When the plastic's not so fantastic

Small businesses often rely on credit cards, but there are other ways, says Paul Gosling

Most of the businesses which use credit cards do so for short-term borrowing and clear their accounts each month. But more than one in 10 small businesses rely on credit cards on an on-going basis and 17 per cent of small firms using credit cards do so to buy fixed assets. Many will pay dearly, when they can probably find cheaper sources for borrowing.

While credit cards may seem attractive when businesses start off - because of the ease with which money is available - the risk is that small firms will pay as much as 29.9 per cent (the current rate on a Capital One Classic card) rather than, say, 9.5 per cent (plus fees) from Alliance & Leicester (best business current account provider, according to Business Moneyfacts), on an unsecured £5,000 business loan. Borrowing on an expensive credit card could add about £1,000 a year to the cost of a £5,000 loan.

Yet the use of credit cards for financing small firms is growing - though it is still lower than in the US where, even seven years ago, almost 80 per cent of small firms used credit cards for finance. The Federation of Small Business (FSB) is worried at the trend, which reflects impatience among new entrepreneurs, who include former students for whom high levels of credit-card debt have become a way of life.

"People are so used to quick decision making with plastic," says the FSB's Parliamentary officer, Stephen Alambritis. "And so many small businesses now are set up from home. It seems to be working, but not in the best possible way." The FSB warns that if a firm does not approach its bank when it needs £5,000 for an initial small capital purchase, it is likely to find the bank less aware of the firm and therefore less receptive when the business needs a £50,000 development loan.

But it doesn't need to be like this. Dr Stuart Fraser, author of the Warwick report, says there's no immediate financing crisis across the small firms sector. "Initial findings show that most businesses are accessing the finance they need," says Dr Fraser. "One in 10 SMEs needing a new loan were rejected, but the majority of these businesses went on to obtain alternative funding, with less than one in 20 of those denied loans finding themselves with severe problems."

The Warwick research found a surprisingly low number of small firms - only 24 per cent - were using bank loans. More use leasing or hire purchase, at 27 per cent. Invoice financing - invoice discounting and factoring - remains a much smaller source, at just 3 per cent, with a similar number of small firms turning to equity.

While Warwick found that most small firms seeking bank loans got them, recent research from IT suppliers Siemens concluded that the perception by small firms that banks were likely to reject loan applications was driving companies into other means of raising finance. Siemens found that businesses are more likely to take on lease contracts than finance purchases through loans. One reason for this is that it enables firms to enter into "refresh contracts", under which they pay a fee to guarantee supply of state-of-the-art technology.

Andrew Harman, managing director of Siemens vendor partner, Annodata Business Communications, argues that systems providers are expected to arrange easy finance to sell their products. He says: "The pace of technology change today is encouraging firms towards leasing and other financial arrangements so that they are not hampered by potential technology obsolescence and capital expenditure. Cash purchasing of technology slows decision making." But the Institute of Chartered Accountants in England and Wales (ICAEW) shares the concern of the FSB at how small firms are turning to easy money. Susan Field, president of the London Society of Chartered Accountants of the ICAEW, points out that one in three businesses closes within three years, often because it has insufficient capital or has not chosen the cheapest appropriate funding source.

Guidance from the ICAEW suggests a pecking order of sources for early-stage finance. First, entrepreneurs might approach families and friends, as well as drawing on their own capital, before considering bank loans and overdrafts, the small-firm loan guarantee scheme, leasing and hire purchase. When moving to the growth stage, the business might consider invoice discounting, factoring, secured loans, equity finance, business angels and venture capital. In this way, suggest the ICAEW, success is more likely.

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