Borrowing and Business: What You Don’t Know Can Hurt Your Finances
So, you’re feeling confident enough about your business to go shopping for a loan. Congratulations! But before you start looking you should understand these five important areas impacting loans, beginning with the difference between interest rates and APR.
What is APR?
APR is the annualized percentage rate, which measures the cost of borrowing money. It includes the total cost for the loan including covering all fees that the lender might charge.
By looking at the APR, you can objectively compare the costs of loans from different banks. That’s entirely different from looking at the headline interest rates that sometimes get advertised. Such headline rates frequently don’t include all the fees that you must pay to get the loan.
In short, if you looked only at the headline interest rates, then you might think you got a good deal when in reality you didn’t.
Always ask the loan officer for the APR in any loan. If they won’t provide it, then choose another bank.
LIBOR and interest rates.
The cost of a lot of business credit moves up and down in line with something called LIBOR, the London Interbank Offered Rate, which is an interest rate charged by banks to lend to other banks.
When the banks see little risk of lending to each other, then the LIBOR will be lower than it would be otherwise. When they see heightened risk of lending to each other, then the LIBOR typically rises as it did during the financial crisis.
Commercial businesses typically pay a fixed amount above the LIBOR for the duration of the loan, see the Small Business Administration website for examples. The prime rate, which is a common benchmark lending rate for both commercial and consumer loans, is usually between 2.5 and 3.5 percentage points higher than the LIBOR rate, according to the FinAid website.
The LIBOR is also partly determined by decisions made by the Federal Reserve, which is a target interest rate for short-term overnight loans between banks. When that rate changes you can usually expect the LIBOR rate to change as well. In the simplest terms, if the Fed Funds rate rises then you should expect LIBOR to increase.
Recently, the Fed has been transparent about likely future changes in Fed Funds rates. If you regularly read the business press, you’ll be aware of most likely future changes in the costs of borrowing.
Fixed versus floating interest rates.
Not all business loans have interest rates which vary. Some have a fixed rate for the term of the loan. Such loans reduce the uncertainty about what would happen to the company’s profitability due to changes in short-term interest rates.
The cost of these loans is typically far higher than for variable rate loans. That’s because the bank takes on the risk of the interest rates changing over the term of the loan.
When a company purchases a long-lived asset, such as a factory building, it can make sense to seek out a fixed rate loan. That’s similar to seeking out a fixed rate home loan mortgage. Often, purchasing a building is a major expense and the predictability of the same monthly payment can help managers plan better for the future.
On the other hand, working capital typically gets funded through credit lines with variable rates of interest. That makes a lot of sense. When times are lean in business, then interest rates are lower and so are working capital needs. Conversely, when the economy is expanding, then although the cost of borrowing is usually higher, so is the demand for goods and services.
Sensitivity and the cost of borrowing.
Before you take out a loan, you need to understand what would happen to your profitability if the cost of borrowing increased.
For instance, if the cost of borrowing is $5,000 a month in interest and your company still would likely be profitable, then that is a good start. But then you also need to know if the business would remain in profit if the cost of borrowing increased. For instance, what would happen it the interest expense was half as much again, or $7,500 a month. Making theoretical changes and then calculating the likely outcomes is known assensitivity analysis. It is something that your Chief Financial Officer or accountant should be capable of doing.
If a change in interest rates of relatively small magnitude would vastly reduce profitability, then you might want to consider a smaller loan.
Likewise, when you conduct the interest rate sensitivity analysis, you may want to consider what would happen to the earnings if revenue fluctuated when the company also had a new loan. If even a small dip in sales would cause the company to lose money then perhaps it would make sense to be cautious by reducing the possible size of the loan.
Wall Street Prep has some useful tips on running sensitivity analysis.
Derivatives and interest rates.
Interest-rate derivatives exist to help companies guard against changes in the cost of borrowing. Rather like knives, when appropriately used, they can be a useful tool. However, when wielded incorrectly they can be harmful.
So-called interest rate swaps can be used to convert a variable rate loan to a fixed rate loan, and vice versa. These products can be useful, but the customers should have a high level of sophistication.
Unfortunately, in the United Kingdom, some banks inappropriately sold small businesses some of these products. That eventually led to losses by some buyers of these derivatives. Given that many of the people selling these swaps hold higher-level finance degrees it is frequently the case that the buyers are far less sophisticated than those selling the products.
Two things to take away from this episode. First, if you have any doubts that you truly understand the product then don’t buy it. Second, just because these problems occurred in the U.K. don’t think they couldn’t happen in the U.S.