Use the Characteristics of Debt to Compare Types
Previous lessons introduced the basic characteristics of debt:
- Intended use of funds
- Anticipated source of repayment
- Risk mitigation techniques
In this lesson, I’ll used the framework to provide an overview of the types of debt commonly available to small business borrowers:
- Lines of credit
- Invoice discounting
- Merchant cash advances
- Inventory consignment
- Term loans
- Equipment leases
Watch the video for full details. I summarize some of the key points below.
Line of Credit
A line of credit gives you instant access to cash up to a pre-specified limit. You can draw the funds at any time prior to the expiration of the line. Repayment is subject to a pre-agreed schedule. The one-time purchase of inventory is a good use of a line of credit.
Revolving Line of Credit
A revolving line of credit acts much like a credit card. During the life of the revolver, one can make recurring draws and repayments. However, revolving lines usually require a cleanup period during which there can be no outstanding balance. Seasonal working capital needs are a good use of a revolver.
Sometimes, the maximum loan balance available under a line of credit is determined by the borrowing base. The borrowing base is a function of the value of eligible collateral – usually accounts receivable and inventory – multiplied by a discount factor. The discount factor is also known as the advance rate.
For example, consider a borrower that has eligible accounts receivable totaling $200,000 and inventory of $100,000. The advance rate on accounts receivable might range from 70% to 85%. The advance rate on inventory, though, is usually much lower – more like 50% to 65%. Accounts receivable are closer to becoming cash. That makes them more desirable collateral.
For purposes of our example, let’s assume advance rates of 80% and 65%, respectively. That yields a borrowing base of $225,000 = ($200,000 × 80%) + ($100,000 × 65%). So, even if the revolving line of credit was $300,000, the total availability under the line would be limited to the borrowing base of $225,000.
Factoring is another type of short-term, working capital financing. Technically, factoring isn’t lending. Instead, it’s structured as the purchase of accounts receivable at a discount.
Factoring is sometimes an option for unbankable borrowers who sell to creditworthy customers. For instance, a fast-growing, specialty food company that sells in volume to large retailers might be a good candidate for factoring.
A factor will advance you 80% to 85% of the face value of an eligible invoice. When your customer pays the invoice, you’ll keep the invoiced amount minus the advance amount and a factor fee. The factor fee might range from 0.5% to 4% of the invoice amount per month.
Try using the invoice financing calculator to calculate the annual percentage rate (APR) using these assumptions:
- Invoice amount = $1,000
- Advance amount = $850 = $1,000 invoice amount × 85% advance rate
- Factor fee = 2%
- Total amount paid back to you = $980 = $1,000 invoice amount x (1 – 2% factor fee)
- Invoice due in 30 days
You should get an APR of 28.24%.
Merchant Cash Advances
Merchant cash advances are a variation of factoring. While factoring is usually for business-to-business (B2B) companies, Merchant cash advances are for business-to-consumer (B2C) companies and are usually based on credit card receivables.
Although merchant cash advances can be unsecured, they are sometimes (but not always) provided by payment processing companies that have access to your credit card collection proceeds before they even hit your checking account.
You can usually get a merchant cash advance of up to 1.5 times your monthly sales. The payback amount might range from 1.1 to 1.5 times the advanced amount. The repayment schedule is not fixed. Instead, payments are a percentage of your sales, known as the remittance rate.
For example, use the MCA calculator to determine the APR on a merchant cash advance using the following assumptions:
- Monthly credit card sales = $20,000
- Advanced amount = $30,000 = 1.5 × $20,000 monthly sales
- Payback amount = $36,000 = 1.2 x $30,000 advanced amount
- Remittance rate (% of future card sales) = 15%
In this example, the APR is 38%. However, bump the advanced amount to 2x monthly sales and the payback amount to 2x the advanced amount, and the APR zooms up to 53%!
Run the numbers before you take down a merchant cash advance. High daily remittances can suck the cash out of your business. In some cases, otherwise healthy businesses have been suffocated by their merchant cash advance repayment obligations.
Let’s turn our attention to long-term debt financing. Term loans are suitable for financing equipment, other long-lived assets, and the accumulation of working capital (in the case of fast-growing companies). Repayment is scheduled, and final maturities may extend to 7 years.
Term loans almost always require substantial collateral and extensive covenants. However, if you meet the rather stringent underwriting requirements for a term loan, the rates of interest can be comparatively low.
Use the term loan calculator to see how fees can substantially boost the APR of a term loan above the nominal interest rate. For instance, try the following assumptions:
- Loan amount = $100,000
- Nominal interest rate = 12% per year
- Origination fees of $3,000 = 3% × $100,000 loan amount
- Monthly service charge = $100
- Loan term = 60 months
In this case, the fees increase the APR to a bit over 15%.
Lenders know that we tend to fixate on the nominal APR (not unlike how online customers can focus irrationally on shipping costs). That’s why lenders will sometimes lead with an attractive interest rate and then add a host of fees. Taken individually, the fees are innocuous. Cumulatively, fees can add percentage points to the effective cost of your loan. That’s why comparing the APR of different loan options is so important.
The Math Behind the Calculators
Click on the following links to learn more about the APR calculators referenced in this lesson: