Characteristics of Debt

Debt can come in a myriad of forms, all of which represent combinations and permutations of a fairly small number of characteristics. Know those characteristics, and you can make sense of – and compare – any form. The key characteristics of debt include the following:

  • Intended use of funds
  • Anticipated source of repayment
  • Term and duration
  • Cost
  • Risk mitigation

Intended Use of Funds

Business loans tend to be designed to accommodate three primary uses: working capital, equipment, and real estate. As a rule of thumb, the maturity of the loan should coincide with the lifecycle of the asset to be financed. For instance, be wary of financing long-lived equipment with short-term loans designed for working capital. In such a circumstance, the need for the financing is likely to extend beyond the maturity of the loan, which creates refinancing risk.

Primary Source of Repayment

Although most lenders anticipate repayment of their loans with the free cash flow generated by the borrower in the normal course of business, asset-based lenders look to the liquidation of specific assets for repayment. Factoring, for instance, is a form of short-term financing that looks to the collection of specific accounts receivable for repayment. While cash flow lenders are primarily concerned with the viability of the borrower, asset-based lenders can be more concerned with the viability of the borrower’s customers.

WHAT IS FACTORING?

Factoring is a financial transaction and a type of debtor finance in which a business sells its accounts receivable (i.e., invoices) to a third party (called a factor) at a discount. A business will sometimes factor its receivable assets to meet its present and immediate cash needs. Source: Wikipedia.org

Term and Duration

The term and duration of a loan is another differentiating characteristic. Short-term loans (those having a maturity of a year or less) are best suited to fund episodic or seasonal working capital needs.

Consider the case of a manufacturer of snowboard bindings. Stocks of inventory ramp up in the Summer and Fall, when bindings are being manufactured for the upcoming season. As a consequence, cash reserves get drawn down. As the manufacturer’s wholesale customers sell products to consumers in late Fall and early Winter, the manufacturer collects accounts receivable, and its cash stock goes back up. As a result, the snowboard binding manufacturer’s cash balance goes up and down over the course of the year in a predictable pattern.

Seasonal Cash Needs

Seasonal cash cycle of a snowboard binding manufacturer.

In this example, the manufacturer would be well-served by a short-term line of credit that would cover the borrower’s cash shortfall between June and January in anticipation of a seasonal cash surplus in the late Winter and early Spring.

Long-lived assets such as equipment and real estate are best financed with correspondingly long-term debt (having a maturity of more than one year). That’s why mortgages, for instance, can have 20 or even 30-year maturities. Somewhat more surprisingly, the rapid and sustained accumulation of accounts receivable and inventory experienced by a rapidly growing company can also create the need for long-term financing.

UNDERSTANDING THE CASH CYCLE

In our Understanding the Cash Cycle course, we demonstrate how the rapid growth of accounts receivable and inventory can create a need for cash for longer than a year.

LEARN MORE

Note that not all loans of a given maturity are created equal. A loan having a final maturity of five years that is repaid in a single “bullet” at maturity will have a longer duration than a loan having the same final maturity but which is subject to repayment in equal monthly installments. Loans with a shorter duration, other factors held constant, are less risky for the lender than loans with a longer duration. That might translate into a lower loan cost, but might also conflict with your cash needs over time.

Repayment Schedules

Long-term loans are typically subject to a fixed repayment schedule known as an amortization schedule. Some loans, though, have a flexible repayment schedule that is a function of revenue.

REVENUE-SHARING LOANS

Revolving lines of credit, which behave much like a credit card, don’t have a fixed repayment schedule. However, the borrower is usually subject to an annual “clean up period” during which time there can be no outstanding balance. As noted above, asset-based loans are often subject to repayment based upon the collection of specific accounts receivable or other assets.

Cost

Usually, but not always, the cost of debt is expressed in terms of an annual percentage rate. The advertised rate is sometimes known as the nominal rate, because interest is usually not the only cost. A variety of fees and discounts add to the total effective cost of a loan.

The best way to compare costs of different loans is to calculate the annual percentage rate or “APR.” The APR takes into account the timing and amount of all loan costs. If a lender won’t tell you the APR on a loan, you might want to consider a different lender.

SMALL BUSINESS BORROWERS' BILL OF RIGHTS

The cost of a loan is a function of a variety of factors including, but not limited to, the following:

  • Risk
  • Administration costs
  • Regulation
  • Cost of funds

Banks, for instance, are highly regulated but have access to low-cost deposits guaranteed by the Federal government. Asset-based lenders, historically, have had high loan administration costs (though the application of technology is lowering the cost for some online lenders). Alternative lenders, in general, have a relatively high cost of funds, which contributes to their need to charge proportionately higher rates to borrowers. Of course, the interest rate on risky loans will reflect a “risk premium.”

Risk Mitigation

Different lenders will seek to manage – or mitigate – risk in different ways:

  • Seniority and subordination describe the relative position of different lenders in the payment queue. Senior lenders are at the front of the line, while subordinated lenders are farther back.
  • Collateral, guarantees, and security represent “second ways out” of a loan by a lender –  a “bite at a second apple,” if you will. Small business owners are often asked to provide personal guarantees of their business loan obligations. In certain circumstances, a third party such as the Small Business Administration will provide partial guarantees of a loan. As a general rule, banks and other secured lenders will seek collateral in the form of assets that have value independent of the ongoing performance of the borrowing company. That’s why accounts receivable and real estate tend to be more highly valued as collateral than are specialized equipment or unique finished goods inventory.
  • Covenants are promises of performance (e.g. minimum current ratio or periodic operating cash flow) or prohibitions of specific actions (e.g. payments to shareholders above a threshold amount). The “breach” of a covenant can trigger a “default.” Uncured defaults can, in turn, give the lender certain rights, including the right to foreclose on collateral assets.

Price and loan duration are relatively straightforward. The bulk of a loan agreement’s “fine print” will consist of attempts on the part of the lender to mitigate its risk. With time and experience, you’ll come to recognize which elements are negotiable. When in doubt, it’s often a good idea to retain the services of an experienced business lawyer.

Lesson tags: financing