Three things you may not know about business debt

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Most of us are familiar with the basic concepts of ‘equity’ and ‘debt’. Equity can be simply defined as the value on our business’s balance sheet that belongs to shareholders. Debt can alternatively be defined as the value on our business’s balance sheet that belongs to someone else (our creditors).

What we may have been traditionally taught about debt:

— Debt comes with a price

— Debt can be useful because it allows the opportunity to grow our business faster due to increased ‘leverage’

— Debt can be dangerous if our business is unable to generate sufficient return to pay the interest that we owe

— Debt is neither inherently good nor evil but managing it can be a ‘tricky horse to ride’

There are a number of things we may not have been taught about debt, including:

1. Conventional loans cost significantly more than the stated interest rate

Many of us are aware of and take into consideration the visible costs associated with conventional loans — the nominal interest rate, the relationship between the interest rate and a base lending rate, the finder’s fee and other financing charges.

However, we have found that less than one in 20 business owners with whom we speak consider the invisible costs associated with personal guarantees, high collateral requirements (and readjustments!), liens and other encumbrances.

Data from the Private Capital Markets Project (conducted by the Graziadio school of Business and Management at Pepperdine University) suggests that the invisible cost of conventional business loans (by comparing with loans that do not have high collateral requirements, liens etc) can run at an additional four percentage points or more! We calculate that hidden cost to be even higher in Bermuda. Definitely something to consider when comparing financing options from institutional lenders vs private capital sources.

2. Loans are not the only source of debt related expense within your business

All liabilities on your business’s balance sheet — including trade payables, shareholder loans etc are debts — there is a significant cost associated the timing of our repayment of these obligations. Although we may be able to quantify the ‘interest’ cost of loan payments, we often don’t have transparency to the ‘invisible’ costs associated with our other liabilities.

To illustrate, let’s look at timing decisions related to trade payables. Let’s say Sam’s retail business (Samco) purchases from a supplier on credit terms of 2/8/30, meaning that Samco can obtain a two percent discount if the invoice is paid within eight days, but it must be paid in full within 30 days.

Samco’s managers may believe it is generally better from a cash flow perspective to “collect early and pay late.” What they may not realise is that the effective annual cost of not “paying early” and taking the two discount in this particular situation is approximately 15 percent! So if Samco’s average inventory value is $1,000,000, the company is forfeiting $150,000 a year in profit — this $150,000 would otherwise go directly to the bottom line!

There may be strategic reasons for paying late, but Samco’s managers should be aware of the opportunity cost of making this decision. Imagine if Samco’s managers also looked at how they were managing accounts receivable and their collections process. Summary: Samco’s shareholders could benefit significantly if management took a value architecture perspective with respect to the business’ financial flows.

3. There are other financing sources out there

Institutional lenders may not always be the best source of capital, particularly when an opportunity doesn’t fit into the standard ‘box’. In cases including those where large sums of money are involved, there is non-standard securitisation of capital or deal structure, opportunity assessment is a bit more involved, capital is required from other jurisdictions etc … private capital sources including syndicated capital funds may be appropriate.

We are starting to see a strong market response with clients requesting that we assist them with sourcing and structuring capital — whether for development opportunities, early stage ventures, bridge financing, getting more liquidity for their business assets etc, and all indications are that as the market thirsts for liquidity, those business owners who are able to effectively source finance will flourish while those who don’t will suffer.

“The basic economic resource — the means of production — is no longer capital, nor natural resources, nor labour. It is and will be knowledge,” — Peter Drucker

Kumi Bradshaw is the president of Firm Advisory Ltd and can be contacted via phone: 441-295-3301 or e-mail kumi@firmadvisory.com

For an in-depth look at value architecture, with actual case studies, download a free copy of the e-book ‘Value Architecture: A Guide To Making Better Business Value Decisions’ at http://bit.ly/TEuYH1 or e-mail for a free copy.

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Published Dec 18, 2012 at 8:00 am (Updated Dec 17, 2012 at 11:34 am)

Three things you may not know about business debt

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