Few family owned companies are in the financial position to be able to fund all capital purchases entirely with cash. Even if a company has enough cash, it can be extremely detrimental to the current ratio and overall company liquidity to use cash to pay for illiquid, long-term assets. For most companies, therefore, debt and term loans are a necessity. Here’s how to manage term loans to your maximum benefit:
1) Finance 75% of all long-term purchases. Using 75% financing will keep your ratios healthy as long as you have the profit to service the debt. Using less debt is hard on liquidity.Using more debt can cause strains on cash flow and profits, particularly when interest rates rise.
2) Match the length of the loan to the life of the asset. If you are purchasing 20-year-life real estate, then make sure you get a 20 year amortizing loan. If you are purchasing a truck that will give you five years of service, use a 5-year loan. Never use financing that is longer than the life of the asset. If you do, you’ll owe money on a loan for a zero value asset at the time you need to purchase a replacement. Conversely, borrowing for less years than the life of the asset is hard on cash flow.
3) Accept loan stops or balloons to achieve lower interest rates. Many institutions refuse to grant long term loans without a stop or balloon. A balloon or stop point allows a lender to reassess a company’s financial status at regular intervals. It also means lower loan rates since it is normally cheaper for a lender to lend you money for one year than for five years, or cheaper for five years compared with ten years. From a lender’s perspective, the longer the loan term, the higher the risk and therefore the need for a higher loan rate.
4) Renew balloon loans early. Ideally, we never want a big balloon payment to show up in the current portion of debt on a year-end financial statement. To avoid this situation, set up your loans with maturity dates at least one month past your year-end or renew them a year early. A large balloon payment in the current liabilities section of your balance sheet can wreak havoc on ratios and cause problems with suppliers.
5) Avoid prepayment penalties.
During years of strong cash flow, you may want to accelerate payments on your term loans. Some loans, however, are subject to large prepayment penalties. As with most loan terms, prepayment penalties are negotiable and should be avoided at the time of loan origination. If you’re already in a loan that contains a strict penalty clause, ask your lender to waive the penalty.
In summary, well-structured, well-managed term loans can be a key, critical factor to safely fueling your company’s future growth.
