Let’s say you’ve been quoted a Line of Credit at 14% APR, but your net profits on sales are 14%. (Example only)
When looking for a line of credit product, a business owner must first consider the true cost and effect on their bottom line in relation to the overall profit margins of their business.
There are sometimes a misconception around how much it costs you based on direct transactions that needs to be put into perspective when considering the costs of taking a loan.
Let’s go over some key points:
Let’s say your profit margins are 14% so you think you shouldn’t take a line of credit that costs more than say 14%…(of course it would ideally be less)
At first this statement makes sense at face value however, it misses several variances that can stymie a small business owner’s ability to correctly price up the true cost of a financing offer, including:
- What profit margins are you referring to? Gross profit, NET or EBITA?
- How is the financing priced? Does it use a base interest charge, APR or some other form of pricing like a factor rate?
- How long will you rely on the financing to capitalise your business and grow?
- Funding should be based on whether, if, and how much it allows the business to grow and the net affect it will have on profit margins.
Let’s look at a case study:
Consider you’re a borrower who wants a loan to help purchase new stock for a manufacturing business. You would be able to ship more product to customers if you had a consistent source of working capital to pay the suppliers that sell you raw materials. However, you manufacturer a product that is highly competitive and net profit margins on any products you produce aren’t very high—in fact, they sit at approximately 14%.
You consider taking out a line of credit for short-term cash flow requirements and straight away believe that any loan costing 14% would eat away all the profits. After some further investigations by the lender, they learn that you manufacture and sell your products in less than 4 weeks after purchasing the raw materials from your supplier. In a typical transaction, you would pay a supplier $50,000 cash and sell it to your customers with a 28% markup. After factoring in all costs including your operational expenses, you bank a 14% NET profit, or $7,000 on the sales.
Now, if it were to cost you $7,000 (14% of $50,000) per transaction in financing costs to secure a line of credit, you might think all of your profits would be eaten away. And there are certainly options out there that can cost far more than $7,000 in interest and fees on a $50,000 loan.
But what if you obtained the line of credit to fund the raw material purchases and paid down the line of credit as soon as the products were sold—in this case, four weeks? In four weeks time, at a rate of 14% APR, the financing cost for a line of credit would only be $538, leaving more than $6,462 of net profit in each sale and that’s not taking into account the tax deduction you would be applying for the financing charges that will add to your overall net profits (all things being equal).
The reality of this type of financing
Understanding how your profit margins are affected by the “headline” rate of a loan, as well as how that price translates into overall financing costs for your business is critical when evaluating your business loan options.