There are a variety of reasons a company’s debt can become inefficient or improperly structured. Companies are not static entities, but instead are constantly changing to meet market demands, growth and competitive landscapes. Over time, these changes can lead to a capital structure that is no longer optimal for the company. Below are some common occurrences that lead to a company with inefficient debt.
No-Bid Loan Renewals
I recently had a client that had been with the same bank for 25 years. The bank met the company’s needs, and the relationship was good. Only later, did the company learn that it was the most profitable customer the bank had on a per-dollar basis. My client had never shopped its banking relationship, and the bank fees for ancillary services had slowly risen well above market, costing the client a significant amount each year.
Companies often believe that all banks and all loans are created equal, particularly in this low interest-rate environment. If a company is using rates as the primary indicator of its banking cost, the perceived value of devoting time and resources to exploring alternative financing options appears nonexistent. In truth, today most banks are as interested in a company’s other banking needs – deposits, treasury management, etc. – than the actual interest payments from a loan. The result is that companies focus on the cost of interest while the bank is looking to maximize profit on ancillary items that may go unchecked.
This is not to imply that your current bank is taking advantage of your trust as a customer, but a reminder to encourage open dialogue during the renewal process so that your company is best served.
Mismatching Assets and Debt Facilities
One of the most common mistakes in building a debt structure is using short-term borrowings to purchase long-term assets. Ideally, the structure of the debt will closely mirror the useful life of the asset. If a company is purchasing an asset that will last five years, it makes sense to finance that purchase with a five-year term loan.
Below is a chart that generically shows proper finance structure:
Optimal Debt Structure
A/R or Inventory
Revolving Line of Credit
Capex Line of Credit
3- to 7-Year Term Loan
Real Property or Facilities
Let’s elaborate on an example of using short-term borrowings to purchase long-term assets and how it can affect a company. A company has fully drawn down its $3 million line of credit to purchase a new facility. This line of credit was intended to both assist the company’s liquidity and provide access to cash during negative cash-flow periods, but instead has been used to purchase an asset.
Now, as the company grows due to added capacity of the new facility, it has no liquidity or access to the working capital needed to grow its inventory. If the company had properly financed the asset purchase, it would be slowly paying off the term debt used to purchase the facility while also having access to a $3 million line of credit to help grow operations and position itself to make the most of its investment.
An Imperfect Understanding of the Company as a Borrower
It is important for a company to understand itself through the eyes of a lender. Only then, can a borrower not only negotiate the best deal, but also ensure the best structure with regards to covenants, guarantees and terms. Often, SD Meridian has seen clients that either agreed to covenants that were too stringent or provided guarantees that were unnecessary because the company was talking to the wrong type of lender. Understanding if the company is a cash-flow borrower, asset-based borrower or something else altogether is important to creating a good marriage of borrower and lender.
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Material discussed is meant for informational purposes only, and it is not to be construed as investment, tax, or legal advice. Please note that individual situations can vary. Therefore, this information should be relied upon when coordinated with individual professional advice.