“My interior design business has been in operation for three years. However I usually find it very challenging because of the irregular income. My clients pay me usually within 30 to 60 days. However even before they pay I do incur costs in getting materials and I also have rent and salaries to pay. I have had a discussion with my bank and they are willing to give me a three-year loan of Kes 1 mn. I think this will really help ease the cash flow burden and in this time I think I will have the business in a more stable condition and start putting surplus money aside. Please let me know if I am on the right track with my thinking”
Many business owners or managers can relate with David’s** story above. His dilemma is that he has a business that has fixed and regular costs such as rent and salaries. However due to the nature of his business, money does not come in every month. In addition to this, when he does get work sometimes there are upfront costs that he has to incur. I ended up meeting with David and this is a summary of our discussions.
Many times we assume the only way a bank can lend us is if we borrow an amount for a fixed time e.g. like in David’s case three years. That is incorrect. If David takes this three-year loan, he will have to pay back a standard amount every month of approximately Kes 35,000, which will only add to his problem. His monthly fixed costs, which he is already having problems paying, will just increase by Kes 35k. He may find that to service this loan, he does have to dip into the amount that he has borrowed so he will be in fact be repaying debt with debt. Following my discussion with him we realised that work does come in, it is just the length of time it takes to be paid that is giving him challenges. What David needs is therefore not a term loan, like the one he is being offered but what is called an overdraft. With an overdraft he will only be charged for what he has used, unlike a loan where he will start being charged interest immediately. If David had a specific project he was doing then a loan would have made sense. However all he actually needs is something that will bridge short term gaps in his cash flow. When the bank approves his overdraft of Kes 1 mn, it means he has access to money up to Kes 1 mn but does not have to use it all at once. The bank will not literally credit his account with Kes 1 mn like with a normal loan but will just allow him to overdraw on his account up to Kes 1 mn. For example he can issue payments up to Kes 300,000 this month to use for rent, salaries, supplies etc. The minute a client pays him, those funds go towards clearing the overdraft, and any surplus will be left as a credit in his account. He will be charged interest for just the Kes 300,000 used and only for the actual days that his account was overdrawn. This will end up effectively being a cheaper source of credit for him. One has to remember though that an overdraft is supposed to be used simply as a short-term bridge. It is not to finance costs for a business that has no money coming in over the long term. Many banks will raise the red flag if they notice a business is consistently operating close to the overdraft limit, and does not have cash inflows. Also remember that an overdraft is renewed annually. The bank can opt to not renew your overdraft if they are unhappy about how it has been handled and you would have to immediately pay any amount that is outstanding.
David though has to remember the overdraft is a temporary solution and he has to resolve the problem in the longer term. Firstly as he builds a reputation with his clients, he needs to start looking at getting a deposit from them prior to doing the work. This deposit will at least cater for the direct costs related to doing that job. If he has to use his overdraft to get these supplies, his costing for the work must also reflect the interest he will be charged so that he does not go out of pocket. He also needs to start negotiating his payment terms and not necessarily always leaving it in the hands of the client to decide when he gets paid. For example he may decide to set a limit of 30 days when agreeing on the terms of his service. Any payment that has to be done later than that can again be priced differently. David also needs to start planning on keeping a cash cushion. The discipline here is that when he does get paid significant sums of money, not to utilize the entire amount. The temptation we have (whether it is in business or our personal finances) is usually to spend as much as is in the account. This is similar to what an individual would refer to as an “Emergency Fund”. This will not only reduce his reliance on the overdraft but act as a buffer that can cushion him for a couple of months in case he goes through a period when business is slow. Lastly as David builds his business, it is worth designing a product or service that brings monthly cash flows so he is not so dependent on the contract jobs that though they pay well, may not happen every month.
Waceke runs a program on personal financial management.
Find her at waceke@centonomy.com
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Hi Waceke,
Thank you for the good advice. Will practice this.