The basics of Debt Financing explained in 5 minutes [Simplified]

ALL ABOUT DEBT

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Tell the story behind the numbers

DEBT FINANCING: OVERVIEW Tell the story behind the numbers

4 DEBT FINANCING OPTIONS

TERM LOAN

1

2

OVERDRAFT & CREDIT FACILITIES

London Coffee Co is planning to expand and is exploring the various debt financing options available. The company is examining the debt route as it would prefer to avoid diluting its existing shareholders by raising equity. In particular the company is looking to acquire another coffee shop from a competitor. Term loan financing is appropriate for major asset purchases and acquisitions. London Coffee Co plans to upgrade its coffee machine for which a capital lease allows flexibility and manageable monthly payments to avoid large upfront costs of purchase.

3

FACTORING

4

With factoring, the company can strengthen its cash flow position by releasing cash tied up in invoices issued to clients who have not yet paid.

CAPITAL LEASES

Overdrafts and revolving credit facilities are designed to address financing needs on a short term basis as the company encounters peaks and troughs in its daily or weekly cash position.

DEBT FINANCING: TERM LOANS Tell the story behind the numbers

London Coffee Co Bank Loan - Key Terms Loan Amount: £20,000

Interest Rate:

10.0%

Loan Duration: 36 months

Loan Repayment Schedule Month

Beginning

Interest Repayment

Monthly

Ending

1

20,000

167

£479

£645

19,521

2

19,521

163

£483

£645

19,039

3

19,039

159

£487

£645

18,552

4

18,552

155

£491

£645

18,061

5

18,061

151

£495

£645

17,566

6

17,566

146

£499

£645

17,067

7

17,067

142

£503

£645

16,564

8

16,564

138

£507

£645

16,057

9

16,057

134

£512

£645

15,545

10

15,545

130

£516

£645

15,030

11

15,030

125

£520

£645

14,510

12

14,510

121

£524

£645

13,985

24

7,920

66

£579

£645

7,340

36

640

5

£640

£645

-

What is the monthly payment if the loan duration is:

London Coffee Co is planning to upgrade its coffee machine to serve premium-quality coffee to its customers. The machine costs £20,000 and the company has decided to apply for a loan for the full amount from the bank. The bank has offered to lend to London Coffee Co at an interest rate of 10.0%. The company would like to spread the payments over 36 months. As a result, the company must make monthly payments which consist of £645 in interest and principal for the duration of the loan. If the company decided to take out a five year loan, they would be required to make monthly payments of £425 but the total amount paid in interest would be higher. Similarly if they were to shop around and obtain a loan at 5.0% for 36 months, this would reduce the monthly cost to £599.

What is the monthly payment if the interest rate is:

Loan Duration

Monthly Payment

Interest Rate

Monthly Payment

1 Year

£1,758

5.0%

£599

3 Years

£645

10.0%

£645

5 Years

£425

15.0%

£693

10 Years

£264

20.0%

£743

London Coffee Co must choose the appropriate monthly amount they can afford to manage their cash flows whilst minimising the amount they pay in interest.

DEBT FINANCING: INTEREST RATES Tell the story behind the numbers

Which factors influence the 10% interest rate? UK Interest Rate

Loan amount

Collateral

Credit History

Capacity to Repay

Loan Duration

Deposit

The bank asked London Coffee Co to secure the loan against the company’s property and equipment, its collateral. If the company cannot keep up with its monthly loan payments, the bank will be claim ownership of its property and equipment. London Coffee Co did not offer any collateral on the loan, which increased the risk of lending and therefore, increased the interest rate at which the bank was willing to lend at. The banks also looked at London Coffee Co’s capacity to repay the loan. It deemed that the amount of cash flow the company is generating is sufficient to meet its monthly interest and principal, which reduced the loan’s interest rate. The company requested a loan with a 3-year term. For the bank, a longer loan duration means a higher risk that the loan will not be repaid. By increasing the loan’s term, London Coffee Co would have to pay a higher interest rate than a shorter-term loan. Similar to collateral, London Coffee has not put down a cash deposit for the loan, which has increased its borrowing rate. By securing the loan against the deposit, the bank would have a level of protection should London Coffee Co fail to meet its payments. London Coffee Co borrowed a similar loan amount when it first started up. As a long-standing customer of the bank and with a clean track record of making loan payments in a timely manner, London Coffee Co has a good credit history. This has contributed to reduction in the loan’s interest rate.

DEBT FINANCING: OVERDRAFTS & REVOLVING CREDIT FACILITIES OVERDRAFTS & REVOLVER FACILITIES According to the company’s balance sheet, the company is not expected to encounter cash flow deficits as it is forecast to have positive cash balances. However London Coffee Co is looking at options to manage any short-term cash flow problems during quiet months. The bank has offered two solutions which the company is weighing up: (i) an overdraft or (ii) Revolving Credit Facility.

Tell the story behind the numbers

OVERDRAFTS The bank has offered London Coffee Co a £1,000 overdraft facility. It is an uncommitted facility which means the bank can choose whether to lend or terminate the facility at its discretion. The amount drawn from the facility is repayable on demand, which makes it unsuitable for certain purposes, such as funding a business acquisition. It is straightforward setup process although the interest rate on the overdraft is high and only this limited amount can be borrowed. REVOLVING CREDIT FACILITY

LONDON COFFEE CO - BALANCE SHEET SNAPSHOT Actual

Forecast

Forecast

SOURCES OF FUNDS

2013

2014

2015

Current liabilities Short-term debt Accounts payable Income taxes payable

0 3,000 2,000

0 4,800 4,598

0 5,600 7,475

Long-term liabilities Long-term debt Provisions

15,000 500

14,000 750

13,000 1,000

Total Liabilities

21,500

24,148

27,075

Equity Common stock Share premium Retained earnings

100 11,000 5,300

100 11,000 13,978

100 11,000 19,598

Total Equity

21,400

25,078

31,058

The bank has also offered a committed facility that provides a £10,000 maximum that can be borrowed over a fixed term of 3 years. London Coffee Co can draw down as much or as little money as it requires at any time, and repay outstanding advances that are no longer required. Any amounts that are repaid can also be re-borrowed. The company can select an interest period and fix the interest rate it pays over that period for each advance it draws. At the end of an interest period, the company can decide whether to repay or "rollover" the advance into a new interest period. To arrange this flexible facility, the commitment fees are higher than an overdraft. There is also a minimum notice period of 1 week before an advance can be received and a £2,000 limit on the amount that may be drawn at any one time.

DEBT FINANCING: FACTORING Tell the story behind the numbers

LONDON COFFEE CO - BALANCE SHEET SNAPSHOT Actual

Forecast

Forecast

2013

2014

2015

Current assets Cash and cash equivalents Accounts Receivable Inventories Other Current Assets

500 400 1,000 2,000

6,926 600 1,200 3,000

15,733 800 1,400 4,000

Long-term assets Deferred taxes Goodwill Property, plant and equipment

1,000 2,000 30,000

1,500 2,000 28,000

2,000 2,000 26,200

USES OF FUNDS

HOW FACTORING WORKS London Coffee Co Clients

The Factor 5. Factor transfers remaining funds

London Coffee Co also makes outside of its store by delivering coffees to local businesses. The company invoices these clients, requesting payment within 30 days and books them in the accounts receivable. At the end of December 2013, London Coffee Co had £400 in invoice value that is awaiting payment. Sometimes, these payments are received after 30 days. On other occasions, the company can be running low on cash for operations and cannot wait until for these payments are made. To free up cash for use in the business, London Coffee Co decides to use invoice factoring which offers the company a cash ‘advance’ in exchange for the value of these invoices. The ‘Factor’ offers 70% (£280) cash advance for the invoice value immediately. The remaining £120, the reserve minus the factor’s commission and other charges are paid to London Coffee Co once the local businesses have transferred the £400 they owe to the factor. The emphasis is on the value of the invoice which is essentially a financial asset. The seller is borrowing against its debtors.

less commission fee

London Coffee Co

By selling these invoices to a factor, London Coffee Co can quickly release cash which is tied up. The company also avoids the risk of non-paying clients as factor takes ownership of the invoice.

DEBT FINANCING: CAPITAL LEASES Tell the story behind the numbers

Example Coffee Machine Lease Value: Residual Value: Lease Duration: Interest Rate:

Monthly Lease Payment:

£10,000 £2,000 36 months 6.0%

£365

London Coffee Co is planning to upgrade its coffee machine to serve premium-quality coffee to its customers. Instead of buying the machine outright for £10,000 in cash, the company wants to lease the equipment over a fixed term. The company will make monthly payments at an interest rate of 6% to the manufacturer over 36 months in exchange for ownership of the equipment. At the end of the lease term, the machine is expected have residual value of £2,000. Using present value calculations, London Coffee Co will need to make monthly lease payments of £365 over the period. The company benefits as the lease frees up a significant amount of capital and spreads the cost over its useful working life. As a result, London Coffee co can now lease the most advanced coffee machine which it would otherwise have not been able to procure if it were to make an outright purchase. In the lease contract, there is also an option to upgrade to a newer machine during the lease period so the company can adapt to new technologies. As a capital lease, London Coffee Co assumes some of the risks of ownership - the lease is recognized as both a non-current asset and liability (the lease payments) on the balance sheet. The company can claim depreciation each year on the asset and also deducts the interest expense from the lease payment each year which will offset against its pre-tax profits.