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Debt Finance and the SME – An uncomfortable pair.

by Eamonn McMahon

So it’s not just Oscar Wilde, Adam Smith, the Bible and your grandmother who are critical of debt. SME companies are also very reluctant to finance via debt. Yesterday evening, while wrapping up a piece on asset finance, our own focus, I came across research from BDRC continental with some dismal conclusions on SME attitudes to debt finance.

One statistic that stood out from their ‘SME finance monitor’ was that 71% of SME surveyed (a significant sample of many thousands) claimed that they would prefer 0 debt and lower growth to having any form of debt. In fact, 8 out 10 SME base their growth projections on what the business can afford without using any form of finance. And a final depressing statistic, some 70% of SME business either ‘agree’  or ‘strongly agree’ that a primary aim of the business is to repay any outstanding finance (including commercial mortgages /asset finance etc!) and then to remain debt free for the future. Blimey.. Did the survey confuse ‘debt’ with ‘death’?

Since the second half of 2007 the cost of central bank financing here in the UK, effectively the primary foundation stone of all other interest rates, has been been reduced from 5.75% to a helium light 0.25%. This is done as a monetary stimulus, to boost the economy by cheapening and consequently increasing the flow of finance. Projects, expansion and asset purchases should all be more likely to take place with cheap financing. In fact the Bank of England has emphasised that increasing credit to SME is a central goal. All well and good but this survey clearly shows that cost of financing isn’t the biggest obstacle. SME companies are quite simply adverse by nature to taking on finance which is an almighty bloody problem and a part of the explanation as to why economic growth has been so sluggish post 2008.

Against a backdrop of historical disdain for debt finance (especially in literature) it may feel intuitively wrong to defend debt finance. Fact is, borrowing is a necessary financial dynamic that helps individuals, companies and governments balance-out usually volatile income with generally stable and sticky expenditure. Debt finance should not be construed as an avenue used in desperation. The national debt in the UK for instance, is closing in on £2 trillion which is approx £31,000 per UK resident – we are born in debt and die in debt. That is one side of debt. More importantly though, debt is a necessary propellant for growth because it helps companies, particularly SMEs acquire assets which are essential to their development.

“Asset finance, you say..? Oh, hello!”

Ultimately asset finance and other debt finance forms accelerate growth and crystallize enterprise value up front. However, while debt finance is a powerful lever,  it has been mis-sold, mis-used and mis-understood. Some rules for jacking up the lever..

  • Debt finance should, when possible, be drawn against and matched to specific future income streams... (preferably from asset use but also perhaps from predictable revenue streams not arising from asset use). Using debt to finance risky revenue growth (example, an overseas marketing campaign) is generally not a good idea.
  • Debt must be affordable. The cost of any debt and resulting cash flow strain from interest and principal repayments should always be fully considered before committing. Sensitivity to changing interest rates and ability to refinance, if likely to be needed, should also be given due thought. Focus on net interest cost for comparing financing costs and gross cost for cash flow consideration.
  • As a rule of thumb, the growth in profits achieved by drawing the debt, regardless of what form the debt takes, should ideally be three times the financing cost in the case of a SME. So if it costs 10k in annual interest payments on an equipment loan, then the additional annual earnings/profit from buying that equipment should ideally be at least 30k.
  • Flexibility is key. SME, particularly smaller companies will typically evolve their business plan according to how economic opportunities present themselves. Where possible,  try to source flexible debt that you can repay without penalty, extend if needs be, or change the timing of payments.
  • Generally refinancing existing loans will be cheaper than drawing fresh finance. Always worth exploring this first.
  • Prioritising asset-based financing is usually best as generally more economical. This is because the financing will a.) be secured against an asset but b.) there will typically have an income stream supporting the servicing of the debt.

Remember your creditor’s priority is your timely repayment of principal and interest. This is dependent on the success of the business so your interests are broadly aligned and not at odds!

Next time a blog post on blockchain applications within direct lending courtesy of another London based entrepreneur.