Financing costs fall into multiple categories: straight interest paid on a recurring basis to a lender, the amortization of up-front points and fees incurred to obtain financing, and preferred stock dividends which must be paid out or accumulated. The up-front costs are typically amortized over the life of the debt and are a non-cash expense after the initial outlay. Some businesses have utilized credit cards to finance their business which, while expensive, work much like loan interest. Leasing is often just a different structure for borrowing. You are having a lender pay for equipment up front, and you pay them back with interest over the life of the lease. Some leases are accounted for as loans and interest while others treat the rent as operating expense.
Less obvious financing costs include the interest rate differential on interest rate swaps. Swaps are considered derivatives and require complicated models to value. A swap merely trades a variable interest rate for a fixed rate and is required on many mid-market loans. You buy a swap and then pay the fixed rate instead of the variable rate. One problem with swaps is the valuation of the projected difference which is often accounted for in equity. If you hold the debt to maturity the swap does what it is purchased to do, protecting the borrower from interest rate swings. If, however, you want to unwind a swap before it matures and the rates have moved against you, the unwind premium can be large. Always consider this if you think you may need to refinance, sell or pay off the obligation early.
Other borrowing methods include factoring receivables and PO financing. These instruments use customer commitments as collateral to purchase inventory and obtain cash early. They are viable options but are expensive and require quite of bit of attention.
To increase profitability by managing financing costs, it is important to have strong financial statements which will minimize your interest rate. Lenders want all the collateral they can get to protect their investments. They also include covenants and financial reporting requirements as conditions for the loan. While it is important to keep your financing costs low, it is also important to not provide excess collateral. If your lender has a lock on everything, the lender will require that you have their permission to enter into additional agreements. The permission may come with a price and possibly bank legal fees.
Avoid complicated borrowing which may require more sophisticated covenant calculations or borrowing base submissions than your staff can support. An asset based loan using inventory and receivables may be a good borrowing instrument but I have seen them with 17 different ways to exclude receivables as eligible for inclusion in the borrowing base. That instance also required all of the company’s deposits flow to the lender as debt repayment. In essence, the company had to request funds each day to cover disbursements. Do you have the staff time and skills to manage that process?
Straight forward borrowing can often be understood and negotiated by the owner and financial staff, but if the loan gets complicated consider including a financial counselor on your side of the negotiation table.
B2B CFO® has over 200 experienced chief financial officers have deep knowledge of financing that can be tapped to help grow your business. A B2B CFO® can help you understand your financial picture and offer independent insight to improve your business’ profits.