What’s the REAL Cost of Business Debt?
Many business owners and executives believe that the real cost of their business debt is reflected in the interest rates and fees of their facilities. Hence, most look to get the lowest price on offer.
But before you sign on the dotted line, realise that business finance is rarely that simple…
Zooming in on the lowest interest rate and fee structure may make sense sometimes, such as when you’re doing a straight refinance as a cost-saving exercise. However, with many other transactions or debt facilities, things can get a little more complicated.
Here’s a few situations when you should look a little deeper.
With Asset Finance, Total Cost Comparison is Key
When it comes to asset finance (i.e. Leases / Hire Purchases / Chattel Mortgages, or whatever fancy marketing name the lender comes up for one of these products), it's critical to not just look at the interest rate. If I had a dollar for every time I’ve seen two different lenders providing quotes where the one quoting the lower interest rate actually ended up being the most expensive, well, I would have more than a few bucks!
Wait, “how can that be right?!” I hear you say… Well, it’s all down to the way that they calculate interest.
Some lenders in the asset finance space don't calculate interest as you would for a normal Principle & Interest loan - for example they could instead front-load the interest (so a $100k loan might have a balance of $120k on day 1), or even trickier methods I won’t bore you with today.
So, you can have one lender that's quoting a 5% rate, another that's quoting 6%, yet the lender charging 6% can actually prove to be the cheaper!
The ONLY way to accurately compare the true cost of asset finance is to actually add up all the individual loan repayments. So if you have a 60-month loan term at $5,000 per month with a $40,000 balloon/residual, your total repayments are ((60 x $5,000) + $40,000) = $340,000.
That is the only number you should really compare when you're evaluating the cost of asset finance.
“Working Capital Finance is Too Expensive”
Taking another step up the “cost of debt complexity ladder”, is the concept of calculating how much working capital finance ACTUALLY costs. I've often heard people say that debtor/invoice finance is very expensive debt; that conventional wisdom says to avoid it.
It's not a fabulous form of debt if your business is relatively mature, if your top line revenue isn't growing. In those instances, debtor/invoice finance absolutely can prove to be a pretty expensive form of debt, which you might only consider if you simply can’t get a bank to approve an overdraft.
However, debtor finance can actually generate significant value in the right circumstances. If it provides you with greater access to capital than what your bank would otherwise give you, which in turn allows you to increase sales revenues and profits – i.e. if you’re getting more benefit than the cost – then it makes a lot of sense.
Let me put it this simply - if this type of finance costs you an extra $200,000 each year in interest & fees; but that give you access to capital that allows you to make an extra $500,000 in gross profit - in my book that’s a pretty damned good deal!
Now let’s step it up another notch…
If you are acquiring a business, or even acquiring anything in your business that involves both debt AND equity, the argument that just the interest rate & fees is important, gets squashed even more. That's where you should start looking closely at two key factors rarely looked at outside of the corporate or institutional world (but that should get more attention)…
Weighted Average Cost of Capital (“WACC”)
This takes into account the cost of your debt, as well as the cost of any funds other than bank debt, such as mezzanine debt, preferential equity, other investor equity, and even YOUR OWN EQUITY.
This can be a complex calculation for a privately-owned business to make. All too often it involves posing difficult questions such as “what is my equity worth?”, or “what returns should I be getting on my equity?”. Typically, business owners tend not to apply Return on Equity hurdles or expectations to their own equity in their own business, that they might apply to other investments.
Why shouldn’t you expect a certain baseline return from the equity you have accrued and/or injected into your business?
So What Is Your Equity Worth?
To put this really simply, let’s say you need $10 million to buy a business, you've got one lender who's proposing to lend you $6m at 5% and another lender who's willing to lend you $7.5m at 6%. Which deal is better?
The only way to really understand the two options is to actually calculate your WACC. Assuming you set an expectation that your equity should earn 20%pa (which in my view is entirely reasonable), here’s the simple numbers on this situations:
So sure the smaller loan size comes with a cheaper interest rate, however if you have to find other investors or inject more of your own equity to make that deal happen, suddenly that debt is not looking so cheap after all.
Liquidity & Tenor
Corporate and Institutional borrowers typically consider these factors to be just as important as cost, if not more-so, however SMEs rarely do.
Without reliable or certain access to funding – i.e. maintaining liquidity – you can literally be playing Russian Roulette; funds get pulled by your bank and it’s potentially “game over”.
Privately-held businesses often complain about a line fee on a partially unused working capital facility, however with liquidity risk in mind, corporates will often specifically choose to incur expense in order to have access to funding lines that they may or may not need.
Tenor is simply what period of time your facilities are approved for (i.e. loan term). Once again, corporates will often choose to pay a premium to have longer terms on their loan facilities, not to reduce the outgoing cashflow of the loan repayments, but to have greater certainty as to their funding remaining in place. Due to market impacts of pricing tenor (which I won’t go into, to save you from more boredom!), the difference in interest rates between a 3 and 5 year loan term (irrespective of whether floating/variable or fixed) can often be about 0.5%pa, so most banks will stick to 3 year terms (so that they can offer a cheaper rate) and most SMEs want it that way.
Whilst liquidity & tenor risks should be considered, the one caveat is that with your bank debt facilities, if you breach your covenants, your bank will probably have the right to pull the rug from underneath you anyway.
Summing up the Cost of your Capital Stack
Debt financing is a proven and heavily relied-upon structure for accessing capital for businesses of all sizes, ranging from the sole trader through to the world’s largest institutions. However, there are issues to look at beyond just the interest rate and fees before you leap in.
Understanding the true and total cost of debt and equity, along with the context you are looking to use the capital for, should be key considerations when evaluating your borrowing options.
Whether you’re looking to acquire another business, needing to finance your growth, restructuring your debt facilities or simply looking for a better deal, STAC Capital’s business debt advisory team can help you consider your options, risks and opportunities, then structure, negotiate and arrange an optimal funding package for you.
So if you’re looking to take the next step in your business, then…