The True Cost of Capital
Money is blood, and its terms are critical to the survival of your business! I’ll be releasing a series of articles, (this is one you want to save), where I’ll reveal several key terms and calculations you need to be aware of when working out the true cost of capital across different financial products!
Now to be clear we are not saying these financial solutions are bad, each has a place and time, but what is important is that you are aware of them!
Unsecured cashflow loans (read here) /lenders, fall part of the private lending market, and there are many private lending products out there. Sometimes small business require them to fill funding shortfalls when banks can't lend. You can read more here from the RBA as to why these lenders exist.
To be clear unsecured cashflow loans are not products that fall part of our private lending offerings.
Effective Cost Vs Face Value Interest
There are two fundamentals you must be across.
- What is the true / effective rate of interest – not face value?
- What is the principal amount of money borrowed that is available to you to use. There is very little use of having large loan amounts if repayments are P&I and prevent effective principal being put to use.
Unsecured cash flow lenders
What they sell
Unsecured financial lending products, that don’t always charge interest but rather a fixed fee or a discount rate (quasi debt factoring system), for a fixed period. They typically look at your trading revenue and lend you 10% to 20% of your yearly revenue, then claw it back via P&I repayments from your top line!
Key calculations
One lender offered a loan amount of $550k, with an 8-month loan period, and fixed repayment of $731k to be paid in P&I repayments over the 8 months.
- That means as a borrower you’re paying $181k in fees on $550k over 8 months, which you may calculate as 181/550 = 33% for the period (8 months) or annualised to 53.6%p.a!
- A different way to look at things is because your balance of funds is reducing over 8 months from $550k to 0, your average balance of funds available to you, you could say is $225k on average.
- Which in effect means the fixed fee of $181k, is being applied to an average balance of $225k, which really in effect its true cost is 80.4% for the period of 8 months!
Lessons in borrowing
- P*I repayments are not always your friend, especially for short term loans.
- Fixed fees / discount rate are just another form of interest being charged.
- Always calculate what the effective rate is based on fees and the average principal available to you!
If you are going to use these financial products, then the inconvenience solved, must be greater than the cost.
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