Leverage considerations
To leverage or Not to leverage?
Many business owners eventually grapple with this question. Using financial leverage requires a careful balance between maximizing returns and managing risks.
Business owners should evaluate their company’s financial health, industry standards, market conditions, risk tolerance, tax implications, growth potential, and management approach when deciding on the ideal debt level.
When effectively managed, financial leverage serves as a powerful catalyst for business growth and profitability. However, it demands meticulous planning and continuous oversight to mitigate potential risks.
how should you be thinking about this decision?
The dropdowns below will guide your Thought process…
Debt can provide the capital needed to invest in research and development, new product lines, or cutting-edge technologies that position a company as an industry leader. For example, a software company could use a loan to fund development of innovative solutions, helping them stay ahead of competitors.
Debt financing allows businesses to quickly capitalize on emerging opportunities in the market. A retail business could use debt to acquire a competitor and expand market reach, or an e-commerce company could fund international expansion into new markets.
Companies can use debt to finance the expansion of manufacturing capacity, open new locations, or upgrade equipment. This allows them to meet increasing demand and scale up operations.
Strategic acquisitions funded by debt can help companies broaden their product offerings, enter new markets, or consolidate market share.
A lines of credit or other debt instrument can provide flexibility in managing day-to-day operations and cash flow needs as a company grows.
Unlike equity financing, using debt allows business owners to retain full ownership and control of their company while still accessing growth capital.
Responsibly managing debt can help build a company’s credit history, potentially opening up better financing options in the future.
Interest payments on business debt are often tax-deductible, providing a financial advantage.
Debt provides access to larger amounts of funding than may be available through internal savings or credit alone. This allows companies to pursue bigger expansion opportunities that would otherwise be out of reach.
Debt can provide the necessary financial resources to fund expansion projects, research and development, new technologies, and other growth initiatives that can help a company expand into new markets.
Unlike equity financing, using debt allows business owners to retain full ownership and control of their company while still accessing growth capital.
Interest payments on business debt are often tax-deductible, providing a financial advantage when using debt for expansion.
Responsibly managing debt and making on-time payments can help build a company’s credit history, potentially opening up better financing options in the future to support further expansion.
When used strategically, debt can improve a company’s return on equity by using borrowed funds to generate higher returns in new markets.
Debt financing allows businesses to quickly capitalize on emerging market opportunities that may require rapid expansion.
Expanding into new markets through debt can help diversify a company’s revenue streams and reduce risk. However, it’s important to note that debt must be managed carefully when used for expansion. Taking on too much debt can strain finances and increase risk. Companies need to ensure they can generate sufficient returns from their market expansion to cover debt payments and interest. A balanced approach, considering
Accountants play a crucial role in evaluating the risks associated with taking out a private business loan. By leveraging their financial expertise and industry knowledge, accountants provide invaluable assistance in evaluating and managing the risks. This comprehensive approach helps business owners make informed decisions and navigate the complexities of business financing with greater confidence. Here are the primary ways they assess these risks:
Accountants begin by thoroughly evaluating the business’s financial health. This involves examining balance sheets, income statements, and cash flow statements to identify strengths and weaknesses. They look for any financial red flags that could impact the business’s ability to repay the loan, such as inconsistent cash flow, high levels of debt, or declining revenues.
Accountants help businesses choose the most appropriate type of loan by assessing the company’s financial goals and constraints. They evaluate different loan options, considering factors like interest rates, repayment schedules, and collateral requirements, to ensure the business selects a loan that aligns with its financial situation and objectives.
Accountants identify potential risks that could impact the business’s financial health. These risks can be internal (financial, operational, marketing, workforce) or external (economic changes, new competitors, natural disasters, government regulations). They document these risks and develop a scoring system to weigh their potential impact and likelihood.
After identifying and documenting risks, accountants help businesses develop strategies to mitigate them. This includes setting up controls to reduce risks, such as improving cash flow management, diversifying revenue streams, or securing insurance. Accountants also advise on maintaining an emergency fund to handle unexpected expenses.
Accountants assess the tax implications of various loan types, helping businesses understand how loan interest, deductions, and repayment schedules affect their tax liabilities. This ensures businesses can optimize their tax positions while managing loan-related financial commitments.
Accountants often have established relationships with financial institutions, which can enhance a business’s credibility during the loan application process. Their professional approval and guidance carry significant weight with lenders, potentially leading to more favorable loan terms and conditions.
The role of accountants extends beyond securing the loan. They continue to support businesses by monitoring financial performance, ensuring compliance with loan terms, and providing advice on managing the loan effectively. This ongoing support helps mitigate risks and ensures the business remains on a stable financial footing.
When choosing a financing option, small business owners should consider factors such as their creditworthiness, the amount needed, funding speed, interest rates, and repayment terms. It’s crucial to carefully evaluate the business’s financial situation and ability to repay before taking on debt. Small business owners have several borrowing options available to them, each with its own advantages and considerations:
Traditional banks offer term loans, equipment loans, and business lines of credit. These typically have low interest rates but require strong credit scores (670+), annual revenue of $100,000-$250,000 and at least 2 years of business history.
These are more accessible for businesses with fair-to-bad credit or those needing quick funding. These lenders often have relaxed eligibility requirements and can provide funds within 24-48 hours. Major online lenders include SoFi, LightStream, LendingClub, Discover Personal Loans & Avant.
Partially guaranteed by the U.S. government, SBA loans offer competitive rates and various types like 7(a) loans, 504 loans, Express loans, and Microloans. They’re ideal for businesses that don’t qualify for conventional loans.
Certified Minority Depository Institutions (MDIs) and Community Development Financial Institutions (CDFIs) focus on supporting underserved markets and may offer educational support.
These provide revolving credit for short-term expenses and may offer rewards like cash back or travel points.
These options allow businesses to get cash for unpaid invoices.
These are based on personal credit scores and income rather than business history. They’re usually available in smaller amounts but can fund quickly.
These provide a set credit limit that can be drawn upon as needed, with interest paid only on the amount used.
These offer a fixed amount repaid in installments over 3+ years, often used for purchasing equipment or vehicles.
While risky, some business owners use their home equity for business funding.
Private lending options offer an alternative financing route for small business owners who may not qualify for traditional bank loans or are seeking more flexible terms. When considering private lending options, business owners should carefully evaluate the terms, interest rates, and repayment schedules. It’s also crucial to research the lender’s reputation and compare multiple options before making a decision.
These are loans provided by non-bank lenders, often with more flexible eligibility requirements than traditional banks. They typically range from $25,000 to $1 million and can be approved quickly, sometimes within 2-3 days
These are asset-based loans provided by private investors or companies. They usually require collateral, often in the form of real estate. Hard money loans are popular among property investors due to the ability to use real estate as security.
Many private lenders operate online, offering a variety of loan products with more relaxed eligibility criteria and faster funding times compared to traditional banks. These can include term loans, lines of credit and invoice financing.
This involves borrowing directly from individuals through online platforms, bypassing traditional financial institutions.
These are loans provided by individual investors or small financial collectives using their own set of rules and risk tolerances.
Some wealthy families have investment arms that provide private loans to businesses.
When accountants evaluate the risks associated with taking out a private business loan, they focus on key financial metrics to assess the business’s ability to repay the loan and its overall financial health. By focusing on these financial metrics, accountants can provide a comprehensive assessment of the risks associated with taking out a private business loan, helping businesses make informed decisions and improve their chances of securing favorable loan terms. Here are the specific financial metrics accountants typically analyze:
**Current Ratio** Measures the business’s ability to pay short-term obligations with its current assets. It is calculated as {Current Assets} / {Current Liabilities}. A higher ratio indicates better liquidity.
**Quick Ratio** Also known as the acid-test ratio, excludes inventory from current assets and is calculated as {Current Assets – Inventory} / {Current Liabilities}. This ratio provides a more stringent measure of liquidity.
**Debt-to-Equity Ratio** Assesses the business’s financial leverage by comparing its total liabilities to its shareholders’ equity. It is calculated as {Total Liabilities} / {Shareholders’ Equity}. A lower ratio indicates less risk.
**Interest Coverage Ratio** Measures the business’s ability to meet its interest obligations. It is calculated as {Earnings Before Interest and Taxes} / {Interest Expense}. A higher ratio indicates better ability to cover interest payments.
**Net Profit Margin** Indicates how much profit the business makes for every dollar of revenue. It is calculated as {Net Income} / {Revenue}. Higher margin indicates better profitability.
**Return on Assets (ROA)** Measures how efficiently the business uses its assets to generate profit. It is calculated as {Net Income} / {Total Assets}
**Return on Equity (ROE)** Assesses profitability relative to shareholders’ equity. It is calculated as {Net Income} / {Shareholders’ Equity}.
**Operating Cash Flow** Indicates the cash generated from the business’s core operations. It is critical for assessing the business’s ability to generate sufficient cash to meet its obligations.
– **Free Cash Flow** Measures the cash available after capital expenditures. It is calculated as {Operating Cash Flow} – {Capital Expenditures}. Positive free cash flow indicates the business can fund its operations and growth without external financing.
**Inventory Turnover** Assesses how efficiently the business manages its inventory. It is calculated as {Cost of Goods Sold} / {Average Inventory}.
**Receivables Turnover** Measures how effectively the business collects its receivables. It is calculated as {Net Credit Sales} / {Average Accounts Receivable}.
**Credit Score** Both personal and business credit scores are critical in assessing the risk of lending to the business. Higher credit scores indicate lower risk.
**Credit Utilization Ratio* Measures the amount of credit used relative to the total available credit. Lower utilization ratios are generally favorable.
**DSCR** Measures the business’s ability to service its debt with its operating income. It is calculated as {Net Operating Income} / {Total Debt Service}. A DSCR greater than 1 indicates the business generates enough income to cover its debt obligations.
**Collateral Value** Assesses the value of assets that can be pledged as collateral for the loan. This includes real estate, equipment and inventory. Higher collateral values reduce lender risk.
**Revenue and Expense Projections** Accountants create detailed financial forecasts to estimate future revenues, expenses and cash flows. These projections help assess the business’s ability to meet future financial obligations.
**Industry Benchmarks** Accountants compare the business’s financial metrics to industry benchmarks to evaluate performance relative to peers. This helps identify potential risks and areas for improvement.
Businesses seeking SBA loans must adhere to specific accounting requirements to ensure compliance and improve their chances of securing funding. Here are the key accounting requirements and processes involved:
Businesses must maintain their books of account in accordance with the system of account classification prescribed by the SBA. This ensures uniformity and standardization across all licensees. If a business’s accounting system cannot accommodate the specified account numbers or titles, it must maintain a listing of its accounts with cross-references to the standard SBA chart of accounts[.
SBA Form 468 – Businesses are required to submit an audited Annual Financial Report using SBA Form 468. This report includes financial statements, supplementary schedules, the Independent Public Accountant’s report, notes accompanying the financial statements and required certifications.
Audit Requirements – The financial statements must be audited by an Independent Public Accountant who will express an opinion on the financial statements and supplementary schedules based on the audit.
Submission Deadline – The Annual Financial Report must be submitted no later than the last day of the third month following the end of the business’s fiscal year. The submission must include electronic data files, printed copies of financial statements, management certifications, the auditor’s report and notes to the financial statements.
For each financing of a small business, licensees must submit a Portfolio Financing Report on SBA Form 1031 within 30 days of the financing closing date. This report must be prepared using software provided by the SBA and electronically transmitted to the SBA.
Eligibility – Businesses must be operating for profit, located in the U.S., meet SBA size standards, and be unable to obtain credit on reasonable terms from non-federal sources.
Creditworthiness – Businesses must demonstrate a reasonable ability to repay the loan, which often involves providing detailed financial information and projections.
Permitted Uses – SBA loans can be used for acquiring, refinancing, or improving real estate and buildings, purchasing machinery and equipment, working capital, refinancing existing debt and other business-related purposes.
Regulatory Compliance – Businesses must comply with SBA regulations, including maintaining accurate and comprehensive financial records and ensuring that all financial reporting is in line with SBA requirements.
Risk Assessment – The SBA requires lenders to certify that the desired credit is unavailable on reasonable terms from private sources and to consider factors such as the business’s operating history, available collateral and cash flow projections.
SBA loan accounting requirements have several significant impacts on small businesses seeking these loans which can be challenging for small businesses, particularly those without sophisticated accounting systems or dedicated financial staff. However, they also encourage better financial management practices, which can benefit the business in the long run. Small businesses may need to invest in accounting software, hire professional accountants, or outsource some financial management tasks to ensure compliance with SBA requirements and improve their chances of loan approval.
Small businesses must maintain detailed and accurate financial records in accordance with the SBA’s system of account classification. This includes proper categorization of expenses, income, assets and liabilities.
Businesses are required to submit an audited Annual Financial Report using SBA Form 468. This involves preparing comprehensive financial statements, supplementary schedules, and having them audited by an Independent Public Accountant.
The financial statements must be audited by a qualified Independent Public Accountant, which can be a significant expense for small businesses.
The Annual Financial Report must be submitted within three months of the fiscal year-end, requiring businesses to have efficient accounting processes in place.
For each financing of a small business, a Portfolio Financing Report (SBA Form 1031) must be submitted within 30 days of the financing closing date, adding to the reporting burden.
Businesses must provide detailed financial information and projections to demonstrate their ability to repay the loan, which requires thorough financial planning and analysis.
Small businesses must ensure ongoing compliance with SBA regulations, including maintaining accurate and comprehensive financial records.
The ability to include working capital in SBA loans can help businesses manage seasonal cash flow fluctuations, which is particularly relevant for accounting firms with traditionally seasonal business cycles[.
SBA loans allow for longer-term financing of equipment, which can help spread payments over a longer period and free up cash flow for other business expenses.
When real estate is part of a business purchase, SBA loans can extend terms up to 25 years, impacting long-term financial planning and accounting.
Owners with at least 20% ownership must provide an unlimited personal guarantee, which affects personal financial planning and risk assessment.
Evolution Capital Solutions is a leading provider of alternative funding solutions, catering to businesses of various types and sizes. We present a broad spectrum of business and commercial real estate financing products, tailored to meet the distinct needs of our clients