Among the most talked-about and featured headlines in finance these days is the topic of rising interest rates. The short-term borrowing rate, set by the Federal Reserve, last year passed the 1% mark for the first time after remaining at our about zero for close to 9 years. The Fed is expected to raise it another three times in 2018. There is no getting around the fact that borrowing costs are on the rise. Set against history, however, rates are still near all-time lows, and debt financing remains a potentially attractive way to help fuel growth.
Borrowing is an important component of running a business. Your business may or may not have debt, and the extent to which you’re comfortable borrowing could vary. Regardless, business owners and finance managers would do well to give some thought to the use of leverage, especially in the current period of slow but steady change in monetary policy that’s taking shape broadly in the U.S. and abroad.
Going into debt is not necessarily a bad thing and can be done in a smart way. Leveraging is a powerful tool if the rate at which your business is expected to grow is greater than the rate at which you are borrowing. Here are a number of key elements to keep in mind for a business considering using debt to finance growth.
1. Types of Debt
There are various types of debt, broadly divided into secured and unsecured. Secured debt means a lender has a hold on underlying assets (i.e. security) and has a way of being repaid if the borrower defaults. This kind of loan will typically have lower interest rates than unsecured debt. Examples of commonly used secured debt include:
- Lease financing (for equipment)
- Asset-backed line of credit (bank debt)
- Factoring (lending against receivables)
Unsecured debt means the lender does not have specific assets that can be seized. Examples of unsecured loans include:
- Small Business Administration loans: A potential borrower needs to apply through a bank that provides SBA loans (information is available at sba.gov)
- Credit cards: I myself have used credit cards to help fund short-term cash flow crunches. But I did so only when I knew I had other funds coming in to pay the cards off, since credit card interest rates are very high.
- Peer-to-peer lenders: This can be a good source of short-term capital based on your credit-worthiness, but can also be quite expensive in terms of the interest rate charged.
- Online lenders: The likes of OnDeck Capital and Kabbage. Be careful when using these types of lenders as the interest rates are very high. This would be a source of last resort.
Aside from the two broad categories, alternative borrowing measures include customer financing, vendor financing, economic development organizations that lend alongside banks, and Small Business Innovation Research grants.
2. Terms for Debt
The following are some of the key aspects of borrowing.
- Interest rate: The interest on secured bank debt will be relatively low. As seen above, unsecured and alternative options such as credit cards can be tied to significantly higher rates. This also depends on the borrower’s credit profile.
- Term (time): short term (1 to 3 years); medium (3 to 7 years); long (7-plus years)
- Security: What type of security is the lender requiring? A blanket lien on all company assets? Or a lien on specific assets only, such as receivables or equipment?
- Personal guarantees: Most institutional lenders, banks especially, require a personal guarantee, which means you are putting your own personal assets on the line for the amount of the loan. If you have any major assets outside the company, this might be too much of a risk.
- Covenants: You need to ensure you can make the payments. The bank will have formulas that you have to meet, such as debt coverage ratio or liquidity ratio, which simply provide the bank a metric for your ability to generate enough cash flow to enable you to repay in a timely fashion.
- Interest-only: You may be able to negotiate a short period (6-12 months) during which you only have to pay loan interest, no principle. This saves you significant cash in the short run, while you are using the funds to invest in the business. Later, when the investment starts generating positive cash, you will be able to make the interest and principle payments.
- Balloon payments: This, too, reduces your payments in the short run. This structure allows for simple interest payments during the term plus a large, single “balloon” payment at the end. You can save considerably in the short run, but only do so if you are very comfortable with the idea of making a large payment (or being able to refinance it) at the end.
- Warrants: Some alternative lenders could require warrants, which are a form of equity to give them upside potential on the business as a whole. This is over and above the interest they will receive.
3. How Lenders will Determine Creditworthiness
Lenders care about getting paid back in a timely fashion. It is important to assess the creditworthiness of the business and owner. Questions to ask yourself and some thoughts to review include:
- What is the credit history for your company itself?
- What is your personal credit history?
- How long have you been in business?
- Recurring vs. non-recurring revenues
- Company assets to pledge (security)
- Personal assets to pledge (security)
Debt financing (borrowing) remains an attractive way to help fuel the growth of your company. To recap, some of the key notions that I hope you’ll take away are the following:
- Ensure you have plenty of cash flow to support the debt
- Understand the covenants and other terms and conditions (e.g. reporting requirements)
- Work with your lenders so that they understand the state of your business and prospects for improvement
- Communicate with your bank/lender about any potential adverse issues with the business
- If you default on bank covenants, you can be placed in what’s called “workout,” which is a way of banks taking control and doing everything they can to get paid back
There are more types of lenders and credit facilities than you can imagine. Finding the right one for you and your business takes time and preparation. However, doing your homework and getting expert advice along the way will ensure that you obtain the optimal credit facility for your company.