Credit keeps the business lights blazing

Debt is part of the fabric of modern life in the UK, for individuals and businesses alike. But while being in the red has largely negative connotations in the realm of personal finance, debt is a normal - even essential - state of affairs for those involved in enterprise. The key is getting the best terms when you are borrowing.

Research from Warwick Business School, published this week, shows credit cards are now the small and medium-sized operation's best friend, 55% of SMEs using credit cards, against 53% using overdrafts and 24% term loans.

Lending is also growing. According to the British Bankers' Association, term lending rose by 16.1% in 2004 to stand at £34.9bn, while overdraft lending saw an increase of 9.1% over the twelve months to £9.7bn, although SMEs remain net creditors to banks.

BBA chief executive Ian Mullen said changing economic conditions over the past year and some 500,000 new business bank accounts were partly responsible for the rise. He added: "It is likely that small firms have been investing in their businesses, supported by nearly £5bn of additional term lending during 2004 from business banks, while benefiting from overdraft support for their cash flow needs."

An overdraft facility is the simplest, most flexible way to borrow money and is a good source of finance to cover unexpected costs. Another benefit is that you pay interest only on the amount you are overdrawn each day. The downside is that the bank can demand repayment at any time and you will have to renegotiate the terms every six to 12 months. You are usually charged an arrangement fee, typically 2% for a £5,000 overdraft.

But in recent years, the proportion of borrowing on overdraft by small businesses has declined. Business loans are more popular, with well over three-quarters of term lending having a maturity of more than three years, with interest charged on a variable rate basis. Term lending is more attractive to many businesses than an overdraft as it is a structured form of borrowing with predictable repayment dates.

The key advantage is that the money is safe for the period of the loan, so this is a useful way to fund start-up costs, buy equipment and fund expansion. Additionally, loans can be tailored to cash flow requirements - you can opt for a variable interest rate or take payment holidays, for example.

The downside is that you will be charged an arrangement fee and you might also have to take out insurance. A typical interest rate for a £10,000 unsecured loan taken over five years would be anything between 6.7% and 9%, but what you are offered will depend to a great extent on your credit rating. Banks assess your credit worthiness using a number of factors - how good your security is, your balance sheet, your banking record, cash flow projections, business plan and so on.

In addition to traditional bank loans, businesses can apply for funding through the Small Firms Loan Guarantee Scheme (SFLG), which offers finance to firms with turnover less than £3m a year that have viable business proposals but who have failed to get a conventional loan because of lack of security. Loans are available for periods of between two and 10 years on sums from £5,000 to £100,000.

The scheme guarantees 75% of the loan and in return the borrower pays the Department of Trade and Industry a premium of 2% a year on the outstanding amount. The APR is arranged between the borrower and the lender. This type of funding can be a godsend for enterprises that have failed to secure funding, but the premium paid for the guarantee means it is not especially competitive.

But, as those survey results show, many businesses are turning from overdrafts and loans to plastic. Research by NatWest bank showed that increased use of credit cards had had a positive impact on cash flow concerns for small businesses. NatWest found that the majority (71%) of businesses that responded saw credit as a necessary tool to enable them to operate successfully. A further 16% went on to say that their business simply couldn't manage without using credit. Most of those questioned used their cards for travel, purchases over the internet and paying suppliers.

Nine out of 10 (93%) paid off their balance in full every month and said the advantages of plastic included not having to use cash (74%), making quick purchases (71%), not using personal money for business needs (66%) and freeing up cash flow (34%).

NatWest's Patrick New says: "This research shows that financial tools such as business credit cards can really help small businesses with their cash flow problems. Many of those questioned also feel in control of their finances which helps to explode the myth that small businesses can't manage their money effectively."

Credit cards offer an easy source of instant cash and the temptation becomes greater with the promise of 0% deals for periods of up to 12 months. But there are caveats. Introductory rates are usually for balance transfers only and once the offer ends, the interest will revert to a less than thrilling rate that could fall anywhere between 12% and 29%, or higher. If you are organised and can pay off your balance in full each month, this type of borrowing is fine - if not, your debt can quickly snowball, particularly if you miss payments.

Invoice finance, covered more fully in our cover story, is a further option. In this kind of borrowing, a factor (usually a bank factoring house) will forward you up to 80% of an outstanding invoice, then chase the customer for the payment it owes you. It then forwards the remaining sum owed and deducts a fee of around 2%. This kind of borrowing is similar to using a credit card as it can provide a quick fix of cash and offers flexibility. The cost will depend on how much money you are chasing, but this is a relatively cheap way of borrowing in the short-term.