Going into debt is sometimes unavoidable when you’re trying to grow a business. Especially for small companies, it can be almost impossible to secure equipment, acquire inventory, and go into production or service without incurring at least some loan obligations.
A company’s ability to take on debt – or debt capacity – can be an asset, if managed carefully. But any time debt is incurred, the new obligation needs to be evaluated in terms of its potential to create enough future revenue and profitability to justify the borrowing.
One advantage of debt financing is that it doesn’t require you to give up any ownership in the company. Still, before you add to your debt pile, make sure you understand the actual cost of borrowing.
Cost of debt: obvious and not so obvious ones
- True interest cost. Since any commercially-obtained loan will require you to pay interest, the real cost of the debt (because of the true interest cost) will be higher than the amount of money you’re actually borrowing. But as a business, you can usually use the loan’s interest expense as a tax deduction, so the after-tax expense of a business debt or loan is a more accurate view of the true cost of debt. (Please see a qualified tax advisor for current information on loan interest deductibility.)Example:Amount borrowed: $100,000
Interest rate: 6.5%100,000 x .065 = $6,500Pre-tax cost of loan = $6,500 per yearCorporate Tax Rate: 20%1 – .2 = .8.8 x 6.5 = 5.2
100,000 x .052 = $5,200
After-tax cost of borrowing with this loan = $5,200 per year
One other matter bears mentioning here. The fact that you will likely make monthly payments on the debt means the effective rate you will pay on the money borrowed will be slightly higher than the nominal or stated rate. This is due to the effects of the time value of money. For example, the 6.5% rate in the illustration above would, because of the monthly payment structure, translate to an effective rate of approximately 6.7%. The 6.5% rate would also be the effective rate only if you had the option of making only one payment at the end of the year, which is not a typical arrangement for most small companies.
Your bank will have this clarified in the loan documents. Contact your financial advisor or accountant for a more detailed explanation.
- Fees and charges. These can take many forms, including one-time loan origination fees, documentation fees, appraisal fees for collateralized property, and closing costs. There will probably also be fees applied if you’re late on a payment and there could be penalties for paying-off the loan early. Make sure you completely understand any fees described in the loan agreement.
- Cost of borrowing: time dedicated to acquiring the loan. Unless you’ve been through the process you can’t imagine the time required for preparing for and attending loan meetings, filling out applications and other paperwork, and contacting lenders. And of course, there’s no guarantee that you’ll be approved by the first or second bank to which you apply. Be prepared to invest considerable working hours to the process.
- Cost of borrowing: servicing the loan. Writing the check, making sure you have adequate funds, and – if you’re stuck – occasionally asking the loan officer for a couple extra days to make a payment can be time consuming and stressful. If you have multiple loans, the time you or an employee spends on debt service can add up.
- Loss of control. The loss of control you experience by borrowing isn’t the same as when you lose partial ownership in the company, like you would if you were to sell stock in the business. This loss comes by way of putting up certain property as collateral for a loan, by having to “earmark” parts of the revenue stream for debt service, and by forfeiting opportunities to put those funds into building your company instead of making debt payments. This is hard to quantify, but should be part of your decision-making progress when considering taking on additional debt.
Debt might be a fact of life for a growing company, but you must understand the actual cost of borrowing as you create debt management plans.
Make sure you understand everything in the loan agreement, get professional help you through the borrowing process, and, as a cost of borrowing, be sure to consider the time, energy and resources involved in obtaining a loan.
Invoice factoring can help your company meet its cash obligations, and is often a viable alternative to taking on more bank debt. Let MP Star Financial help you sort out your options and decide if invoice factoring makes sense for your company. Call MP Star Financial for more information at (800) 833-3765, extension 150.