Two wheat farmers in field discussing business funding options

Becoming more profitable

Understanding your business funding options

At some point during the life of your business, it’s likely you’ll need to obtain business funding.

Bruce Gray

Business Manager, Trigon Financial

There are many different reasons you may want to seek business funding, and there are numerous finance options available.

Choosing the best business funding option to suit your needs can be difficult and confusing. It’s important you don’t make financial decisions based on the most convenient or least time-consuming option, as this may not be the most cost-effective or suitable method for your business.

Finance is often chosen simply on the face value interest cost, based on the notion that the lowest rate will provide the best option for any purpose. In reality, there are a number of considerations to make aside from the face-value interest rate quoted.

In considering the best choice of finance, it is important to match the method of financing with the purpose. Some common reasons for using finance are:

working capital
equipment finance
property finance – purchase, renovations, improvements
IT software and services
motor vehicles
business expansion – growth, acquisitions.

Some of the most common types of finance available are:

overdraft
bank bills
term loans
leasing
commercial hire purchase
rental.

It is common to consider using a bank facility (overdraft) when you need finance because you often have an existing relationship or an existing facility, and it’s quick and convenient compared to arranging a new line of finance. It is also generally considered to be a comparatively cheap form of finance.

However, there are two factors that need to be considered before taking this course. Firstly, consider the purpose of the finance and whether this method is best suited from a tax, depreciation and ownership perspective. These issues are covered in more detail below.

Secondly, consider the real cost of the bank facility. The interest rate on an overdraft is not generally the real cost of the funds. This can only be calculated by taking into account the additional fees that apply to the account, such as facility fees, account fees, unused limit fees, etc.

Baker with tray of freshly baked bread after securing business funding options

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Business funding for equipment

Almost every business needs items of equipment such as industrial plant and machinery, computers, copiers, printers and other office equipment, furniture and motor vehicles.

Some high-tech equipment represents a substantial investment, and for every item of capital expenditure, a decision needs to be made as to how to fund the purchase. Even if the business has the option to pay cash, you should consider whether this is the best business decision. There may be more effective ways of employing your available cash reserves.

When considering whether to use business funding or not, it’s essential to first decide what the acquisition is intended to achieve.

Does the business need to or wish to own the asset? This will depend partly on its ‘effective life’ and how quickly it will become obsolete and need replacement.

For example, computer hardware now has a relatively short effective life, and it may not make sense to own the asset in three years if it is then obsolete and has little or no value. However, it may be better to acquire ownership on a three or four-year finance contract for an item of equipment with an effective useful life of 10 years.

To make an informed decision, it is useful to have a general understanding of the differences between the various methods of financing assets like office or manufacturing plant and equipment. These will usually fall into the following categories:

In an on-balance sheet transaction, the asset being financed is brought into the accounts of the borrower as an asset and depreciated in the same way as assets that are fully owned. Therefore, the advantage from a tax treatment angle is both depreciation and interest on the finance can be written off against income.

With an off-balance-sheet transaction, the asset remains on the books of the lender who can claim the depreciation. The borrower can only claim as tax deductions the interest or lease payments on the transaction as they are made.

There are two different types of leasing agreements: finance leases and operating leases.

In both cases, the title is held by the financier and the lessor pays a lease rental to use the goods.

The difference between these two forms of finance is essentially the risk of ownership and accounting treatment of the transaction.

The risk of ownership remains with the lessee. The lease will have a fixed term and an agreed residual value at the end of that term. The lessee will guarantee the residual value so that, if the goods have depreciated to a lower figure, they are required to make up the difference. The lessor can and usually will offer to sell the goods to the lessee for the residual value at the end of the contract term.

The lease can be for any period of time and is only subject to the residual being no less than the depreciated value of the asset being financed. It is an on-balance sheet transaction, but the lessee retains ownership and the ability to claim depreciation of the asset on their balance sheet. The lessor can only claim the lease payments as tax deductions as they are paid.

The risk of ownership remains with the lessor. An operating lease provides the lease payments as a tax deduction. An operating lease is an off-balance sheet transaction. However, it can only be for 75% of the estimated life of the equipment and provides no guarantee regarding the ownership of the equipment.

You may be able to purchase the equipment at the end of the term at fair market value – this figure however is not identified and could be 10%, 15% or 20%, etc.

A rental agreement is similar to an operating lease. It overcomes many of the restrictions of the operating lease. Title of the equipment remains with the financier, and there is generally no option to purchase at the end of the finance term.

The financier will assign an undisclosed future value to the equipment and factor this into the rental payments, with the intention of being able to make a profit on the sale of the goods at the end of the term.

In some instances, depending on the nature of the equipment, the financier will offer to sell the goods to the borrower at the end of the term.

Commercial hire purchase provides the user with depreciation and interest as deductions. It is an on-balance sheet transaction. At the end of the term, the borrower obtains full title to the goods.

This can be a very effective method of finance for IT and high-tech equipment as it provides the same tax advantages as if the asset was purchased for cash without the initial capital outlay. The net tax benefit will often exceed the finance costs.

The financial position of each business will be different, so it is not possible to make a general rule about what lending product will best suit individual circumstances. It is advisable to consult your accountant or financial advisor before entering into any transaction for major capital items.

Business funding options for common expenses

This usually takes the form of a fixed-term mortgage, which enables amortisation (gradually writing off the initial cost of an asset) of a major capital expense over an extended period and provides the ability to deduct all borrowing costs, depreciation and property maintenance costs.

If there is an option to lock in a fixed interest rate, this also needs to be considered in light of the prevailing rates and likely movements in the foreseeable future.

Finance lease or commercial hire purchase are generally the most suitable method for financing vehicles. If the vehicle is wholly for business use, the full cost of the finance can be claimed as a tax deduction. In the case of a lease, this is the monthly lease payment.

For a commercial hire purchase contract, this is the interest component, but depreciation on the vehicle can also be written off against income.

The variables are numerous, so the best choice will depend on the nature and cost of the equipment, its useful life, and the depreciation rate allowed under the tax laws.

An operating or finance lease, a rental or a commercial hire purchase contract would probably be the most effective option.

Many businesses now rely heavily on complex, customised IT systems. Finance for computer hardware is straightforward and generally readily available. Leasing or commercial hire purchase is the most common method of financing these items. Rental is becoming a more popular method to avoid ownership of obsolete equipment.

However, typically the major cost of an IT system is now the software licenses and services (implementation, training, maintenance, conversion, etc.) and there is a common misconception these items can not be financed because they are intangibles.

There are financiers who specialise in computer software and services and have products designed to maximise the tax advantages available.

In the course of making any decision regarding a major capital expense for your business, it is wise to consider whether to obtain finance for the purchase and what the most effective form of finance would be in each particular instance. Seek professional business funding help to ensure the decisions you make take into account all the implications with respect to the tax laws and your financial circumstances.

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*Based on 958 meters switched between 1 July 2019 to 3 April 2020