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.
About the Guide
Business Finance is a highly specialised area where relevant skills and experience are required to succeed. Our Business Finance Guide offers insights into best practices for structuring and obtaining commercial finance.
Borrower Enquiry Form
Included below is a Enquiry Form to complete and connect to a Finance Partner to assess for further discussion.
The information in this Guide is general information only. It is not intended to be a recommendation or constitute advice. We recommend you seek advice as to whether this information is appropriate to your needs. Whilst every care has been taken in the preparation of this Guide, the author and associated entities, its directors, or consultants expressly disclaim all and any form of liability to any person in respect of this Guide. This includes any consequences arising from its use by any person in reliance upon the whole or any part of this Guide.
PART A: SECURITY PROVIDED FOR DEBT
Security or Collateral are the assets that an individual or entity borrower provides to a lender, as security for credit. For the credit provider, this serves as a protection against potential loss of capital.
TANGIBLE VS INTANGIBLE SECURITY
Tangible Security usually takes the form of acceptable property security or cash. This is the most common form of commercial lending especially in the small to medium business market. A registered first mortgage is taken over property and is commonly supported by personal and directors’ guarantees, and a General Security Agreement (GSA) over the borrowing entity and other entities in the group that directly or indirectly provide serviceability support for a loan.
Intangible security is sometimes referred to as “Cash Flow Lending” and is more difficult to obtain especially in the small business market. Businesses that can demonstrate strong balance sheets and future cash flows may be able to obtain lending facilities without the provision of property or cash security.
TYPES OF SECURITY
1. PROPERTY SECURITY
2. GUARANTEES & INDEMNITIES
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.
3. GENERAL SECURITY AGREEMENTS & ”PPSR”
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.The requirements include:
- 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.
FINANCIAL POSITION & BACKGROUND OF THE PRINCIPALS AND DIRECTORS
In most instances, the personal financial position of the borrowers will be reviewed, as supporting guarantees or security are usually required. The capital base accumulated by the individual borrower should indirectly reflect their business life. A lender will look to connect that to some extent.
Often, marginal performance by the business in a period can be mitigated by the borrower’s capital base.
In all cases, financiers will request a completed Asset & Liability Statement for all individual borrowers and/or guarantors. This will help assess the viability of the guarantor to meet obligations in the event the obliger is not able to do so.
A key determinant is the applicants’ experience in their industry. This must be evaluated in considerable detail to ensure that the necessary business expertise is present to support future goals and objectives.
RETIREMENT OF DEBT
The financier will want to show a demonstration of the way the debt will be retired. Typical strategies they look for are:
- Full payment over the term of the loan out of current cash flow
- A forecasted increase in earnings, building capacity to retire debt in the future
- The acquisition of new contracts or revenue streams that are recurring in nature
- The divestment of non-core assets
Tip: The sale of the primary security is not a sufficient debt strategy in most instances. Credit providers want to see the “first way out”.
PART B: REPAYMENT STRUCTURE & AMORTISATION
Setting a loan term can be one of the most challenging aspects of structuring commercial lending. Loan term is a topic that drives significant negotiation between lender and borrower.
The bank is seeking to have more money out for longer, but they need to satisfy their internal risk parameters and have the loan repaid as quickly as possible.
Tip: The key is to match the loan term with the period in which the assets being acquired provides the maximum benefit.
THREE COMMON REPAYMENT TYPES
1. PRINCIPAL & INTEREST (P&I)
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.
2. INTEREST ONLY (IO)
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.
3. INTEREST CAPITALISATION (ICAP)
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.
DETERMINING LOAN TERM
The loan term and the repayment type offered will depend on both the Security and the Purpose for which the funds will be utilised.
Lending products are increasingly available that accommodate for different availability of security.
The following table is a very simplified overview of key loan terms available based on different types of security or collateral provided:
|COLLATERAL TYPE||LOAN TERM||INTEREST RATE||LVR|
|Residential Property||Up to 30 Years||Lowest||80%|
|Commercial Property||Up to 25 Years||Low||70%|
|Business Equipment||Up to 5 Years||Low||N/A|
|Business - Trading (GSA)||Up to 10 Years||Higher||50%|
|Unsecured||Up to 2 Years||Highest||N/A|
FOUR TYPES OF COLLATERAL
1. RESIDENTIAL PROPERTY
Using a residential property as security for a business loan generally enables borrowers to access “better” terms.
2. COMMERCIAL PROPERTY
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.
- 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.
- 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
3. BUSINESS EQUIPMENT
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
4. THE “BUSINESS” AS SECURITY
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.
C. LOAN RATES
LOAN RATE OPTIONS
1. VARIABLE RATE LOANS
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.
2. FIXED RATE LOANS
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.
3. HYBRID LOANS – CAPS AND COLLARS
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.
PART D: CAPACITY & COVENANTS – THE FIRST WAY OUT
CAPACITY AND SERVICEABILITY
There is no one “right” approach to assess borrowing capacity of the business borrower. Key measures of serviceability include:
1. INTEREST COVER RATIO (ICR)
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.
2. DEBT SERVICE RATIO (DSR)
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.
3. MULTIPLE OF EARNINGS
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
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.
PART E: CHOICE OF LENDERS
Business lending has evolved. Credit rules are less technical than consumer credit, and several innovations have helped new lenders compete in the segment.
In real estate and property development, the risk aversion and regulation imposed on major and second tier banks have opened the door for a range of non-bank financial institution (NBFI) lenders to enter the market with increased sophistication.
BANK AND NON-BANK LENDERS
1. MAJOR BANKS (BIG FOUR)
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.
2. SECOND TIER LENDERS
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.
4. FINTECH LENDERS
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.
5. PRIVATE FUNDERS
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.
PART F: BASIS OF RECOMMENDATIONS
Structuring Business Finance is more complicated than many, including some accountants, realise.
In our experience, the structure and subsequent conduct of borrowings usually is more material than the credit provider selected. Therefore, it is critical to focus on identifying the needs of the business first, rather than jumping straight to a credit solution or provider.
SIX FACTORS FOR A BASIS OF RECOMMENDATIONS
Feedback from business borrowers shows that the following six factors are most critical when forming a basis of recommendations. A basis of recommendation is a best practice step in the commercial lending process.
It is best to take these six factors into account at varying levels depending on the customer’s needs:
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.
PART G: UNDERSTANDING INTEREST RATES
All prospective lending terms depend on the borrower’s relative risk of default, combined with a “score” calculated by bespoke risk grading systems that capture both qualitative and quantitative measures.
This also presents a required Return on Equity (ROE) for the business, which forms the ultimate basis of the lender’s rate pricing and fee model. So, it considers the probability of default based on risk grade and then calculates the “loss given default”, which generates the capital cost requirement based on the lender’s cost of funds.
RISK GRADING AND PRICING
- The primary purpose of the funding
- The quality of the collateral provided for the loan (i.e. if funding is “unsecured” the pricing model will automatically throw up a high interest rate)
- An LVR based on the collateral provided (a higher LVR will place upward pressure on pricing)
- The strength of the capacity to service the debt (using a range of measures)
INTEREST RATE STRUCTURE
Unlike getting a mortgage, business customers are often unsure of the interest rate they are paying for their commercial finance. SME loans are typically packaged as a simple all up interest rate. However, larger loans will usually be linked to a “market” base interest rate with margins and costs added on.
Interest Rate Components include:
|BASE RATE||BASE MARGIN||TREASURY MARGIN||LINE FEES|
|In simple terms, a commercial loan will be based on a Bank Bill Swap Bid Rate (BBSY) interest rate or a similar benchmark at which the financier borrows money.||Customer margin is determined by factors including character, capacity, and capital. On a bill facility, the interest rate is rolled over every 30, 60, 90 or 180 days. At rollover, the interest rate is reset to the current base rate plus the margin. As an example, this may be quoted as 2.0% over BBSY.||Raising money to lend is expensive. Some financiers will separate a cost (called a treasury margin) built into “their” bespoke base rate or identified as a separate cost component. This might be anywhere from 20 to 40 basis points.||A line fee is payable to keep credit available for the borrower to use. A line fee is charged on the loan facility limit. Interest is only paid on the balance of a loan.|