Principle 1: The purpose of a loan should contain the basis of its repayment.
The types of loans can be classified by maturity and then the purposes for which is type of loan is employed.
Short-term finance (up to 3 years)
i. Working capital for a new product or new business; repaid out of the sales proceeds.
ii. Temporary working capital (for example, for a temporary injection of funds into production); often used to meet seasonal needs. It is repaid out of the subsequent cash proceeds.
iii. Investments in more ‘fixed’ assets which have short working lives, for example, cars. Repayment will come out of whatever the investment ‘earns’.
Note: Normally it is not recommended to purchase what are normally ‘long-term’ assets with short-term finance.
Medium-term finance (approximately 3 to 10 years) and long-term finance
a. More general, less seasonal working capital.
b. Used for more permanent asset purchases, whose effective lives are likely to be equal to or longer than the period of the loan. The lender will require the company to provide quite detailed information on its past performance and expected future prospects.
A company should not borrow more than a specified proportion of the total asset value or equity base of its business. Of course, the ‘specified proportion’ will vary, depending on the nature of the company.
Principle 2: Every loan should have two ways out
These two ways are:
(i) Through successful investment of the funds, for example, profitable sales from buying a machine, time-savings through buying a new lorry.
(ii) If the investment is not ‘successful’ as defined above, then the assets should be marketable. Of course, funds could be diverted from the other operations of the firm, if possible, and, if the company is able to do so, it could issue new capital.
Implications of the principles for a company seeking bank finance
The company should be sure of the following:
(i) its financial position and future prospects;
(ii) its need for finance;
(iii) the amount of finance required;
(iv) the period for which the finance is required;
(v) what sort of security is required and is possible;
(vi) how it will repay the loan;
(vii) the implications of any charges imposed on the company.
Venture capital investment
Usually this is for investment in new developments or technologies, typically with more money used initially. For this reason, it is used for high-risk ventures and the funds will consequently normally come from equity capital.
Implications of the above principles for the provision of venture capital
(i) The venture capital source will not normally have any security over the assets of the company, and will therefore require much stricter, more detailed information on the future prospects of the business.
(ii) The source will want to be able to sell his shares if he wants to ‘get out’ of the venture, once it is successful – it is therefore likely that the source will have to undertake some sort of forecasting of the future share price and of the marketability of the shares in the future.
(iii) If the venture is unsuccessful, then the source has virtually no recourse, that is, the source of the equity capital always bears any subsequent loss.