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Money
that finances business is called capital. Bank loans
approved for day-to-day business operations (working
capital) have characteristics that make them different
from those approved for equipment purchases (long term
capital or capital assets). A bank loan officer can often
assist you in finding a workable combination of these
different types of capital. Using loans approved for
purposes other than those for which they were approved is
considered an abuse of your loan privilege.
Equity
Equity funds come from personal moneys of the
partners (such as savings, inheritance or personal
borrowings from financial institutions, friends, relatives
and business associates) and from stockholders of the
shares in a corporation. These funds are normally
unsecured and have no registered claim on any of the
assets of the business, freeing those up to be used as
collateral for the loans (debt financing). Higher equity
creates " increased leverage." Leverage reflects the
business's ability to attract other loans and
investment. An equity position of $30,000 may enable the
business to obtain debt financing of up to three times
that amount, $90,000. A fully-leveraged business has no
further ability to borrow money.
Long Term Debt
"Term" refers to the time for which money (a
secured loan) is required and the period over which the
loan repayment is scheduled. A long term loan is arranged
when the scheduled repayment of the loan and the estimated
useful life of the assets purchased (e.g. building, land,
machinery, computers, equipment, shelving, etc.) is
expected to exceed one year.
Short Term Debt
Short Term Loans usually take the form of
operating term loans (less than one year) and revolving
lines of credit. These finance the day-to-day operations
of the business, including wages of employees and
purchases of inventory and supplies.
Leverage
This is the relationship of debt financing to
equity financing (leverage or debt-to-equity ratio). A
proposal which involves $6000 of debt, and is based on an
equity contribution of $2000 is said to have a debt/equity
ratio of 3:1. Generally, the lender would like to see a
new business owner who is just building a reputation have
this at 2:1 or even 1:1.
Abusing your
Loan Privilege - An Example:
Your business plan tells the banker that your
proposed business requires a revolving line of credit of
$40,000 to meet its day-to-day expenses over a number of
months. The line of credit is approved because the banker
believes that amount of money is absolutely necessary to
enable you to operate over the specified time period.
Shortly after this approval, you approach the bank again,
this time with a request for a term loan of $25,000 to
purchase new office furnishings. The bank denies you the
term loan as it does not feel that, at this stage, the
business can service such a large amount of debt.
Disappointed by this refusal, you nonetheless decide to
buy the new office furniture, taking the required $25,000
out of your operating line of credit
account.
What has occurred?
The integrity of your business plan has been betrayed!
With the depletion of your operating line of credit, you
can no longer expect to purchase the inventory deemed
necessary to achieve your projections. The business will
be less able to generate the sales revenue required to
service the existing (plus additional) debt; and your
revolving line of credit will have surrendered its ability
to revolve. You return to the banker pleading for an
extension of your line of credit, but the banker, feeling
betrayed, has lost confidence in your management ability
and may withdraw the line of credit privilege, insist on
more equity, recall the loan in its entirety or force the
business into receivership. Furthermore, this performance
will remain on file as a black mark against your
management ability long after the business is only a hazy
memory.
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