How Much Can You Safely Borrow?

How Much Can You Safely Borrow?

A construction company once approached me for advice. They’ve been in business for five years at that point, and they have never borrowed money before that time. They did approach banks, but they weren’t sure how to tell them about what they need. The president was an engineer by profession. His wife was the one in charge of their financials.

They managed to succeed through hard work, and now they have their sight on bigger contracts. To be specific, they were looking to get supply and install contracts from one of the Top 100 corporations in the Philippines. Realizing that they need more money than they have now, they approached banks to ask for advice. Unfortunately, the answers they got didn’t manage to clear up their questions.

You see, this business needed some analysis done on their financial statements. They know they needed more money, and they had a rough idea how much they wanted to get from the bank. However, they wanted to know how much they can SAFELY borrow. That amount escaped them.a

INTRODUCING THE DEBT SERVICE CAPACITY RATIO

So what I did was dig deep through their business and their financial statements to see how I could help. Among other things, the most important concept they learned was the Debt Service Capacity Ratio. This is one of the most important computations you would have to make for your own business when planning to raise money.

As the name implies, it’s a measure that compares your income towards the regular payments you have to make towards your loans. It computes how many times your income can cover those regular payments. For example, a DSCR of 2:1 means that you have twice as much as income for a particular period compared to the loan payments you have for the same period of time. A ratio of 1.5:1 means that you have 1.5x, and so on and so forth.

Banks have different ways of computing this ratio, but in general, you want to have a ratio that is at least 1.5:1. Anything lower than could be dangerous for your business, depending on several factors.

COMPUTING THIS RATIO

You may want to compute the ratio differently – depending on the nature of your business. If your sales are mainly cash sales, then the first formula would suffice. Though if you have a lot of sales on credit, then you may want to use the second computation.

1. EBITDA Computation

So here’s the formula:

EBITDA/Total Annual Debt Amortization

EBITDA means (earnings before interest, taxes, depreciation and amortization). In most financial statements, you can compute this by deducting Gross Profit less Operating Expenses, excluding depreciation expenses, interest expenses and amortized costs. These expenses are excluded because they are non-cash expenses.

Total annual debt amortization refers to the sum of all debt payments (both principal and interest). You should be able to compute this through some simple calculations, or through using an amortization calculator <link>.

2. Cash Computation

The EBITDA formula can be misleading for a business who does more sales through credit than through cash. EBITDA doesn’t really distinguish if you have received cash for your sales or not, but your debts are always paid in cash. Using that formula in situations like this may lead to the wrong conclusion that you can pay a loan that you cannot.

As an alternative, you might want to use this formula:

Cash After Operations/Total Annual Debt Service

Cash After Operations is all cash sales and collections less all cash operating expenses. You can see this figure in your Cash Flow Statement if your accountant did it correctly.

The total annual debt amortization is the same as the previous formula.

With these two formulas at your disposal, you can now make an educated decision on how much you can safely borrow from the bank.

Why are banks so slow?

Why are banks so slow?

From the last post, I told you about some the debt service coverage ratio. If you haven’t read that yet, here’s the link.

Now I want to let you in a little secret.
You see, a couple of weeks ago, an associate of mine approached me about a problem they had with a bank.
This is the second time they’re borrowing money, but this time the loan that they’re getting is bigger in amount. Their first loan was a small business loan which was less than 5 million. Now they need more than that. And they needed it fast.
They approached the bank where they got the first loan, and they thought that it will be processed as fast as the first one.

“Why are banks so slow?!”

After a few weeks of no feedback, they missed the opportunity and lost millions in sales.
They heard of me from a common friend and started complaining about this.
You see there are a couple of reasons why banks can be REALLY slow in processing loans. This is especially true with big banks, but can also happen to smaller banks as well.
It’s all about TIME
It all boils down to TIME. Specifically, the time the account officer can spend on your account.
Imagine how many applications your account officer can be handling. With a lot on his plate, he has to make quick decisions on where to dedicate his energy. He has a quota that needs to be filled, too.
With all of those happening, his incentive is to prioritize the simplest and most complete applications.
So if your application is filled with incomplete documents, and your proposal too hard to understand, expect a long wait.

How to make the process faster

For this business, I help them get the loan faster by doing three things:

1. Fixed the Proposal

I made sure it was as simple to understand as possible. Since I knew the information that was important to the bank, I highlighted the information in the write-up. This made it easier For the officer to read it and understand it. It also served as a template for his own credit proposal, again saving some time.

2. Reviewed the Consistency of the Documents

Each element of the proposal, including the supporting documents, should be consistent. I reviewed their documents and directed the responsible teams to make the changes necessary to make that happen.
An example of some simple things that a proposal may be inconsistent with is the reported sales versus the bank statements presented. The borrower’s staff sometimes attach the bank statement used by the purchasing team (and thus representing costs) instead of the account where collections are deposited.
If banks notice that, that could cause another delay in the process.

3. Constant Followup

Because we made life as easy as possible to the account officer, all that was left was to check on the progress of the application.
It helped that we developed relationships with multiple funders. We were able to identify the right bank. Still, we had to monitor what was happening and address any problem quickly.
In the end, they got what they needed. The loan was on time, and they managed to get the contracts they wanted.

Conclusion

Banks processing can be tedious. Though, if you know what you are doing, are diligent and really try to push things forward, the process will be faster.

What’s the difference between equal payments and diminishing balance?

What’s the difference between equal payments and diminishing balance?

I want to share with you a question a client recently asked me.

You see, this client got loans before from various banks. As hers is a small business supplying vegetable products to restaurants in Metro Manila, most of her loans are actually housing loans. She just used the proceeds for her business.

Now that her business has grown, she can’t tap ordinary housing loans anymore. When she was applying for a business loan, she encountered a different payment mode than she was used to.

EQUAL PAYMENT versus DIMINISHING BALANCE

She asked me to arrange the loans for her, but also wanted to know which payment mode was more advantageous to her business. So I went to explain it to her this way:

Equal Payment

This means that you have the same amount of regular payments to make at a specific period. Say, you got a Php 10 Million loan that charges you 10% interest per year for 5 years. If you accept the equal payment structure, you would pay a regular monthly amount of P212,470.45 or the next five years. This payment already includes principal and interest.

Diminishing Balance

This means that you pay the same amount of principal every payment period, and then pay the interest on the loan based on the remaining balance. Say, you have the same Php 10 Million 10% interest loan, now you would be paying 250,000 in the first month, 247,916.67 in the second month, and 245,850.69 on the third month. This payment will continue to trend downward.

Why do they differ?

My client got slightly confused by this, so I explained to her the difference between the two. The equal payment method is derived from what we call the annuity formula. It was designed mostly for investors who wanted to get a fixed amount of return for their money invested. For loans, it simplified the payment and allows both the lender and the borrower agree on a fixed amount to be paid at regular intervals

There’s a downside to this payment method. The formula makes it so that you pay more interest than principal at the start of the loan. This means that your loan balance gets smaller more slowly compared to diminishing balance. This could be a disadvantage if interest rates change in the future, or you transfer the loan to another bank.

Compared to a loan with a diminishing balance, you get to pay a fixed amount of principal every payment period. The downside is a bigger initial payment, though your loan balance decreases faster.

In our example above, during the first month of the loan, here’s how the payment would look like. [PP mean principal payment, IP means interest payment, and BL means remaining balance]

Equal Payment

Month 1 – PP – ₱129,137.11; IP – ₱83,333.33; BL – ₱9,870,862.89

Month 2 – PP – ₱130,213.26; IP – ₱82,257.19; BL – ₱9,740,649.63

Month 3 – PP – ₱131,298.37; IP – -₱81,172.08; BL – ₱9,609,351.26

Diminishing Balance

Month 1 – PP -₱166,666.67; IP – ₱83,333.33; BL – ₱9,750,000.00

Month 2 – PP – ₱166,666.67; IP – ₱81,250.00; BL – ₱9,502,083.33

Month 3 – PP – ₱166,666.67; IP – ₱79,184.03; BL – ₱9,256,232.64

What should you choose?

As she was diversifying her business towards a rental property, we figured out that the equal payment mode would be easier to plan for. While there are a lot of considerations, we used a simple rule to determine what payment mode to choose.

1. When buying an asset with a consistent stream of income, choose the equal payment mode.

Since she was a buying an asset that would generate a consistent stream of income, it was better to get the loan with an equal payment mode. It was easier to plan for.

Also since the initial payment was smaller, the excess cash can be reinvested somewhere else.

2. When expanding the business using an asset that can create massive sales growth, use the diminishing balance method

If you are purchasing an asset which could result in a massive increase in cash flow (say, a license or an exclusive contract), then the equal payment method would be ideal. Your loan can be paid off faster, and banks would have an easier time accommodating requests for advance payments.

CONCLUSION

We tried to simplify the distinction between the equal payment and diminishing balance mode of payment. With the simple rules I outlined above, you should be able to gauge whether a mode is right for your needs.

Essential Tips SMEs Need to Know About Lending in the Philippines

Essential Tips SMEs Need to Know About Lending in the Philippines

Clients usually say that banks only lend money to companies who don’t really need it. As a former banker, I can relate. It’s true that most bankers would want a company who has strong fundamentals as a client. The more cash they have, the better. But then again, they won’t be borrowing in the first place if they had all that cash.

Borrowing money from banks is even harder for small and medium enterprises. For small enterprises, most of your access to financing would be limited to government institutions.

Medium enterprises have more options with financing institutions, though the funding available to them is still not as flexible as those available to larger corporates.

There was this client of mine who was engaged in the supply of electrical equipment and generators to the largest names in this sector. They haven’t borrowed from banks before. With their business starting to get bigger, they needed more financing to help with the increased demand. They were a bit nervous and confused at the start.

We sat down to strategize for both their long term and short term financing requirements. Here, I broadly outline what we discussed.

1. Craft a financing plan for your business

The first component of the strategy was creating a financing plan for them. While this was part of their larger business plan, we had to develop objectives and targets for financing so they could execute their plans.

Your financing plan should be comprehensive, especially if you are borrowing money for the first time. In general, you need to plan for:

a. When you plan to borrow

b. How much should be borrowed

c. How and when you would repay the loans

In the case of my client, he was concerned about the timing of when the loan would come in. They had a lot of projects lined up for the next year, so we had to plan for all of these.

2. Invest in real estate

Banks really love real estate, especially here in the Philippines. As a collateral, it’s the top of mind of solution for most bankers here in the Philippines. This client didn’t have real estate properties available to be used as collateral. We had to approach it differently. It was a harder approach, too, and one I won’t recommend if you can do it the easier way.

We planned that they should start investing and purchasing real estate properties in good locations. If you do it well, you can position yourself with a lot of collateral value in the future.

For example, those who invested in property 5 years ago now enjoy having banks lend them money at almost 1.5x the amount of what they bought it for. Imagine those who started investing in properties for longer than that.

This is a long term plan, but a plan that pays for itself if you do it correctly.

3. Prepare the right documentation for your loans

Some businesses never planned to borrow money from institutions. They thought that they could just borrow from their suppliers, family members, and business associates forever. It’s only when getting larger project do they realize that they can’t rely on those sources forever.

Then begins the mad-crazy rush to get financing. Unfortunately, they were not prepared with the documentation requirements for the bank. Lots of missed opportunities later, translating to millions of pesos, they learn their lesson.

Fortunately, my client was not like that. Mostly because of the documentation requirements of their customers and the good management skills of its leaders, they were ready with the right documents.

These documents vary from company to company, but in general, I recommend preparing good records of:

a. Bank Statements

b. Customer data on order volumes, credit terms, contact details

c. Supplier data similar to customer data requirements

d. Aging of receivables

e. Customer testimonials

CONCLUSION

SME lending in the Philippines is still a tough place to work with. You have to work hard to get the funding you need at the price you can afford.

Most of the time, you won’t be able to have the time, energy and resources to seriously create a workable plan to get the right funding. Not dedicating time to this though could mean that you can lose a lot of money from paying high interests. Worst, it could mean that you lose millions of pesos worth of opportunities, simply because you don’t have the right financing at the right time.

If you feel that you want to get faster and simpler financing to take your business to the next level, subscribe to my email list and get my free ebook. There I provide a more comprehensive guide on how to prepare yourself and your business to get the financing you need when you need it.

Till next time!

How Growing Companies Can Tap Banks for Financing

How Growing Companies Can Tap Banks for Financing

There comes in the life of your company that orders come in regularly, and you cease worrying (at least not as much as before) about where you’re going to get more sales. You are at that point where you start to attract more customers, and they come knocking at your door. At that point, you’re considered a growing business.

Unfortunately, you also attract competitors. Success begets more success, but that success may not be yours, but for your competitors.

Remember: A competitor with the same competence as you but with better financing can kill a growing business.

Why Growing Companies Need Financing

I remember this contractor who supplied blocks to top real estate developers. Their blocks were favored by these companies, as it proved itself to be cost effective over the life of the building , despite a higher upfront cost. The owner was really happy with his business, and with his initial investment, he kept the business on track.

His business was really profitable, and because of that, it attracted several competitors. At first, this didn’t have much of an effect in his business. He was content and confident that no matter what these competitors do, he can take care of it.

Problems began when he suddenly got offered a huge order for his blocks. He had to refuse it: he can’t possibly afford to manufacture such a huge number.

Because of that, he created an opening for his competitors to actually enter the market. This competitor eventually took larger and larger orders from him.

Now he’s back to worrying about where his next orders will come from. He lost a big chunk of his old business, with that competitor taking over his old customers.

3. Things to Do to Get the Financing You Need

While there are core things you need to do to get financing, which I outline in my book, there are three things I want to highlight. You should pay careful attention to these three, so you would have an easier time in raising the money you need.

1. Sit down and plan for your growth

Things are different for your business when you are ready for aggressive growth. Just like the business we talked about earlier, you would have been less worried about where to get new sales. At that point, you would have the time to take stock and really plan where your business would be in terms of products, customers or even markets in the next few years.

I’ve helped companies craft their financing plans, and in a future post, I’ll give you an overview of how we do it.

2. Craft your growth story

Your growth can’t be simply about numbers. Most growth plans need outside money to execute. Because of this, you should be able to sell your growth plan as a kind of a story.

Be able to tell your funders an exciting tale of how you started your business, the success you have experienced, and how they can take part in your success in the future.

3. Emphasize your best customers and past performance

As a growing company, your customers may be better known than you are. Learn how you can leverage their reputations and your past transactions with them.

If possible, ask for recommendations. That could go a long way in establishing trust with your potential funders.

Conclusion

Growing companies need to scale, or their markets and customers may be taken away from them. Getting the right financing is crucial to the success of any growth. Learn how to get it right, and you’ll succeed.

I’ve been helping clients do just that. Together with my team, we have raised hundreds of millions of pesos for our clients. If you want to know more about how i do it, you can download my ebook through this link.