Debt Management

Governments worldwide are trying to jumpstart their economies after the Coronavirus induced economic slowdown. Loans and grants are being given to businesses in order to increase economic activity and reverse the slowdown. The situation in Nigeria is more urgent following the #ENDSARS protest. Nigerian national and sub-national governments have developed programmes to give loans to young entrepreneurs in order to address the one of the grievances of the protesters – high, unsustainable levels of youth unemployment. Majority of these youths would never have handled the amounts of funds now being offered. Many would never have taken interest bearing loans before and therefore, are unable to comprehend the damaging effects of compound interest. How should we (youth and young-at-heart) take advantage of the generosities of governments without creating a ticking time bomb that would negate our efforts and take us backwards?

Firstly, take only what you need. Do not take a loan higher than what your business needs just because a higher amount is available, or your mates are taking a higher amounts. If you take more than you need, it is obvious that the extra amount would be frittered on non-productive things (e.g. extra laptops) or diverted completely out of the business. If you take additional debt and spend it on non-productive items, your business cannot generate the revenue for repayment of that higher loan. You will set yourself up for loan default.

Revenue to loan repayment ratio is very key. You do not want to use all your revenue for debt servicing (loan/ interest repayment). You should have a healthy amount after debt servicing for running your business comfortably without having to look for additional funds. The rule of thumb ratio is 33%. You should not spend more than one-third of your sales revenue on debt servicing, if you do, it means you are taking more debt than your business can bear.

Even when you take the exact amount needed, do not draw the whole loan immediately. Interest is only paid on the amount drawn, therefore any delays in drawing would reduce your interest burden. So, delay withdrawals until they are become necessary. The same principle applies to repayment. The faster you reduce your outstanding balance, the lower your interest. That is why two businesses can get the same loan amount, approved on the same day, at the same interest rate, and yet pay significantly different interest amounts.

This brings us to the credit facility structure.

Should you take a loan or an overdraft. Simply put, a loan is for long term expenses and repayments are periodic. While overdrafts are for running expenses and the account balance can fluctuate up and down within an approved limit; so that you can pay in sales revenue into the account to reduce the deficit balance and consequently reduce your interest burden. Therefore, negotiate with your bank to divide the credit into two – loan (for machinery and equipment) and overdraft (for salaries, utilities, and raw materials).

Interest bearing credits charge compound interest. Interest is charged on whatever you have outstanding to the lender. If you delay payment of loan and/or interest, interest would be compounded on the interest. Interest is charged monthly, so even if you are given a moratorium (grace period) before loan repayment is due, interest is being calculated and charged, and interest is charged on the outstanding, unpaid interest during each month of the grace period. Therefore, insist on paying your monthly interest, even during the moratorium. This way you would reduce your interest burden.

Low interest rates accompany government sponsored palliatives. If you are on the normal bank loans programs, ensure you are getting the lowest rates possible. Always negotiate. Pay attention to penalty rates too, these are charged on late loan repayments, on top of the normal agreed rate.

Why are we placing so much emphasis on interest burden? Because interest is taken out of your profits. The less interest you pay, the more profit would accrue for business growth and for motivation to continue the business. Also, compound interest is the cause of many business failures because the business did not manage it well.

Entrepreneurs should also look for non-interest funds e.g. grants and Islamic finance products. Others include suppliers’ credit (you collect raw materials and pay at a later date) and upfront payments (customers pay upfront for goods and services) – this way you have access to free funds to run your business more profitably.

Debt is an excellent leverage to propel any business to higher levels, but it must be managed with great caution. Happy investing.

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