When seeking short-term, line-of-credit debt financing, an entrepreneur must first understand the “cost” of the line in relation to the overall profit margins of their business.
After speaking with thousands of small business owners about their capital needs, a common misperception has surfaced:
My profit margins are 10%, so I can’t take a line of credit that costs more than 10%…(insert your variation on percentage).
While at first glance, this statement makes complete sense, it misses several key considerations that can hamstring a small business owner’s ability to correctly evaluate the attractiveness of a financing offer, including:
- What profit margins am I referring to? Gross or net?
- How is the financing priced? Does it use standard APR or some other form of pricing?
- How heavily and for how long will I rely on financing to capitalize my operations and grow the company?
Business financing should be evaluated on whether, if, and how much it allows the company to grow and the OVERALL effect on profit margins.
Recently, I spoke to a potential borrower who wanted financing to help purchase inventory for his scrap metal wholesaling business. He has good operational experience and would be able to ship more scrap metal to his customers if he had a consistent source of financing to pay the dealers that sell the scrap to him. However, it is undoubtedly a volume-based strategy, and the net profit margins on a single scrap metal transaction aren’t very high, they sit at approximately 10%.
He expressed to me that he couldn’t take out a line of credit for his short-term needs that cost more than 10% because it would eat away all the profits. After some further questions, I learned he sells his inventory in less than two weeks after purchasing it from the dealer. In a typical transaction, he would pay his dealer $40,000 cash and sell it to his customers with a 20% markup. After factoring in operational costs, he books a 10% profit, or $4,000, on the deal.
Now, if it were to cost this business owner $4,000 (10% of $40,000) per transaction in financing costs to secure a line of credit, all of his profits would be eaten away. And there are undoubtedly options out there that can cost far more than $4,000 in interest and fees on a $40,000 loan.
But what if he obtained a line of credit to finance the scrap metal purchases and paid down the line as soon as the inventory was sold—in this case, two weeks? In two weeks, at a rate of 10% APR, the financing cost for a line of credit would only be $160, leaving more than $3,800 of profit in each transaction. In fact, the APR would have to be closer to 261% to generate $4,000 worth of interest charges in only two weeks.
In this particular borrower’s case, the line of credit will enable him to purchase more inventory at a better unit-price, recouping some of the lost margins or even growing margin altogether, generating higher overall revenues and profits.
Understanding how your profit margins are affected by the “sticker” price of a loan, as well as how that price translates into overall financing costs for your company is critical when considering your financing options. Let us know if we can help walk you through your options.
In this post, I described the relationship between loan pricing and a short-term operational need like inventory. In my next post, I will describe the effect of loan pricing on financing a long-term asset and overall profitability.