A Value Architecture Perspective: 3 Things You May Not Know About Business Debt
Most of us are familiar with the basic concepts of ‘equity’ and ‘debt’. Equity can be simply defined as the value on our business’ balance sheet that belongs to shareholders. Debt can alternatively be defined as the value on our business’ balance sheet that belongs to someone else (our creditors).
What we may have traditionally been taught about debt
• Debt comes with a price.
• Debt can be useful because it allows the opportunity to grow our business faster due to increased ‘leverage’.
• Debt can be dangerous if our business is unable to generate sufficient return to pay the interest that we owe.
• Debt is neither inherently good nor evil but managing it can be a ‘tricky horse to ride’.
There are a number of things we may not have been taught about debt however:
1. Conventional loans cost significantly more than the stated interest rate
Many of us are aware of and take into consideration the visible costs associated with conventional loans – the nominal interest rate, the relationship between the interest rate and a base lending rate, the finder’s fee and other financing charges. However, we have found that less than 1 in 20 business owners with whom we speak consider the invisible costs associated with personal guarantees, high collateral requirements (and readjustments!), liens and other encumbrances. Data from the Private Capital Markets Project (conducted by the Graziadio school of Business and Management at Pepperdine University) suggests that the invisible cost of conventional business loans (by comparing with loans that do not have high collateral requirements, liens etc) can run at an additional 4 percentage points or more! We calculate that hidden cost to be even higher in Bermuda. Definitely something to consider when comparing financing options from institutional lenders vs. private capital sources.
2. Loans are not the only source of debt related expense within your business
All liabilities on your business’ balance sheet – including trade payables, shareholder loans etc. are debts – there is a significant cost associated the timing of our repayment of these obligations. Although we may be able to quantify the ‘interest’ cost of loan payments, we often don’t have transparency to the ‘invisible’ costs associated with our other liabilities.
To illustrate, let’s look at timing decisions related to trade payables. Let’s say Sam’s retail business (Samco) purchases from a supplier on credit terms of 2/8/30, meaning that Samco can obtain a 2% discount if the invoice is paid within 8 days, but it must be paid in full within 30 days.
Samco’s managers may believe it is generally better from a cash flow perspective to “collect early and pay late.” What they may not realize is that the effective annual cost of not “paying early” and taking the 2% discount in this particular situation is approximately 15%! So if Samco’s average inventory value is $1,000,000, the company is forfeiting $150,000 a year in profit – this $150,000 would otherwise go directly to the bottom line!
There may be strategic reasons for paying late, but Samco’s managers should be aware of the opportunity cost of making this decision. Imagine if Samco’s managers also looked at how they were managing accounts receiveable and their collections process. Summary: Samco’s shareholders could benefit significantly if management took a value architecture perspective with respect to the business’ financial flows.
3. There are other financing sources out there
Institutional lenders may not always be the best source of capital, particularly when an opportunity doesn’t fit into the standard ‘box’. In cases including those where large sums of money are involved, there is non-standard securitization of capital or deal structure, opportunity assessment is a bit more involved, capital is required from other jurisdictions etc… private capital sources including syndicated capital funds may be appropriate.
We are starting to see a strong market response with clients requesting that we assist them with sourcing and structuring capital – whether for development opportunities, early stage ventures, bridge financing, getting more liquidity for their business assets etc. and all indications are that as the market thirsts for liquidity, those business owners who are able to effectively source finance will flourish while those who don’t will suffer.
“The basic economic resource - the means of production - is no longer capital, nor natural resources, nor labor. It is and will be knowledge.” --- Peter Drucker
Kumi Bradshaw is President of Firm Advisory Ltd.
T: +441 295 3301 E: firstname.lastname@example.org
Firm Advisory Ltd. helps “business owners measure, grow and harvest the value in their companies”
For an in-depth look at value architecture, with actual case studies, download a free copy of the ebook ‘Value Architecture: A Guide To Making Better Business Value Decisions’ at http://bit.ly/TEuYH1 or email us for a free copy.