In a previous post, I explored the idea of loan pricing and how an APR affects a small business’s bottom line.  I wrote this initial post because I heard from a number of entrepreneurs that,

If the sticker price of my loan exceeds my net profit margin, I won’t be able to turn a profit.

In my last example, I examined the effect of a credit line to finance a short-term need, like inventory, and how the interest rate on that line affected the profitability of the company.

Today, I’d like to transition to examine how the interest rate on a fully amortizing term loan affects profit margins and the correct way to evaluate a financing offer.

An Example – Frozen Yogurt Franchisee

Recently, we funded a rapidly growing frozen yogurt franchisee with a 36-month, $200,000 term loan to open their third location. The first two locations had generated about $700,000 in combined revenue for the most recent year with net profit margins at about 20%–or $140,000 of net income.

The APR for this term loan was 16%.  At first glance, it might seem like an interest rate like this one would eat away a good chunk of the profits associated with opening the 3rd location. But a closer look at entire picture reveals that the loan will actually allow the company to grow both the top and bottom line.

It’s important to understand how an interest rate translates to an expense on a company’s income statement, as well as what portion of the company’s operations are being financed by that debt.  In the case of our frozen yogurt customer’s loan, interest expense in years 1, 2, and 3 will be about $28,000, $18,000, and $6,900 respectively (check out a handy amortization schedule generator that allows you to quickly assess which portion of your loan payment is going to reduce principal and which portion is going to pay interest).

If we assume that the revenues of the 3rd location will be similar to the first two (about $350,000 per location) and net margins will remain the same, the company should generate about $1,050,000 in sales and about $182,000 (20% net profit margin or $210,000 minus $28,000 in new interest expense) in net income in year 1.  Net profit margins remain at a healthy 18% clip, returning to the prior 20% level after the interest expenses go away as the loan is repaid. It’s also important to note that the overall free cash flow of the business has increased substantially with more than $40,000 in new profits in year 1, allowing the company to reinvest funds and perhaps open future locations with nothing but internally generated cash—the cheapest form of financing there is!

I recognize that this can be confusing, and choosing the right form of financing can be difficult for a busy small business owner.  That is why I’m here.  Let me know if I can help walk you through your options