Debt financing: the true cost of debt
By Daniel Barrett
Most businesses use debt as part of their financing structure to finance growth, fund working capital, or to finance an acquisition.
When considering a debt financing facility, the immediate and most common aspect to focus on is the interest rate of the debt. While the interest rate is an important aspect, there are other key considerations that should be evaluated.
The total cost of a debt facility
The interest rate is a key component of a debt facility, but there are several other considerations which can significantly impact the total cost to a business:
1. Prepayment fees: Some lenders will deduct a portion of fees from the loan amount and lend the net figure, with the entire value of the loan due for repayment. This increases the effective interest rate. For example, borrowing £1m at a rate of 7%, but only receiving £900k (after the deduction of fees), increases the effective interest rate to £70k/£900k or 7.7%.
2. Reporting and administration requirements: All finance facilities will require the borrower to provide regular reporting to the lender. But the format of this can vary greatly from quarterly management accounts to monthly customised reports, and the additional cost of a businesses’ finance team producing the reporting needs to be considered. Similarly, invoice discounting facilities, which are very popular due to their lower headline interest rates, involve a significant amount of administration to ensure that all invoices are uploaded, reconciliations are provided, and that funding is drawn down in a timely manner. Again, it is important to understand the required work and the internal cost of this when evaluating if an invoice discounting facility is an approximate solution.
3. Covenants: All debt financing facilities will come with a set of conditions (often referred to as covenants). These covenants require the borrower to fulfil certain conditions and will often restrict or forbid certain activities. It is important when evaluating a financing facility to ensure that the impact on a business under different performance scenarios, particularly a downside scenario, is clearly understood.
4. Cash management cost: In addition to reporting and covenant requirements, ensuring that an appropriate finance solution is implemented can have a significant impact of the internal cost of a facility. For example, if a facility that has a low interest rate, but that is for a smaller amount than is really needed, or that puts significant restrictions on what the business do, might require someone in the business having to intensively manage cash on a day to day basis. The cost of this internal person (both in terms of what they are paid, but what they could be doing with their time instead (the ‘opportunity cost’) should be factored into the cost of the facility.
The ‘cost’ of not having appropriate debt financing
So far, we have focussed on the cost of a debt facility. It is also important to look at it from a different angle, and that is a on cost-benefit basis. Most businesses borrow money to finance growth, fund working capital, or to finance an acquisition, which should deliver a benefit to a business and its shareholders. Given that debt funding can help to delivers a benefit, the cost of a debt facility can be evaluated in terms of the benefit it delivers to the company (or the cost of not having appropriate debt funding). For example, if a business borrows £2m for 3 years that costs £250k over those 3 years, but allows it to open 10 new stores, increasing the profitability of the business by £1m, then the value to shareholders of this could be £4m or £5m (assuming a conservative multiple of 4x to 5x). This is significantly more than the £250k cost of the debt. Thus, the ‘cost’ to shareholders of not taking out financing, and not growing can be significantly greater than the cost of a debt facility.
Never have businesses had so many options in terms of types of debt solutions and the range of lenders to borrow from. However, every situation is different, so it is imperative to ensure that the most appropriate financing solution, and not necessarily the option with cheapest headline interest rate is put in place to help the business achieve its objectives.
At CreditSquare we work with businesses looking to raise between £1m and £30m of debt funding, and support them in determining and implementing the most appropriate debt solution.