Financing A Business For Expansion

 


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A start up business is often funded by one or more of personal savings, loans from relatives or use of credit card debt. These sources are used first because they are usually readily available. Family loans are often available at no or low interest cost and repayments are usually very flexible.

However these sources of business finance have shortcomings. Personal savings and family loans are usually limited in amount. While it is possible to extend credit card limits, the cost of credit card debt is high, with interest rates between 10% and 19% pa. Record keeping for income tax purposes is also more complicated if the same credit card is used for both business and personal expenses.

So, while the initial sources of finance help establish a business, at some point the proprietors may have a need to expand their business. High demand for a product may require investment in more stock or in a manufacturing capability. Extending the business to a wider market may entail additional advertising. High growth in a service business can lead to employing (additional) staff. Any of these reasons for business expansion requires additional funds. The limitations or expense of start up finance makes it unsuitable for business expansion.

A sometimes overlooked source of additional finance is borrowing or extending a loan against property. Many business owners are also home owners. While the home usually still has a mortgage over it, it may be some years since that loan was taken out. Two things will have changed since then. The mortgage will be lower by being partly paid off. Secondly, the value of the property will usually be higher. Depending on those two amounts, an additional loan could be taken out to be used in the business.

Example: Original property value: $200,000 Original Loan: $160,000 (80% of property value) Some Years later: Current property value: $250,000 Current Loan value: $150,000 Potential additional loan: ($250,000 x 80%) - $150,000 = $200,000 - $150,000 = $50,000

The business could obtain a $50,000 loan using the increased value of the property as security.

There are a number of points to note about this strategy:

  • In order to gain full tax deductibility for the interest on the $50,000 loan it must be clear that it has all been used in the business

  • The two loan amounts ($150,000 & $50,000) should be in two separate loan accounts or sub-accounts

  • The financial institution assesses the overall loan first against the property value and second against the capacity to make repayments, so the business should have the capacity to cover the additional repayments

  • While the mortgage is a cheaper source of finance (7%-8% pa), it is also potentially a longer term commitment (25-30 years)

    As with any major decision affecting a business, professional advice should be sought and considered before a commitment is made.

    Mitchell Holmes CPA lives in Cairns, Australia and is the owner of management consulting website http://www.fixmybusiness.com.au and online accessories store http://www.sublimeaccessories.com

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