An accountant for a family business is constantly looking at forward cash flows. Be it upcoming tax liabilities, loan repayments or lease obligations.
The management of forward cashflow makes the interplay between short-term v long-term lending critical. And the management of these amounts can be critical for the ongoing success of family-owned businesses (especially start-ups).
Short term finance
This is the type of finance that is used to fund the ongoing working capital of a business. Some accountants will also refer to short-term finance as a “current liabilities”. These are liabilities that are payable within one year.
A simple way to see your short-term liabilities is to look at your statement of assets and liabilities your family business accountant prepares with your tax return (it is also called a balance sheet).
So what type of short-term finance is there?
This is normally the most expensive form of finance but is still a workable solution. Typically a family business has a “cash flow range” that the business will enjoy of the course of a year.
The purpose of an overdraft is to help fund the business as the cash flow cycle goes to the bottom and then the business cycle will then accumulate enough cash overtime to eliminate the overdraft completely.
Many microbusinesses will use a credit card simply because they can and because it is there.
The risk in this instance is that the cost of the credit card is immense. A business that is strapped for cash will continue to incur very high costs and this will only worsen the business position.
Further, if the business is buying items, like inventory, the credit card fees will take a big chunk out of your gross profit margin.
We normally see the high use of credit cards by a business that is in the first stage of financial trouble.
If your business is using a personal credit card of the directors: this can expose yourself when the liquidators step in. The individual, when paying a creditor, technically becomes an unsecured creditor of the trading business. If that person is paid straight away (which is normally the case) the payment is seen as a “preferential payment” by the business to the individual.
A liquidator can see the preferential payment and will often ask for it to be refunded.
The Tax Office
The Tax Office was historically seen as a second bank by many family businesses.
The biggest effect here is that a negotiated payment term with the Tax Office is typically seen as a kiss of death when it comes to dealing with your bank. So while it might sound like a good idea – if you want a strong banking relationship – avoid using the Tax Office as your bank.
Further, unpaid tax debts can now impact your credit rating.
Long-term debt (or non-current liabilities) are typically cheaper and have less concern than short-term debt. Why? Because the capital is not due to be paid now.
Almost every solvency measure used in a business will focus on the short term debts of a business.
So what are the normal long-term debts?
A term loan
These loans normally go over a period of 5 years or more and give you a reliable monthly repayment. They make cashflow forecasting easier and they are dependable.
A commercial bill
The benefit of commercial bills is that the interest rate is cheaper. They are normally tied to an interest rate marker (like the Bank Bill Swap Rate) plus a premium for the risk of the family business borrower. The premium varies but is normally around 1% to 3%.
Typically a commercial bill “rolls” at a set interval or 30, 60 or 90 days. However, we have seen commercial bills that roll over yearly.
The downside of a commercial bill is that the “roll” is an ongoing choice by the bank and the family business. So in times of trouble, the bank may not choose to extend the term deposit – and while the might be rare it is worth considering and negotiating with your lender of choice.
A hire purchase
A hire purchase is designed to allow you to purchase an asset and then pay the debt off to the lender. Normally this repayment term is tied to the life of the asset and you can choose to have the debt fully repaid at the end of the assets life.
A lease is not a finance arrangement. It is not a debt of the family business and you do not acquire an asset when you do a lease.
When you lease an asset you rent it. The rental can be a fixed term so it feels like you own it – but you do not. At the end of the lease you have the option of giving the leased asset back to the bank or buying it from the bank at market value.
Some leases, at a commercial level, cannot be distinguished from a hire purchase. So many family business accountants will record these leases as a hire purchase.
Ratio’s to show solvency
The use of financial ratios is crucial to understanding how money works within a family business. And many banks will use reporting covenants that a family business must maintain to ensure a good banking relationship.
The quick ratio is a measure of how well the company can fund its short-term ongoing operations.
It is normally calculated as
(Cash + debtors)/Short-term liabilities
A common rule of thumb is that a family business should have a quick ratio in excess of 0.5.
The current ratio is a more generous version of the quick ratio. It includes other short-term assets like inventory.
It is normally calculated as
Short-term assets / Short-term liabilities.
A common rule of thumb is that the current ratio should be in excess of 1.
The gearing ratio compares a family business’ long-term debt to its overall assets. For many family businesses, especially property developers, a true understanding of the gearing ratio should be based on the market value of the total assets of the family business.
A high gearing ratio is indicative of a lot of debt within the business. This would typically be normal for a capital-intensive business like a winery or heavy manufacturing business.
Lenders are often concerned about the gearing ratio as it is in an indicator of their ability to recover their monies in the event that the business cannot repay its debts.
The gearing ratio is calculated by
Total debt / Shareholder equity
A final point with debt structuring
The effective structuring of debts, and the management of security positions, can have a big effect on the tax effectiveness of your borrowings together with future expansion flexibility. Our blog post 10 Reasons why you should not cross collateralise your loans covers this area well.
Limitations of ratio’s
If you have seen one family business – you have seen one family business. The use of ratio’s to compare two businesses, without a deeper understanding, gives a false impression.
Some businesses might have a wealthy family so the solvency of the business is not really a concern – even though the ratio’s are awful. And some family businesses might be heavily indebted simply to fund an aggressive investment strategy the family have created.
What is important is to set a number of ratio’s, working together and designed for the family business in question, as a forward-looking target for the operating business. These ratio’s should then be actively looked at in the day to day management of the family business. And that engagement in the financial measures of the business can then be communicated to your financiers and impacted on covenant reporting.
What is important is that the solvency and measures of a family business is done hand in hand with the solvency and measures of the family. An advisor who does not focus on the needs of both entities – family and business – will effectively miss the point when considering the financing options of a business.
At Westcourt FBA we can undertake a solvency and loan positioning review for a family business. This is done face to face over a 4 to 5 hour period, with pre work, a written report and a follow up meeting, so that an intimate understanding of both elements of your financing are considered (family needs and business needs). If you are interested in having a chat to us please call. We don’t sell home loans and such so we won’t be pushing you to change lenders simply to get a commission cheque.