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ny time we enter a period of changing interest rates, some business owners may find debt financing to be increasingly attractive. Business owners often think that the only cost of debt is its stated interest rate. If you borrow $1,000 at 5%, you have to pay $50 in interest every year, and that’s that, right?
No! Debt is much more expensive, for many reasons:
- All businesses have to pay back the principal, too! Many people forget to include this after-tax payment in their calculations. Banks lend other people’s money and have to be able to get it back! Many borrowers and lenders have forgotten this repayment risk to their detriment.
- Use of debt financing may entail loan covenants that restrict the borrowers’ prerogatives
in areas such as compensation, capital expenditures, dividends, and distributions. The interest rate does not reflect these costly limitations on control and ownership benefits.
- A personal guarantee or other collateral is almost always required: THAT can be restrictive and hugely expensive when things go badly!
- Additional reporting requirements (audits, monthly statements)
can be costly, time-consuming burdens.
- Other compliance requirements (such as credit life insurance or asset appraisals)
add costs.
- If the repayment schedule is inflexible and cash flow is barely sufficient or inadequate to cover current obligations, the risk of insolvency is material. (In this case, the loan could be called, or placed in “workout,” in which even more onerous controls are enforced)
.
- Today, some debt has floating interest rates pegged to the prime rate (e.g. prime plus 2.5%)
. If interest rates rise, the cost of debt will rise accordingly.
- Debt from non-bank capital firms almost always includes “equity kickers” such as stock options and warrants that can dramatically increase the cost of the financing package. Typical “mezzanine” financing has an overall cost of 15% to 18% (including both debt and equity components)
, even though the debt component might have a stated interest rate of 8% to 10%.
Do not be fooled by the interest rate alone: the hidden costs of debt are far greater!
With this little tutorial in place, do not stop yourself from arranging whatever loans you need to survive, especially if the bank is offering uniquely attractive terms. Just, recognize that any future principal payments are after-tax disbursements of cash and that earnings must be correspondingly higher to be able to make those payments in a timely manner. You always want to borrow only the amount of funds you need to survive and eventually thrive. No more … no less!
There are some alternatives to adding bank debt that may be able to drive your plans faster with less impact on future cash flows. These options may not be the best choices for you and your business, but an understanding of these approaches should help you develop optimal plans. Another look at the funding resource options presented earlier may be in order if your debt load is stacking up “too high”!