What you need to know about the matching principle

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Almost every startup business encounters cash flow problems from time to time and may need to think about a short-term business loan. However, taking out a short-term loan can be risky in itself as it increases the company’s monthly outgoings (though of course it will stave off imminent liquidation).

Cashsolv, experts in business continuity, are here help you decide if taking out either short-term or long-term small business finance is the right for your business.

The answer lies in the matching principle.

Introducing the matching principle

The matching principle argues that loans should be carefully matched to their intended purpose. In other words, it makes sense to fund an investment in capital equipment with a long-term loan. This is because the asset is likely to give you service over a number of years, so you should aim to borrow over the same period.

Alternatively, it could make sense to take out long-term finance to purchase inventory to fund business growth. Let’s say your company has the opportunity to take on a huge new client. One so large that it will deliver a step change to your business. You don’t have the cash on hand to buy stock to service the account, and of course you will need to pay suppliers before your new customer pays you, so you have no choice but to borrow if you wish to move ahead.

However, if you’re simply borrowing to cover a sudden short-term cash flow crisis, long-term borrowing may not be the way to go. Once the company is over the hurdle you should ideally be able to repay the loan and return to business as normal. However, this isn’t always the case for a number of reasons.

Why you should try to adhere to the matching principle

Short term business loans for working capital typically involve a floating rather than fixed interest rate, and it is fairly obvious that the base rate which is still at a historic low is only going to move upwards.

When it’s time to renew the loan, giving the lender the option of renegotiating the interest rate, you could find yourself paying more than you bargained for. Instead, if you’re able to take out short-term finance and apply the fiscal discipline to repay the loan on time and in full, you won’t encounter any nasty surprises.

Secondly, your lender will probably have the option of withdrawing the loan at each renewal date. How would you cope if you’ve been using working capital finance as a crutch for several years, then suddenly it’s gone?

Loans to finance cash flow should deliver a definitive solution for a particular problem, not act be used to paper over poor cash management practices for years on end.

That said, most lenders (both banks and alternative lenders) are generally quite supportive and try not to withdraw loans at short notice. However, if your cash flow is clearly worsening and you’re struggling to keep up with repayments, you may find yourself being transferred to an arrangement with far less favourable conditions.

This will only add to the misery you’re already experiencing and could place your business in a very unfortunate position.

How should you mitigate risk?

The first thing to do is be realistic about why you need to borrow and over what term. An injection of money to cover a cash flow blip should be paid back as quickly as possible and not used as an ongoing sticking plaster.

However, if your company is consistently ramping up its volume of business then you are likely to have ongoing cash flow issues and will need a longer-term solution.

Be upfront and frank with your lender, explaining your financial position and the challenges you face. Also, make sure you talk to both alternative lenders and banks, as the latter have become cautious in their lending criteria since the financial crash of 2008, whilst alternative lenders often take a quite different view of the market.

If your borrowing need is clearly short-term but you’re struggling to see how you will manage the repayments, then you should examine your finances more broadly.

In particular, look carefully to see whether you can free up cash by renegotiating your terms of business or reducing your outgoings. Persuading your suppliers to move from 30-day to 60-day payment terms could transform your cash flow, as could relocating to smaller and cheaper premises or changing your energy, fixed line telephony or mobile phone contracts to more competitive providers.

Make sure you plan for contingencies

Whether you’re borrowing over the short or long term, though particularly the latter, it’s important that you factor in all eventualities. In other words, there is no point in borrowing a certain sum only to hit another cash flow crisis and find that you actually needed more.

For sure, there are significant disadvantages in borrowing more than you need via a term loan. You will find yourself paying interest on money you don’t require and could encounter early repayment penalties if you attempt to pay it back ahead of schedule.

It’s therefore vital to assess carefully what you require, how long you should borrow for, and how much “wiggle room” you should build into the loan in case your financial situation suddenly changes.

Don’t forget to talk to alternative lenders

As already mentioned, alternative lenders and banks generally apply different acceptance criteria, so when seeking finance, you should ensure you speak to both. Banks can be particularly cautious about lending to small businesses without extensive track records. These companies tend not to have the breadth and depth of management expertise of their larger counterparts and are much more susceptible to relatively minor changes in their markets.

Of course, conventional term loans are not the only option on the table. You could also consider a business line of credit, which acts like an overdraft, enabling you to borrow and repay at will. The additional flexibility will usually result in a significantly higher interest rate, but of course you will only pay interest when you are actually using the facility.

Another expensive but potentially very useful way to borrow is a merchant cash advance, via which you repay the capital and interest through a fixed percentage of your daily credit card sales. The advantage is obvious – you will never find yourself facing significant repayments during a quiet period for your business.

Finally, invoice factoring and discounting can tame a troublesome cash flow forever by enabling you to borrow against the value of your invoices the instant you issue them. In effect, you get paid immediately, with the finance company taking a portion of the proceeds in return for providing the service.

Identify your need, then identify your lender

In summary, there are two steps you should take in order to get the finance you need to stay in business.

First, decide whether it makes to sense to borrow across the shorter or longer term using the matching principle, and then talk to the broadest range of lenders, keeping all possible options on the table. You’ll find this approach will pay dividends, wherever your business takes you.

Carl Faulds is Managing Director of Cashsolv, he offers advice and support to overcome cash flow problems and identify possible underlying problems that can be addressed to ensure a positive future for your business.

 

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