. Lenders are also willing to consider the resale value of any equipment, stock or work-in-progress. Personal financial guarantees, provided by small company directors, can be used as security.

So what should I go for?

It would be inappropriate to try and generalise about debt finance, and you shouldn’t make any decision without seeking some independent financial advice first. But a mix of the two facilities is often a good idea. The overdraft can cover unexpected dips in cashflow while the loan can be used to pay for start-up losses, fixed assets, plant and machinery and working capital.

It’s a good idea to shop around to see what’s on offer. If you ask your debt finance so be calculated to include with all the charges you are likely to face you will be better placed to make a decision. This is known as the Annual Percentage Rate (APR).

It is best to ask for more than you actually need for both facilities: if you start defaulting on payments or go over overdraft limits it will have an adverse affect on your credit-rating as well as increasing your debts.