Survey Says: Additional money gets used for debt financing, capital equipment, working capital

The Small Business Branch of ISED (Innovation, Science, and Economic Development) recently released the results of its “Credit Conditions Survey – 2016.” A total of 2,111 small businesses completed the questionnaire, which asked questions about the financing future of these small businesses.

Canadian Metalworking asked finance columnist Ken Hurwitz for his opinion on the survey and its responses. Here’s what he had to say.

CM: How can businesses use surveys like this to take a snapshot of their own organization and compare it to what others look like in the marketplace?

Hurwitz: The first and most important point that can be learned from this type of survey is the availability of financing and the simplicity that can be found when leasing.

I am shocked at how often I sign up a new customer and the first thing they tell me is how amazed they were at the speed and ease of the process. Small businesses typically have one lending experience with their bank, and it almost always was when they were starting out as a young company, which is the toughest time to deal with a tier 1 lending institution.

In many cases, these customers, particularly ones who are trying to finance an asset with an excellent resale value, could have had a much easier time if they just diversified from their bank. An alternative lender, such as a leasing company, is not looking to compete with a bank because there are many types of transactions that these lenders are not usually equipped to handle (like an operating line). But if a small business uses its bank just for its operating line and then arranges a separate transaction for equipment with a leasing company, it will automatically double its borrowing capacity.

CM: What can be learned about industry’s use of borrowed money from this survey? (Editor’s Note: Debt financing was the biggest use of requested capital at 26 per cent and leasing was 9 per cent.)

Hurwitz: One of the biggest misconceptions about using an alternative lending institution is the expectation of a significantly higher rate of interest or cost of funds. The reality is that for any established business, small or large, its bank will always be the cheapest cost of funds. First, the bank will has all of the owner’s personal assets and guarantees as well as business assets tied up as collateral for whatever loan it is providing. The bank is in an equity position from the onset, and it’s normally secured at a rate of 3-to-1 in the bank’s favour.

A typical alternative lender is in a much different position, normally 1-to-1, with the main collateral being its security in the asset it is financing. When you look at the rate savings from the study, you see it is only about half of 1 per cent even though the leasing company is taking significantly less collateral. Also, a well-established leasing company has access to many different funding sources, each of which evaluates the customer based on one transaction, as opposed to a bank, which ultimately caps the amount it will lend to any of its customers.

CM: The survey shows a large jump in required capital between short-term and long-term loans (59 per cent and 84 per cent, respectively). Why is collateral so much more important in a long-term financing situation?

Hurwitz: This is really about how a bank or tier 1 institution looks at the transaction, and what it is financing.

A long-term transaction normally is done at a low interest rate; therefore, the only way for the lending institution to make a profit is make ensure the customer pays over a long period of time. It is a simple mathematical formula of compound interest.

For example, it is more expensive, from an interest cost perspective, to borrow $100,000 for 10 years at 5 per cent than for 5 years at 10 per cent, and that’s how a tier 1 lender makes its money. But here is what’s most important to note: If you are on solid financial footing, the premium in interest rate to use an alternative lender is about 0.5 per cent, with the added bonus of not having to supply nearly the same level of collateral or personal guarantee.

CM: It seems shop size, geographic region, and age of business all play roles in how lenders view risk and how these shops use new capital. Can you explain these variances?

Hurwitz: Most businesses use a local bank for ease of depositing money. The survey also shows that most businesses use their local institution exclusively for lending purposes as well, so it makes sense in smaller regions where there are fewer customers and institutions and ultimately less overall business.

There is also a comfort level for a tier 1 lender because it knows exactly where its customers are located in the event there are any issues. An alternative lender, such as your typical leasing company, is less concerned with where the customer is located, it just needs to be somewhere in Canada. As the survey shows, the typical leasing transaction is normally smaller than what is done at a bank, and the monthly payments are taken as a pre-authorized debt, so there is no need to be down the street or around the corner.

CM: The big question from the survey is what the funding was needed for. Fixed assets came in at 32 per cent and working capital at 49 per cent. Does this mean that these companies do not have enough income to cover their day-to-day expenses and need a loan to get them through?

Hurwitz: Most small businesses know only one lender and for whatever reason do not spend much time investigating alternatives despite the fact that many are available. There is also the stigma associated with having to borrow money and pay interest. For some it is just the thought of taking on debt, while others they would rather pay cash because they are averse to paying interest.

Say a manufacturer just landed a new contract and needs capacity. It can either pull money out of its working capital and pay for an expensive piece of equipment in cash or avoid it all together and add extra shifts to make deliveries. However, what I see most often is that when businesses get busy and are in a growth mode, they don’t realize there is even more pressure on their working capital.

They now have to buy more material and tooling, as well as pay a second or third shift. And when they finally deliver, they won’t be paid for 60 or 90 days in many cases.

This is why you see the most common reason for needing to borrow is for working capital, with second place being fixed assets.

I have to admit I smiled when the study noted the main reason for not seeking financing was “not needed,” yet the next question was intended use for financing was “fixed asset and working capital.”

Based on my experience in the manufacturing industry, I would bet the people who don’t think they needed financing are the same ones that went out and spent a significant chunk of their working capital on a new machine, figuring they would save themselves the interest, and then the following year they were part of the 49 per cent of respondents who said they needed to borrow money for working capital.

Ken Hurwitz is senior account manager, Blue Chip Leasing Corp., 416-614-5878, www.bluechipleasing.com.