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Businesses are financed either by equity or debt, usually by both. Equity, of course, is the capital paid into the business by its owner and other investors who buy shares.

This money can be recovered only by selling the shares or by selling the company, and investors are at risk for the total of their investment. Debt is based on contractual arrangements under which both repayment of the principal and payment of interest are specified, although certain forms of debt bear no interest: an example is trade credit under which a buyer may have up to 90 days to satisfy a bill. All forms of credit, in effect, represent loans from one party to another. Thus leasing of rental space or of equipment may be viewed as loans of real estate or of equipment, with rents and lease payments representing interest. All such transactions are recorded on a company’s books as liabilities. A company’s debt-equity ratio (liabilities divided by equity) represents the degree to which it is said to be “leveraged.” The ratio is one of the measures lenders use to make judgments on whether to lend or not or, alternatively, on how much to lend.

The old-fashioned, traditional view is that debt should be avoided; progressive thought holds that a good balance between debt and equity gives a company optimum flexibility for growth; speculative views favor maximum leverage in order to achieve the highest possible return for stockholders.

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Characteristics Of Loan Transactions

Lending and borrowing transactions are characterized by time factors, costs, and risk considerations; all three are closely related.

Time Factors.Term loans are classified by the length of time for which money is lent. Loans come in shortterm, intermediate-, and long-term forms. Revolving credit and perpetual debt, however, have no fixed retirement dates. Revolving credit, better known as a “line of credit,” provides a sum of money which the borrower draws down and then pays back, borrowing again when funds are needed again. Interest is paid only when funds are being used. Brokerage houses that extend margin credit for customers on certain securities work the same way. The holder of a perpetual loan, usually issued through a registered offering, only pays interest on the money and decides in his or her own time when to retire the principal.

Repayment Schedules match the type of loan obtained and also affect the costs of the borrowing. Payment terms available either call for combined payments of principal and interest at regular intervals or require interest payments only with the principal repaid as a single sum at the end of the contract. In the first case interest is charged only on the remaining balance of principal so that the interest portion declines over time. Under some types of leases, the lessor gradually acquires the real estate or the equipment being leased. In these cases the lease payment remains the same but the lessor’s costs decline because he or she is able to claim a portion of the property as depreciation against taxes.

Cost. The cost of a loan is the interest charged.

Interest may be fixed for the term of the loan or may be variable. If the rates are variable, they may be adjusted daily, annually, or at intervals of years (3, 5, and 10).

Such rates (called floating rates) are tied to some index such as the prime federal lending rate. As a general rule interest costs are based on the current cost of money and the relative risk of the loan, so that collateralized debt costs less than unsecured debt.

Security. Assets pledged as security against the loss of the loan are known as collateral. Credit backed by collateral is secured. In many cases, the asset purchased by the loan often serves as the only collateral, but in other cases the borrower puts other assets, including cash, aside as collateral. Real estate or land collateralize mortgages.

Unsecured debt relies on the earning power of the borrower.

Common Types Of Loans

Consumers and small businesses obtain loans with varying maturities in order to fund purchases of real estate, transportation and production equipment, raw materials, parts, and other needs. The source of such funding may be friends and relatives, banks, credit unions, finance companies, insurance companies, leasing companies, and trade credit. State and federal governments sponsor a number of loan programs to support small businesses.

Short-Term Loans A special commitment loan is a single-purpose loan with a maturity of less than one year. Its purpose is to cover cash shortages resulting from a onetime increase in current assets, such as a special inventory purchase, an unexpected increase in accounts payable, or a need for interim financing. Trade credit is also a kind of short-term loan extended to the business by a vendor who allows the purchaser up to three months to settle a bill. In the past it was common practice for vendors to discount trade bills by one or two percentage points as an incentive for quick payment.

A seasonal line of credit of less than one year may be used to finance inventory purchases or production. The successful sale of inventory repays the line of credit. A permanent working capital loan provides a business with financing from one to five years during times when cash flow from earnings does not coincide with the timing or volume of expenditures. Such loans are common in seasonal businesses where, for instance, goods are manufactured in summer for winter sale or vice versa.

In all such cases, creditors expect future earnings to be sufficient to retire the loan.

Intermediate-Term Loans Term loans finance the purchase of furniture, fixtures, vehicles, and plant and office equipment. Maturity generally runs more than one year but less than five. Consumer loans for autos, boats, and home repairs and remodeling are analogous intermediate loans.

Long-Term Loans Mortgage loans are used to purchase real estate and are secured by the asset itself. Mortgages generally run between ten and forty years. A bond is a contract held in trust with the obligation of repayment.

An indenture is a legal document specifying the terms of a bond issue, including the principal, maturity date, interest rates, any qualifications and duties of the trustees, and the rights and obligations of the issuers and holders.

Corporations and government entities issue bonds in a form attractive to both public and private investors. A debenture bond is unsecured, while a mortgage bond holds specific property in lien. A bond may contain safety measures to provide for repayment.

Mixed Motives

In virtually all lending/borrowing situations the motives of the parties involved are in some conflict, at least on the margins. The business borrower’s primary motive is to obtain the necessary financing to run the business at the least possible cost. His or her ideal source of funding is paid-in capital, but such equity is put at risk, and the owner feels this risk particularly if it is his or her own money. At the same time, if the money comes from investors, they will own shares of the company, and the more is owned by outsiders the less control the owner has. Even the most persuasive owner, able to get equity funding from others easily, will be constrained at some point—lest he or she lose control of the business. In this balancing act debt becomes an attractive alternative source of money. The owner’s motive will be to get as much unsecured financing of this type as necessary at the lowest possible rates of interest and to obtain secured loans only if there is no other way. The owner will try to avoid debt because servicing it costs money—and it has to happen from cash flow. The less debt the business has to carry, the more rapidly his or her own equity will grow.

Independent investors in the business (if any) have yet another set of motives: they want to pay as little as possible for each share and see the value of that share grow. Investors like to “leverage” their investment by seeing it matched by borrowing. Since the borrowed money is used on their behalf, the more borrowing they can leverage the better. But, here too, constraints set it.

Under current law the creditors of a business are first in line when the business fails. If the company is highly leveraged, investors are likely to lose their entire investment. Thus leverage is good—but it must be kept in line.

The lender, finally, is moved by a desire to earn money by lending it safely. Sources of large amounts of cash (banks, credit unions, insurance companies) are typically restrained by law and prudence from speculative investment of the money they hold in trust for others.

They are conservative by their very structure and aim at predictable earnings by the safest possible means. Lenders ideally want secured loans at high interest rates, the latter kept low by competitive forces. They prefer to lend to the financially strongest possible borrowers; if competitive pressures force them to lend to weaker customers, they hedge the risks by charging more. From the lender’s point of view, a financially strong borrower is one who has invested much and therefore has a great stake in the business’s success; the business will also have a long, successful, and steady history of operations, and will offer ample collateral.

A small start-up with a brief history of mild success is thus in a relatively weak bargaining position and must make a very strong case before a favorable action by a potential lender is assured.

Qualifying For A Loan

The three main factors that will help the small business qualify for a loan—aside from a successful track record—are good cash flow, a favorable debt-equity ratio, and carefully prepared documentation.

Net Cash Flow to Debt The lender first looks at a loanapplicant’s cash flow because it is the source of loan repayment. Cash flow is often different from the profitability or assets of a business because sales booked appear on the books immediately but may show up as cash only later (when payment is received) and purchases made are immediately shown as costs but may only require cash later (when payments are actually made). The lender will initially calculate the amount of cash available to service the current portions of any new debt. If this amount is minimally 1.25 times the debt service required, the business is at least in the ballpark to receive a loan. A company with a net cash flow of $5,000 a month and a future debt with a $1,750 monthly payment, has a ratio of cash to debt of 2.86—plenty, in other words. To be sure, the lender will look for a history of such cash flows: a two-month history will not be enough. The higher this ratio and the longer the history, the more inclined the lender will be to lend. If the cash flow is lower, the battle is almost certainly lost—for now.

Debt-Equity Ratio This ratio is calculated by taking a company’s liabilities and dividing them by the company’s equity. A ratio of 1 means that for every dollar in equity the company has 1 dollar of debt. A company with no debt at all will have a debt-equity ratio of 0. Using data provided by MSN Money, in 2006 the combined debtequity ratios of all companies part of the S&P 500 Stock Index was 1.04, suggesting that debt was just a hair greater than equity in these leading companies. But this ratio varies industry to industry. In capital-intensive industries the ratio will be significantly higher; in others much lower. In 2006 Microsoft’s ratio was 4 cents to each dollar of investment; General Motors, struggling to stay solvent, had a ratio of nearly $20 in debt for each $1 of equity; General Electric’s ratio was $1.94 to $1.

The ratio will tell the lender the commitment investors have made in the company, and the higher this commitment is in relation to borrowing, the more confidence the lender will have in being repaid.

Documentation In addition to favorable financial ratios, the lender will be looking at the company’s performance over time. The borrower should anticipate providing the lender a loan proposal justifying the loan. Parts of that proposal will be a business plan, financial statements, and details on other debts and liabilities.

Sometimes unfavorable ratios can be overcome by a consistent history of profitable performance and high growth—and even innovative plans with high potential for success will carry weight. But the wise business owner will not bet on that.

The New Automation In the modern lending environment, computers and the Internet have amplified (and sometimes even usurped) the role of lending officers at financial institutions. One such development is loan origination software (LOS) offered by a number of companies over the Internet to banks, credit unions, and other financing agencies. These packages automate judgment on loan applications by calculating ratios, using averages for industrial categories, weighting experience factors, and even obtaining credit ratings automatically. One such package is LiquidCredit Bank2Business offered by Fair Isaac Corporation, a leading company in the field—but there are a number of others. These packages “score” loan applications and thus give loan officers confirmation for their own judgment—or give them pause. Downsizing in the banking sector, as reported by Mike Byfield in Alberta Report has caused an increase in caseloads and thus reliance on such services. So much for the bad news. The good news is that capital markets in the mid-2000s were flush with money. Conditions continuously change and cycle, to be sure, but the well-prepared business owner with good justification can still prevail and get his or her loan.

That, of course, is just the beginning of getting on with the program.