Many businesses will want to be able to use assets such as machinery, vans or a shop which they cannot afford to purchase outright, and so they will need some sort of business finance in order to assist with the use of the asset. The cheapest source of finance is usually your bank. There are two ways to borrow money from a bank, namely by an overdraft or by a fixed-term bank loan.
If you want to borrow from the bank to purchase something substantial, such as a van, a lorry, a coach or premises, then the fixed term bank loan is the usual option. Let’s say you want a new van, and you estimate that the van will last you four years. It makes sense to take out a four year bank loan with constant repayments. Some of the repayments will be interest on the loan, and some will be repayments of the original loan itself, but the bank will work out the repayments just so that they are constant and the loan itself is repaid entirely after four years (the Excel spreadsheet has finance functions which can also do the calculation). Loan interest is a deductible business expense which your accountant can work out, while something like a van gets tax-reducing capital allowances.
After four years, you can trade in the van for a new van, and take out a new loan, so there is always a bank loan on the go. The loan itself is a contract. As long as you keep up the repayments and pay them on time, the bank cannot normally do anything to vary the contract.
Another way to borrow money from a bank is through an overdraft. The bank allows you, for an annual fee known as a revisal fee, to overdraw on your current account so that you are borrowing money from them. Let’s say you are a shop and you want to stock up before Christmas. You could arrange an overdraft so you can pay for the stock, sell it over Christmas, and repay the overdraft in January out of sales proceeds. The profits you make should easily cover the two or three hundred pounds you pay as a revisal fee.
Although you pay this fee, there is no contract in an overdraft. The bank can demand at any time that you repay it and may do so if they think you are not being sensible. Let us say that it is not sensible to use a bank overdraft in order to pay for an item like a van or a shop which is to be used in the long term. Instead you should borrow on a “horses for courses” basis. Use an overdraft to finance short-term assets like stock or debtors if you have to give credit. Use a fixed-term loan or mortgage to finance long-term assets. Your accountant should be able to discuss this with you and warn you if your financial structure may cause problems.
I was recently watching a television programme whose theme was brutal fascist banks putting the boot in to poor businessmen (they were indeed all men in this case). It was obvious from the programme that the businessmen in question had little idea about the distinction between an overdraft and a loan, and the programme makers did nothing to enlighten them. As with anything, there are often two sides to every story, but of course, the other side of the story doesn’t make good television.
As an alternative to borrowing from the bank, you can also borrow from the business which wants to sell you something, and the seller is likely to have an associated finance company to advance the cash. One popular scheme is called “hire purchase”. You pretend to hire the asset for a fixed period of time, and with your last rental payment you make an additional payment of an “option fee” which represents an outright purchase of the asset. If you default on the rental payments then the asset can be taken away immediately since it is just on hire after all. There is also likely to be an “administration fee” which you pay up front to cover the possibility of you not keeping up the payments.
The effective interest rate on the hire purchase agreement is known as the annual percentage rate or APR, and the HP provider is likely to be able to work it out on a calculator of some sort (it can be done on Excel). Commercial HP interest rates are likely to be higher than bank loan rates, but then you have the convenience of being able to arrange the loan at once rather than having to go back and forth between the bank and the seller.
For accounting purposes, hire purchase is treated the same way as an asset acquired by a bank loan. You get capital allowances up front if capital allowances are obtainable. We would set up the loan history on a spreadsheet so we know how much loan interest to post as a business expense. This tells us the APR as a by-product and we will give you a hint if we think you are paying more than the going rate, or are paying other fees in excess of the usual charges.
David Porthouse & Co is a forward-looking firm of accountants based in Carlisle with a keen interest in new technology with the aim of speeding up accounts production and making accountancy more affordable for our clients. David Porthouse is also a specialist in company accounts and corporation tax.