Business Finance Guide

Most people are familiar with a registered real property/mortgage. In Australia, this is usually a Torrens title mortgage, which operates as a statutory charge on the relevant lot or interest in the land for the amount of debt or liability secured. It may also be over a lease.

In most cases, an individual guarantee and indemnity will be required from the natural person(s) that support the borrowing entity.

For example, Jane Smith provides a “guarantee and indemnity” in respect of the obligations/conduct of the borrowing entities, Smith Group Pty Ltd & Smith Holdings Pty Ltd. This potentially means the personal assets of the borrower, Jane Smith is at risk. A certificate of independent legal advice is generally required for each individual guarantor.

The Personal Property Securities Act 2009 (PPSA) is a law regarding security interests in personal property. The PPSR is a register of security interests in personal property.

• A General Security Agreement (GSA) over the general assets of a guarantor, including tangible movable property and other property such as intangible property.
• A specific security agreement over specified goods.

For example, Smith Group Pty Ltd & Smith Holdings Pty Ltd provides a “General Security Agreement” over all present and after-acquired property.

Principal and Interest or “P&I” repayments are designed to ensure after a specified term (usually 15 years for commercial property) that the balance of the loan is fully repaid.

The P&I repayment is a contracted ongoing repayment, based on the outstanding loan limit (not balance), the interest rate and term remaining. The repayment can change over time as interest rates move as a result.

Repayment basis will vary on the type of facility. As a rule, there is less flexibility on the timing of repayments compared to home loans.

Interest Only or “IO” repayments do not require the repayment of principal for a period of time (usually a maximum term of 5 years). These loans typically attract a higher interest rate.

Generally, the overarching maximum term is 15 years for a commercial loan, so upon the IO term maturing, the P&I term will be based on the total period, less the IO period. As a consequence, borrowers will usually find themselves with higher residual repayments.

For example: If your loan term was 15 years with 5 years interest only, the residual term is 10 years P&I.

IO may suit businesses that want to preserve cash flow. However, Principal & Interest from the outset can be desirable in many cases. The best option will ultimately come down to the opportunity cost of the “saving” and borrowers need to be aware of this.

Interest capitalisation is when no repayment is required until the end of the term. Instead, the bank adds interest charges to the loan balance over time.

This option usually exists only for construction and property development financing.

Using a residential property as security for a business loan generally enables borrowers to access “better” terms.

Lending using commercial property as collateral is diverse. Security types are broadly defined as Standard or Non-Standard. Standard commercial properties are usually preferred and the best terms can generally be extracted. Standard security generates more lending options and terms.

Examples include:

• Commercial Offices
• Industrial Warehouses & Factories
• Retail Premises & Shopfronts
• Residential Development Stock

Specialised commercial properties are generally a higher risk to credit providers, as they have a smaller available market on exit.

Examples include:

• Specialised Accommodation (Motels, Hotels, Caravan Parks)
• Aged Care Facilities
• Child Care Facilities
• Agri/Farms/Rural properties

Commercial Property and WALE
When financing a commercial property with multiple tenancies you will need to know about the “WALE” or Weighted Average Lease Expiry.

WALE measures the average time period in which all leases in a commercial property expire. It is a key measure for assessing the certainty of rental income streams and is a common assessment tool for commercial property financiers, especially in determining the initial loan term offered.

For more on WALE, please review our blog here

When purchasing or leasing a new physical asset, often it can be used as security for financing. The terms of asset finance will depend on the asset’s expected useful life and valuation.

Like commercial property, credit providers prefer non-specialised assets that can be easily liquidated. Assets purchased from established vendors are new and have a common usage that will drive appetite from lenders.

The types of funding arrangements are diverse and include:

• Finance Leases
• Operating Leases
• Novated Leases
• Commercial Hire Purchase (CHP)
• Chattel Mortgage
• Rental Agreements

These structures all generate different outcomes for borrowers from a taxation and ownership perspective. As such, professional advice should be sought in all cases when considering this type of financing structure.

For more, please read our equipment finance blog here

Borrowing secured with a GSA but without property collateral, is a sign that a business has performance and processes that allow them to be distinguished from others in their industry.

It is variable because the interest rate resets at each roll. These can be packaged by lenders in a variety of ways. For simplicity, we also include bill facilities, even where they are technically fixed during their 30,60,90 or longer terms.

Unlike mortgages, which typically move in the same direction as the Reserve Bank cash rate, commercial rates are market-driven, correlated to changes in funding costs.

Variable rate loans are most popular with borrowers as there are generally few or no restrictions. Most variable loans are flexible, and they allow unlimited extra repayments.

The interest rate is fixed usually for a term of 1 to 5 years. Fixed rates can be restrictive, extra repayments can trigger “break costs”.

Break costs occur when you repay more than what is allowed under the product. A larger prepaid amount and a longer fixed period can potentially mean a more significant break cost. If interest rates continue to decrease after fixing, your break cost liability increases.

Some short term fixed commercial facilities can be combined with scheduled principal reductions at each rollover, allowing the borrower to choose a structure to suit cash flow.

For larger or more complex debt needs - there are additional products that support a tighter ongoing management of interest obligations. Examples of these are Caps and Collars.

A Cap is a maximum interest rate that will apply.
A Put is the minimum interest rate that applies.

A Collar is designed to have interest rates operate between these two points.

Generally, rates will vary between the Cap and the Collar, but will stay within the bands. This type of interest rate mechanism gives a borrower more certainty while retaining flexibility. At a cost of course.

ICR is a measure of how easily a business can pay interest on its outstanding debt. Most lenders will not add back depreciation and amortisation when looking at this measure. Using the example this is calculated as:

Total EBITO ($848,000) / Total Interest ($78,000) = 10.87

When a trading company's interest coverage ratio is 2.0 or lower, its sustained ability to meet interest commitments may be questionable, especially if there is uncertainty around the reliability of future income.

A measure of how easily a business can pay total debt repayments on its outstanding debt. Using the example this is calculated as:

Total EBITDAO ($862,500) / Total Repayment Obligations ($700,000) = 1.23

Where this ratio is 1.0 or lower, cash flow will be negative! So how close it goes to 1.0 times depends on the quality and certainty of the income of the business.

Tip: DSR can be a more relevant measure of liquidity, unlike ICR it includes the actual cash commitment to reducing debt. Where strong amortisation is needed, the gap between DSR and ICR can be wide.

A valid test of borrowing capacity is to apply a multiple limit to the adjusted EBITDAO.

This has become increasingly popular in assessing borrowing capacity for service firms in particular. Using the example EBITDAO is calculated as:

Total EBITDAO ($862,500) x Maximum Multiple of 3.0 = $2,587,500 (Indicative Borrowing Capacity).

Tip: Usually an appropriate method where consistency of EBITDAO is evident. It is increasingly relevant where the lending is not supported by tangible security.

Covenants in a banking context are restrictions or requirements that lenders place on the borrower.

These restrictions can be many and varied, both quantitative and qualitative, positive and negative and provide a structure for monitoring the performance of the borrower.

In fact, our experience is that many business borrowers either are not aware or do not understand the basis of their ongoing covenants. Business owners need financial literacy in this area to prevent covenant breaches.

Covenants can be many and varied. Qualitative performance measurements include:

• Debt/EBITDA Ratios
• Interest Coverage Ratios
• Debt/Equity
• EBITDA

Example in Bank Speak:
Aggregated Actual EBITDA of ABC Pty Ltd will not for any Relevant Period be less than the respective Relevant Amount. Relevant Period and its respective Relevant Amount mean: A. 1 July to 31 December each year, $300,000; and B. 1 July to 30 June each year, $600,000.

Qualitative performance measurements include:

• Ensure assets are maintained and kept in good working order
• Dividend/Distribution Payout Ratio
• Limitation on new acquisition and/or merger activity

Example in Bank Speak:
ABC Pty Ltd will ensure that the sum of the Distribution and all other Distributions made in respect of each financial year does not exceed 100% of the NPAT.

Tip: A savvy businesses will review performance regularly to maintain compliance with covenants.

The Big Four refers to CBA, Westpac, NAB & ANZ. They have a majority market share (over 60%) of the Australian SME lending market. As deposit-taking institutions, their loans are funded mainly by their customers through bank deposits (plus funding sourced through other markets).

In the overall mix of their total lending, their business lending has been declining. This is due to the higher capital requirements for SME loans and the complexity in assessing the fundamentals of SME borrowers compared with residential mortgages.

This includes where a personal use asset (owner-occupied property) is used as security or where the predominant purpose of the business borrowing is viewed as being for investment or personal purposes.

In recent times, and under the threat of competition, the majors are looking to bounce back. This is best evidenced in small businesses - say up to $1M of borrowings - where there are simplified assessment criteria, longer loan terms and higher LVRs, to compete better against Fintech, Neobanks and other providers.

Second tier lenders are authorised Australian Deposit Taking Institutions and are regulated by APRA and other governing bodies. Participants include Macquarie, ING, Bankwest, Bendigo & Adelaide Bank, Suncorp and Bank of Queensland.

As major banks have retreated (in relative terms) from SME lending, one of the expectations was that second tiers may fill the void. On the whole, they didn’t, with a credit appetite that sat alongside or behind the majors. Significantly, they just didn't have the underwriting skills.

Tip: One exception has been the development of policy niches for certain industries such as Medical, Professional Services and others. This is where
second-tier lenders are looking to have a point of difference.

This growing segment of SME banking includes Up, Volt, Revolut, Judo, Hay, Tyro and 86 400. They usually operate via a website and mobile application, without physical business centres and generally offer fewer products and services than larger banks.

Appealing too, is the perceived lack of bureaucracy found in traditional banking, as Neobanks can operate under reduced regulatory supervision and capital requirements.

As a broad description, we define these as lenders that rely on technology and automation in making credit decisions. Fintech uses “AI” as a processing hub that gathers data from information sources to help with credit scoring algorithms.

Sometimes the “tech” can be supported by several manual processes, so the lines are often blurred. However, they are generally accessed by an online application process, with automated decisions and funds transfers. They have no physical business centres, and most are not full banking services providers.

B2B fintech companies include Stripe, Square, Prospa and Moula. Better known B2C fintechs are Athena, BeforePay, Flare, Raiz and Nimble.

The funding base is varied. It is supported by sources including larger institutions or high net worth individuals. These loans are delivered and packaged in a variety of ways. The investor can provide debt directly to a borrower as a mortgagee (known as on a contributory basis) or via a structure of debt securities or similar where the funding is “pooled”.

As the segment has matured and become more competitive, so has the appetite and understanding of risk. We have seen a significant reduction in the “gap” between private lending costs and traditional lenders.

How long is the initial loan term, and the basis for repayment? Short-term P&I or Interest Only? What does the new cash flow position look like?

How much will it cost? What is the interest rate? Be careful here - it isn't always simple.

As things change or the business grows, is there future borrowing capacity to meet needs?

Covenants are important - but some lenders can frustrate with qualitative demands or a thirst for endless paperwork.

Treasury, Foreign Exchange, Trade Facilities, etc. Are there specific additional services needed from a banking relationship?

Quality of people is a critical factor for many businesses at the front and back end. Other borrowers may be “low touch”, so this is less of a factor for them.