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Plethora of product choices

FIFTY-SEVEN financial institutions currently provide approximately 720 different debt finance products for small business, according to research group Cannex.

This may seem an overwhelming level of choice for the average small business trying to assess the competing options, but the reality is that most of these products fall into a handful of categories.

The traditional product for managing short-term working capital needs is the business overdraft.

Overdrafts are defined as an extension of credit by a lender to cover the amount by which withdrawals exceed deposits in a transactional account.

A KPMG Consulting report, Small Business Banking in Australia, says overdrafts provide a convenient and flexible way to cover day-to-day spending.

They also help businesses to smooth cash flow fluctuations, due to seasonal variations or unforeseen circumstances, and take advantage of opportunities, such as supplier discounts for immediate payment, as they arise.

An alternative product for businesses with relatively small requirements (eg less than $20,000) is a business credit card.

It works just like an overdraft (or a personal credit card), with the flexibility to either make a minimum repayment each month or repay the full amount.

For longer-term borrowings, banks provide a range of term loans. These loans are for a defined term, normally up to five years for fixed rate loans and up to 15 years for variable rate loans.

A Reserve Bank study, Recent Development in Small Business Finance, found that about half of all small business borrowing is at variable interest rates, 40 per cent is at fixed rates and the remainder is through bill lines.

The interest rate on term loans depends on the type of security offered, with residential property delivering the best rates.

The Reserve Bank has found that the weighted average interest rate on variable rate loans was 8.0 per cent. This includes the risk margins added by banks to their advertised indicator rates.

As shown in the graphic, rates ranged from less than 5 per cent to more than 15 per cent. The most common rates were in the range of 6 per cent to 8 per cent.

“Seen in a long run context, interest rates on small business loans are relatively low; apart from 2000, the current rates are the lowest since the early 1970s,” the Reserve Bank said.

This partly reflects the changing mix of lending. In particular, the Reserve Bank found that “small businesses have shifted their borrowing to lower-cost products offered by banks, such as loans secured by housing, or to lower-cost lenders”.

As well as competing on interest rates, banks and other lenders have been enhancing their commercial loans with some of the ‘bells and whistles’ that have become widely used in the home loan market.

These include redraw facilities, which enable borrowers to draw down ‘surplus’ repayments, and offset accounts.

Some products are a hybrid of the ‘line of credit’ overdraft products and term loan products.

They provide ‘at call’ funding for larger purchases and investments but, unlike overdrafts, they have a limit (usually two or three) on the number of free withdrawals per month.

Businesses wanting to borrow $100,000 or more can use commercial bill facilities.

These facilities are keenly priced, based on prevailing interest rates in the short-term money market.

They offer a high degree of flexibility, with terms from seven to 180 days. The term can be extended by renewing the agreement via a rollover.

As well as these traditional bank lending products, there is an ex-tensive range of alternative debt products for business.

These include hire purchase, leasing, factoring and invoice discounting.

Finance leases allow businesses to acquire plant and equipment, including motor vehicles that are used in the business, without tying up large amounts of capital.

They involve the lessor (typically a financial institution) buying the assets and renting them to a business (the lessee).

The term of a lease is normally from one to five years and in most cases the plant, equipment or vehicle being leased is sufficient security.

Asset finance, usually in the form of a hire purchase or chattel mort-gage, is similar to a finance lease.

It allows businesses to purchase plant and equipment over a predetermined period with guaranteed ownership at the end.

The suitability of these products depends on the circumstances of individual borrowers, with GST treatment often being a key factor.

Factoring and discounting, also known as debtor finance or cashflow lending, are alternatives to overdraft finance.

They suit fast-growing businesses, since they allow a business to automatically increase the amount of finance available as its sales in-crease.

Both of these financial arrangements are primarily secured against the unpaid invoices of a business.

They involve the purchase by the financier of book debts on a continuing basis, usually for immediate cash.

In most cases, the financier will advance up to 90 per cent of the value of invoices.

The key difference between the two is that factoring companies manage the sales ledger and collection of accounts under the terms agreed with the business.

In contrast, businesses using invoice discounting retain these functions and therefore their clients are unaware of the involvement of a discounter.

p          Next week: In part two of the series we look at the major players in the business lending market.

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