Many companies rely on financial leverage such as loans, mortgages, and credit facilities to sustain and grow their businesses. Current economic conditions may place higher reliance on financing for the operational success and continuance of your company. Once you have acquired financing from a bank, a private lender, or another financial institution, it is essential to plan for what comes next. The following tips will help you get the most out of your financial leverage.
An important place to start is understanding the terms of your loan, ideally before signing the agreement to acquire funding. Reviewing your loan agreement, including any subsequent amendments, can help to ensure your continued understanding of the terms agreed upon with your lender. Thoroughly read your loan agreement to understand its key components better and identify opportunities, including the following:
Is your interest rate fixed, meaning it is locked-in for a specific term or variable (i.e. floating), meaning it fluctuates with market rates?
Many business loans with variable rates are based on the Prime Rate as the benchmark rate, with the interest rate being Prime plus or minus x%.
Given the economic impact of the global pandemic, the cost of financing has decreased significantly, with interest rates near historic lows.
This presents an opportunity to negotiate fixed interest rates on loans currently variable to lock in at a lower rate for a fixed term.
This section of the loan agreement will specify the amount and frequency of payments required over the loan duration. A longer loan term will result in lower payments but higher interest costs overall.
Consider whether your loan agreement allows some flexibility to make prepayments without incurring extra fees. Prepayments are in addition to your scheduled payments and will enable you to repay the loan early.
A shorter loan term, more frequent payments (e.g. bi-weekly vs. monthly), and prepayments against the principal can help save on interest costs over the duration of your financing term.
Does your lender require annual financial reporting?
The reporting requirements section of your agreement will specify which type of financial reporting is required. This includes a Notice to Reader, Review or an Audit engagement. These engagements vary from not assure limited assurance to the highest level of assurance, respectively. Your accountant must be aware of the type of engagement required and the frequency and deadline of reporting. (e.g. annually, within 120 days of each fiscal year-end).
Many financing agreements will also call for cash flow projections or Pro-forma financial statements. This is an excellent exercise to forecast the upcoming year and cash flow requirements.
However, there are costs associated with preparing the reports that are important to be aware of.
The security section of a loan agreement specifies the asset(s) the lender has a legal claim to if the borrower defaults on the loan. These assets are referred to as collateral.
Your loan agreement may require specific assets as collateral, a general security agreement and/or a personal guarantee as security.
Financial covenants are ratios that the borrower is expected to meet. They are typically calculated on an annual basis but could be required to be maintained more frequently. One common financial covenant is the debt-to-equity ratio. This ratio is used to evaluate a company’s financial leverage by assessing its ability to meet its financial obligations. They include factors such as making loan principal and interest payments. Another standard ratio is the current ratio. This is a liquidity ratio that measures a company’s ability to repay debt obligations that are due within one year.
A breach of covenants may allow the lender to increase the interest rate on the loan. They may also demand immediate repayment of the balance. Monitoring your debt covenants is essential to ensure your business’s financial health.
In addition to understanding your loan terms and reviewing your current leverage, it is important to monitor future spending as well. For instance, avoid using a short-term excess of cash for purchases that could otherwise be financed. As an example, if you have a surplus of cash this month and spend it on a vehicle, you could face trouble covering operational costs in the following month with a cash shortage. It is more difficult to get a working capital loan to cover payroll than it would have been to get financing for a vehicle purchase in the first place.
With a strong understanding of loans and your current leverage situation, you may recognize opportunities to help your business save money on interest costs, repay your debt quickly, ensure compliance with financial covenants, and plan for the future.
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