Many businesses operate with borrowed money. In financial terms, borrowed money gives a business operating leverage. The term leverage means the same thing that it does in physics. A business that borrows uses the money like a lever to amplify the force that it can apply. Businesses also borrow money because it can be less expensive to borrow than to raise money other ways. Creditors typically have some sort of claim on a business, and they can be fairly certain of a return, so they demand less risk premium than equity investors. Even so, borrowing money can cause problems for businesses. It is important to understand how to borrow.
Sources of funds
Generally speaking, businesses commonly borrow four ways.
- Borrowing a lump sum: This is what people generally think of when they think of borrowing money. A borrower obtains money from a lender for a period of time. The borrower pays the money back according to some sort of schedule and pays the lender interest on the outstanding balance. This is typically the least expensive way to borrow.
- Securing a line of credit: With a line of credit, the borrower arranges for a lender to loan money as needed. The borrower does not obtain the money until it is needed. Interest is only paid on the outstanding balance. The lender may charge a fee for maintaining the line of credit. This costs more than borrowing a lump sum, but since interest is only paid on the outstanding balance, it could cost less than borrowing a lump sum. For some businesses this could be as simple as using a credit card. For other businesses, this could involve a sophisticated arrangement with a lender.
- Trade credit: Many business owners do not think of trade credit as financing, but it is. Vendors do not always demand cash payment on delivery of goods. They often offer terms allowing some period of time to pay. Vendors offering time to pay may also offer discounts for early payment. The cost of trade credit varies.
- Securing customer payment in advance: This is more common in construction or in businesses that use progress billing than in other industries. A good example might be a contractor that secures an upfront payment for supplies before beginning a remodeling project.
There are advantages and disadvantages to each of these methods, and business owners should consider the cost of each method, how they affect cash flow, and flexibility. If your business needs a large amount of money for a set period of time to purchase equipment or inventory, then it probably makes sense to borrow a lump sum.
If you need cash to smooth out cash flows or to address timing issues, then you might consider a line of credit. Businesses that buy and sell expensive inventory might consider a line of credit. For example, an antique dealer might keep a line of credit open to have funds in case he or she makes an extraordinary find.
The advantage of borrowing the lump sum is that it costs less for the amount borrowed. However, if the business cannot generate an immediate return because the funds are sitting waiting to be used, then even a lower cost is too high a cost and the payments on the loan are going to be due regardless of whether the funds help produce additional income. A line of credit, on the other hand, may require a small fee, and the cost of funds will be higher. However, since the interest is only paid on outstanding balances, then the total cost is likely to be smaller. The table below put this into perspective. With the $50,000 loan, interest is due every month, and the total amount paid is actually higher than with the line of credit even though the line of credit has a fee and a higher interest rate. This is because even though the highest amount borrowed was greater, the average amount was lower, and the time the balance was outstanding was shorter.
| Lump Sum (6%) | Line of Credit (10%)* |
Borrowed | Interest | Borrowed | Interest |
| January | $50,000 | $250 | | $21 |
| February | 50,000 | 250 | $75,000 | 646 |
| March | 50,000 | 250 | 50,000 | 438 |
| April | 50,000 | 250 | | 21 |
| May | 50,000 | 250 | 10,000 | 104 |
| June | 50,000 | 250 | 10,000 | 21 |
| Ttl Cost | | $1,500 | | $1,251 |
| *$100,000 Line of credit at 10% with a .25% fee. |
The decision to use trade credit is dependent on a variety of factors including the terms, business cash flow, and the cost of other sources of funds. It is possible that if the business has sufficient cash flow, trade discounts that may be offered by a vendor may make trade credit less attractive.
Leita Hart has condensed cash management into four basic principles, and she describes them in simple easy to understand terms. She demonstrates the concepts by using examples from familiar companies such as Dell and Wal-Mart, and she explains how the principles can be applied to businesses of all types and sizes. The book includes ideas for:
Posts
