Need more capital? Refinance an existing loan? The important questions are: How much new money will I get and what will it cost?
To answer those questions, let’s review two financing alternatives: an existing loan from a bank and a proposal from a specialty finance company. The finance company has higher advance rates, so it will loan more. The advance rate is the percentage a lender uses to determine the amount of money it will loan against certain assets. In our example, the finance company offers advance rates of 90% and 60% against receivables and inventory, respectively, and the bank offers 75% and 25%.
Now let’s analyze the two alternatives.
First, the cost:
Bank 8.5%
Finance Company: 10.5%
Which should you choose? To help you decide, let’s gather some data. If you were going to borrow only $100,000, the clear choice would be to borrow from the bank. You’d save $2,000 per year:
$100,000 x 8.5% = $8,500 per year
$100,000 x 10.5% = $10,500 per year
But let’s say you really need the extra $50,000. What’s the cost? Well, we know that the total cost of the $150,000 loan will be:
$150,000 x 10.5% = $15,750
But the cost of the first $100,000 available through the bank is just $8,500, so the incremental cost of the extra $50,000 is $15,750 minus $8,500, or $7,250. This places the extra $50,000 loan at an effective interest rate of 14.5%, calculated as follows:
$7,250 divided by $50,000 = .145 or $14.5%
In theory, if you can put the extra $50,000 to work and earn more than 14.5% (your cost of capital), then go for it. If not, it’s a losing situation.
If you plan to use it in your business, the question is: Are you putting in excess of 14.5% on your bottom line? If not, you might want to stick with cheaper forms of financing.
From Your Bank From Finance Company
Advance Advance
Rate Amount Rate Amount
A/R ($100K) 75% $75,000 90% $90,000
Inventory ($100K) 25% 25,000 60% 60,000
Total money loaned $100,000 $150,000
This article originally appeared in The Business Owner Journal, the periodical of choice for owners of small and midsize private businesses. All rights reserved, D.L. Perkins LLC. © 2012.
This publication is intended to provide general information on the subject matters covered. It is sold and distributed with the understanding that neither the publisher nor any distributor or advertiser is engaged in providing legal, tax, insurance, investment or other professional advice. The advice of a qualified professional should be sought before any reader applies a concept presented herein to his or her particular situation or business.
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