How do you decide what the right program is for you? Let’s dig into all the factors that go into a program. It’s important for you to realize that most people who will offer you financing don’t actually understand what we’re going to discuss. The devil is in the details and the knowledge I am going to share with you is power. This is something that most people don’t understand.
Financing isn’t just about a rate or a payment. It’s about cash flow and return on investment (ROI). When you are analyzing a financing program, you need to compare the payment vs. the increase in cash flow (if there is an increase) and you need to compare the cost of the financing vs. the return on investment. Let’s look at an easy example of an investment property. If you look at a mortgage for $500,000 over 30 years at 4%, you would say that you have a great rate, historically speaking. The monthly payment would be $2,387 assuming there aren’t taxes and fees included (that is a pipedream). Over the course of time, once the mortgage is paid off you would have paid $859,320. That means that $500,000 would cost you $359,320 over the 30 years! That’s almost 80% more than the purchase price of the house! Now, if this is an investment property how do you analyze that you’re making the right call? Let’s say your monthly rent is $2,400/month, this assumes you would net $13/month and assume the risk and any repairs that need to be done over the 30 years. I would pass in this situation. What is your monthly rent is $5,000/month. This completely changes the dynamics of taking the loan because now you stand to make an additional $2,613/month or $31,356/year. I would absolutely move forward in this situation. Business financing needs to be analyzed the exact same way.
Let’s dig into some business examples. Let’s say you own an auto repair business and you are currently doing $30,000/month. You would like to buy 2 additional lifts for $15,000 each along with a tire balancer for $5,000. The total purchase price of the equipment is $35,000. You receive equipment loan terms that are as follows: $35,000 over 5 years at 10% with monthly payments of $743.65. You would pay a total of $9,618.79 in interest on top of the $35,000. How do you decide if you purchase this equipment? Well let’s dig in further. If buying the two lifts allows you to service an additional 4 cars each day and you only are open 5 days each week that is an additional 20 cars each month. If your average ticket (average cost of a business transaction) is $300 that would mean you would make an additional $6,000/month. Now if you currently do not have a tire balancer and you are losing business, this is analyzed two ways. First, if you can do two balancings/day at $40/each- that’s an additional $80/day at 20 days would mean an additional $1,600. The other factor to consider is how much business are you losing? How many customers are going to your competition and not coming back? It’s harder to quantify but it’s still important because you want to have the best business possible. Essentially, what is your opportunity cost/lost in this situation? Even if you are turning away two clients a month that could be costing you an additional $600/month or $7,200/year. Just on a cash flow comparison you are making an additional $7,600/month compared to a monthly payment of $743.65. So you have a net cash flow INCREASE of $6,856.35 and a yearly increase of $82,276.20. That’s $82,276.20 that you otherwise wouldn’t be earning. Now to compare the return on investment! If you are making an additional $7,600/month and $91,200/year ($7,600 x 12) and you analyze it over the full term of the loan which is 5 years ( $91,200 x 5 = $456,000) you get your increase in business. Take the increase and subtract the total cost of the equipment and financing ($35,000 + $9,618.79 = $44,618.79) so you get a return of $456,000 – $44,618.79 = $411,381.21 of a total return off this financing program and equipment purchase. I would move forward with this every time!
Let’s take the same example above and change the terms because you either haven’t been in business two years, have bad credit, or both, and you are being offered a merchant cash advance (essentially subprime business financing which is quicker and easier to obtain). The terms could be as follows: $35,000 with small daily micropayments of $281.25 until $47,250 is repaid. This is essentially an 8 month term factoring in 21 daily micropayments each month. Your total monthly payment is $5,906.25. On a cash flow basis, your net increase is still an increase of $1,693.75 and your return on investment is $60,800 – $47,250 = $13,550. I would still say move forward. Is this less appealing? Absolutely. Does it still make sense? Yes it does. The reason you would be in this situation is because you are a much higher risk to finance; but, it will still help you make money and better your business.
Let’s assume you own a restaurant now. You are looking to expand your restaurant by building a patio to have covered outdoor seating. You currently have 20 tables inside and are doing $100,000 in sales each month. Roughly $5,000 per table. By adding the patio, you can add an additional 5 tables which should increase your sales another $25,000/month and $300,000/year. The cost to complete the renovations and get the additional tables, settings, menus and help is $200,000. You are offered an SBA loan for the full $200,000 over 10 years at 6% with an origination fee of 4%. Your monthly payment would be $2,220.41 and you would wind up paying back a total of $266,449.20. When you factor in the cost of the loan and the origination fee, your total cost would be $274,449.20. On a cash flow basis, you would have an increase in cash flow of $22,779.59/month( $25,000 – $2220.41 = $22,779.59). Your absolute return would be ($300,000 x 10{years} = $3,000,000) – $274,449.20 = $2,725,550.80. I would move forward here. Before we get too far ahead of ourselves, I do want to point out these calculations do not take into consideration the cost of doing business and net profits. For example if your restaurant is operating at a 30% profit margin your actual return would look completely different.
Let’s assume you choose to pass on the terms above because you don’t want to wait the 30 – 60 days it takes to complete the SBA loan process, and decide you want to apply for a line of credit. In this case you are approved for a $200,000 line of credit at 15% simple interest over 6 months with a 2.5% draw fee. The line of credit would have a monthly payment of $38,333.33 and would cost $30,000 over the 6 months. If you compare the monthly cash flow, you would have negative $8,333.33/month in cash flow. The numbers look much worse when you compare the cost/ROI over that same 6 month time frame because the total cost of the financing would be $35,000 and the total cost would be $235,000. So over 6 months you would be laying out $235,000 and only having an increase of $180,000. Essentially negative $55,000. Over the course of time would your business increase? Yes, but I would pass as this – it clearly isn’t the right program for the job.
This leads us to another principle of analysis financing to grow your business. You want to use short term financing for short term needs and for larger purchases that don’t need to be consistently purchased use longer term financing. Shorter term needs are marketing, inventory, hiring, supplies, stationary, smaller tools, and meals. These are things you spend money on at least on a monthly basis if not more regularly. You shouldn’t tie up longer term financing such as an SBA loan for these types of needs. Larger purchases such as equipment, renovations, start up capital, a building or debt consolidation a business needs longer term financing to purchase. This will help a business maintain strong cash flow. Shorter term financing programs are anything under two years which include Lines of Credit, Merchant cash advances, P.O. financing, Project funding and invoice factoring. Longer term financing options are SBA Loans, Term Loans, Business Loans, CRE SBA Loans, and Equipment Financing.
Let’s dive into other factors that need to be considered when taking financing is the financing secured or unsecured? Secured means that you are putting up collateral for the financing. Great examples of secured financing include a mortgage, SBA loan, and equipment financing. This means that if you fail to repay the loan, you put up physical property that can be repossessed. Unsecured financing, in my opinion, is a little deceiving because companies still file a UCC lien against receivables or other business assets that in case of default can be liquidated to pay back the debt. UCC liens are public record and many brokers will collect that data and solicit via calls, texts, and emails. This can become troublesome for a business owner because of the amount of calls they will receive. Business owners should ask if the financing program is going to report to their business credit or personal credit. Why would this matter? IF the program reports to your personal credit, it may impact your ability to purchase a house by impacting your debt-to-income ratio. If it reports to an entrepreneurs business credit, you will want to know what bureau so you can confirm it’s being reported properly.
Most entrepreneurs don’t know what programs are available to them and what the terms and qualifications look like. Knowing what program to use and what to use it for is 95% of the battle.