Advice and Guidance on Borrowing Money

When a company borrows money, whether it is to financean expansion, to cover working capital needs, or toacquire another business, preparation is required. It is important tounderstand that payments of principal and interest will often berequired each month.

1. Interestpayments are a tax-deductible expense and will appearon the income statement.Repayments of principal are not an expense, will not appear on the income statement, and are not tax-deductible.

2.Only the principal portion of the unpaid balance will appear onthe balance sheet; it will appearas a current liability if it is due within one year or as a long-term debt if it is due in more than one year, or it may be splitbetween the two categories. Interest is never a liability onthe balance sheet unless a payment is overdue. This will bereferred to as an accrued liability.

3.As previously mentioned, the key issues to be negotiated whenarranging a loan are:

The amount: When the company is planning the project, a cash flow forecast is necessary, both for analytical purposes and also to present to the bank. Don’t askfor less money than you really need. This may impair rather than improve your negotiating ability. Somepeople believe, incorrectly, that asking for a smaller amount will enhance their chances of having the loan approved. However, being inadequately funded will hurt the project and may require you to cut back at a time when you are trying to build the business. Thisis very counterproductive.

The interest rate: Evaluate the issue of a fixed rate versus a variable rate. A variable rate may be tied to the London interbank offer (LIBOR) rate or the prime rate. Forexample, it may be quoted as ‘‘prime _ 2,’’ which means two percentage points above the prime rate. If it istied to a prime rate, make sure that you know whose prime rate will be used. Will it be your bank’s prime rateor the rate quoted by the large money center banks, such as Citi, Chase, or Bank of America? Understand that when interest rates are moving higher, they generally move quickly. This is in the bank’s best interest.When interest rates are declining, they are often ‘‘sticky,’’ meaning slow to move.

The years of payments: The questions involved here are, ‘‘What is the maturity date of the loan?’’ and ‘‘Overhow many years will the loan be amortized?’’ The first of these questions indicates how many years of principal and interest payments you will have to make. Make sure that the project being financed will achieve itspotential before the maturity date of the loan. Also, if the project is projected to achieve a positive cash flowin three years, where will the company get the cash it needs to make payments in the first and second years? Payments must be scheduled (read minimized) in such a way that they are very low in the early years andthen increase in the latter years. This permits the loan tobe repaid with the cash flows generated by the projectitself. If the maturity and the number of years ofamortization are not the same, a balloon payment will be required, as mentioned previously.

Fees, compensating balances,and restrictions: Incorporate all fees into the loan. That saves cash for theproject and postpones the payments over the life of the loan. Remember that a compensating balance reduces the amount that is actually available for the project.

Collateral: Keep it to a minimum. Try not to pledge all of your assets. Doing so restricts your futureflexibility and creates greater vulnerability should cash flows notgrow as fast as expected. Banks usually haveloan/collateral formulas. Find out what these formulas are early inthe discussions.

4.When negotiating, use your banker as an adviser. Her advice is free, and she is often very knowledgeable. Bankers’ conservatism serves as a protective mechanism. Your company has needs and will make substantial profits after your project succeeds. The bank has needs, aswell. But its upside profitability is limited to theinterest rate it can achieve on the loan.

5.Learn how to use the amortization schedule. An example follows:

Loan Amount $100,000

Time to Pay 5 years

Interest Rate 8.5%

The monthly payment will be $2,051.65. Total paymentsover the 60 months will be $123,099, broken down as follows:

Principal $100,000

Interest 23,099

Total $123,099

The payments during the first two years will be mostlyinterest. In fact, after the first year, the amount of principalstill owed will be more than $83,000.

The number of years of amortization can be morecritical to success than the actual interest rate. If the same$100,000 loan has an interest rate of 9.5 percent (100 basis pointsor 1 percentage point higher) but is for a seven- rather than afive-year term, the monthly payment will be reduced to $1,634.40. Toimprove cash flows during the early years, a higher interestrate but longer term will be beneficial.

Consider a twenty-year amortization with a seven-yearballoon. This means that the monthly payments of principal and interest are calculated as if this were a twenty-yearloan. If this loan had a 10 percent interest rate, the monthlypayment would be reduced to $965.02. What this means, however, isthat after seven years, the principal amount will still be$84,072.45, and this balloon payment is due at that time. This could bedangerous if the company has the cash to repay the loan in theearly years but diverts the funds to other uses rather than preparingto repay. When the balloon comes due, the company’s negotiatingpower is limited or nonexistent. The best strategy might beto arrange the twenty-year amortization and then begin to prepayafter a year or two. The company can also prearrange aschedule of two years of reduced payments and then extra payments foryears three through seven, after which the loan will befully paid off.