Boost Your Credit

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. (by Jean Bonnette)