5 Areas Where Small Business Makes Financing Mistakes
IRVINE, Calif. — When taking on financing as a small business, the correct course of action always hinges on answering this question: What are you trying to accomplish? Small businesses often miss the vital details when they assess whether to borrow, such as the full financing cost, the drain on their time, the opportunity costs and baked-in fees.
The right financing option varies for every company, but there are five areas where small businesses frequently make financing mistakes:
- Be aware of your real interest rate. If you borrow $1,000 and pay $1,100 back over three months in weekly installments, for instance, your interest rate wasn’t 10%, as simple math would dictate. Taking a closer look at the time frame for the note and your average principal outstanding reveals that it’s closer to 80%. That’s a difference of 70 percentage points in your financing cost.
This mistake happens because most businesses simply calculate annual percentage rate (APR) as total fees divided by the amount borrowed, rather than calculating the interest based on the amount outstanding at every point in time (i.e. the amortized amount). The difference is massive for small businesses as financing mistakes are compounded. In the example above, the actual annual rate is eight times higher than the optical.
- Pay attention to hidden fees. Many lenders charge origination fees of 3% to 4%, which are deducted from the loan amount. Depending on how quickly you pay that loan back, that fee can have a large bearing on the true interest rate you’re paying. A $30 fee on a $1,000 loan is really a 3% fee up front that will significantly skew your real APR, especially for short-term loans.
When borrowing money, be aware of the fees that accompany the capital infusion: administrative fees, application fees, contract fees, due diligence fees and more.
- Treat opportunity cost like a real cost. Banks routinely take up to two weeks to review a loan application and, if approved, another 15 to 60 days to fund the loan. For executives running a business, that’s time they could have spent generating sales and tending the company.
- The intangible costs for smaller or short-term loans can be greater than interest. The loan amount and pay period matter a great deal. Often, companies in need of working capital are borrowing smaller amounts and paying it back over shorter periods of time than traditional, long-term loans.
These need to be approached differently than longer-term loans for large amounts. In these instances, the actual interest rate can be the least important consideration.
Since the amount sought is small and paid back rapidly, such financing wouldn’t accrue the large amortization costs common in loans of six months or longer.
Sometimes, costs outside of the actual loan should take priority. For example, if you pay a bookkeeper $50 an hour to work on processing a loan for two hours, that’s $100 that needs to be assessed on the total cost of the loan and is often a greater cost than the interest itself.
- Financing occurs far more often than we realize. Giving your customers a 2% discount for paying within 10 days rather than 30 days is really a 2% finance charge equivalent to a 73% APR.
In another scenario, if you’re offering your customers a 10% discount to pay immediately or pay full price on net-30 terms, you may have a better alternative. The alternative would be to get financing, which may cost you 4% for the month and then receive the full payment in 30 days. In this case, financing saves the company 6%.
Similarly, if you let customers pay with a credit card, you are essentially incurring a 3% financing fee to grant them 25 days to pay, since that is the “float,” or grace period of most credit cards. That is almost a 50% APR.
Copyright 2023 The Business Journal, Youngstown, Ohio.