Every entrepreneur starts their business with their funds and funds from family and friends. This is your equity. But as the business grows, so does the need for financing. Your business needs to pay salaries, buy equipment, advertise your product or service. Hence, you opt for a business loan. You have done all the paperwork and finally convinced the banker to give you a loan, also called a credit facility. But before you get excited and sign those loan documents, read them carefully. Understand the terms of the loan and any subsequent amendments. These terms are crucial elements to find opportunities to optimize your loan.
Five Key Elements in a Credit Facility
A loan agreement has many elements like interest rate, prepayment, loan term, collateral, and financial covenants. If these elements have favourable terms, they can bring opportunities in future to optimize your credit facility and make the most of it.
This article will look at each of these five elements and understand how you can leverage them to optimize your credit facility.
The Interest Rate on Credit Facility
The bank offers two types of interest rates, fixed and floating. Each has its benefit. For instance, the central bank lowered the interest rate to a record low to make borrowing affordable during the pandemic crisis. In this case, loans with a floating interest rate stand to benefit. You can use this opportunity to optimize your credit facility by renegotiating the interest rate terms with your bank and moving from a floating rate to a fixed rate, and locking in a low-interest rate.
Over the years, if the business flourishes and your creditworthiness improves, you can look for refinancing options or renegotiate terms with the bank. You can compare the renegotiated interest rate terms with other refinancing options and choose the one that offers you maximum cost savings.
Terms of Repaying the Business Loan
The next important element after interest is repayment. There are three aspects in the repayment terms of the loan that you should look at:
- Duration of the repayment (longer the duration, higher the interest cost, and lower the monthly instalment)
- Frequency of the repayment (bi-weekly, monthly)
- The flexibility of prepayment (charges and other clauses involved) to know if earlier repayment is beneficial.
This repayment element needs no explanation as many businesses, especially cyclical ones with volatile cash flows, try to cut costs by deleveraging their balance sheet when they enjoy strong cash flows. Hence, they seek flexible repayment terms.
It would be best if you strived to repay the loan when possible, as that frees your cash and any collateral associated with the loan. Check the loan agreement for collateral, as they are assets on which the bank has a legal claim if the borrower defaults. The collateral depends on the nature of your business. It can be inventory, real estate, personal guarantees, third-party guarantees, or accounts receivable. You cannot sell a collateral asset or take another loan on it.
Ensure which asset you are using as collateral so that you are well aware of what you stand to lose in case of a default. When you know how many unencumbered assets you have in your balance sheet, you can make informed decisions on securing more loans in the future without hampering your financial situation.
Financial Covenants of the Credit Facility
Even if you have assets to put as collateral, you should look at your existing loan’s financial covenants before taking on new debt. For example, your lender might have certain financial covenants – conditions or restrictions – that you should abide by to continue enjoying the interest rate, duration, and other terms, as stated in the original agreement. Breaching any of these conditions might alter your loan terms.
For instance, your banker might require you to maintain a certain debt-to-equity ratio. This ratio assures the banker of your ability to repay principal and interest. If you breach this ratio, the bank might ask you to prepay some or all of the principal and interest. There are also conditions like reporting your operating income quarterly or annually to assure the banker that you can pay interest regularly.
These ratios and reporting requirements help the banker and the business owners know their debt position. This way, business owners can plan their expenses and cash flows better.
Know Your Debt Well Before Taking a New Loan
It is essential to take and manage loans responsibly. A poorly managed debt profile can spell doom for your business. It is better to plan ahead on where to spend the loan amount and ensure this spending generates returns that justify the interest you pay for it. A business needs funding for many reasons, like buying equipment, funding working capital, setting up a plant, or refinancing debt. Each funding requirement is different and generates different types of returns (some long-term, some short-term, some assured, some risky).
Banks offer different types of loans. So, if you take a working capital loan, do not spend the extra cash to buy equipment, or you will face a funding shortage in the near future. A piece of equipment needs a longer time to generate returns, and you may not be able to repay the loan due to a lack of funds.
Contact ESS CPAs LLP in Burlington for Experienced Financial Advice
Debt financing goes deeper than just taking a loan. ESS CPAs LLP experts can guide you through lucrative loan terms. They can also advise you on the opportunities to save on borrowing costs and optimize credit facilities. Lower financing costs could give you the financial flexibility to improve your competitiveness and profit margins. Contact us online or by telephone at 905-517-2297.