Borrowing for Leverage

Borrowing is justified for leveraging operations of a business entity. There is a cost attached to borrowing, which needs to be kept at a minimum if a loan is to be meaningful and profitable to an organization. It is prudent to always consider the cost of borrowing as well as the cost of not borrowing according to the needs that arise prompting to you to consider borrowing.

Borrowing may be done through equity financing or debt financing. Equity financing is generally done to get a company off the ground although it may be resorted to at times of a major expansion. A company for its intermittent special cash needs would raise debt by issuing debentures and various types of bonds although the more popular form of debt financing is through banks and other financial institutions. Most lending institutions lend for all purposes without discrimination while some specialize in lending for specific purposes only.

Borrowing is not necessarily a sign of financially instability. The healthiest of corporations too carry some level of indebtedness to lending organizations. Some loans carry significant tax concessions on the interest or the principal components or both. Take advantage of institutions that lend for specific purposes at concessionary rates of interest. If you are borrowing for adding motor vehicles or plant and machinery, consider the option of leasing instead, with their inbuilt tax benefits. Never rush to borrow. Always borrow only the minimum required and as late as is practically feasible.

When borrowing, there are many factors that need to be considered carefully before deciding on your prospective lender:

  • Obtain quotes from the best banks and reputed financial institutions for the capital required. Having segregated the best quotes, negotiate further on the rate of interest, other finance charges and all loan terms in general.
  • If the project envisaged is expected to take some time before yielding income, search for a lender who agrees to deferrals on interest or principal, or both. Make sure that you provide for cash flow to meet repayments when installments start falling due.
  • In order to have a safe working capital to play with, re-schedule whatever possible loans to be repaid over longer periods with smaller monthly installments. A disadvantage in spreading the loan over a longer period is the increase in the total cost of the loan to the organization.
  • Make your ultimate choice of the prospective lender on the basis of an analysis of the total effective cost of the loan offered by each. This may be done by creating a realistic scoring system that assigns due weighting to the factors involved according to their level of impact on the finances and cash flow of your organization.  Study each package in detail with special emphasis on interest rate and all other financial terms including repayment period allowed with or without deferrals on interest and/or principal. Pay special attention to what is in small print. That is the area, which often contains the most restrictive or obnoxious terms (if any) of an agreement.
  • Always match long term needs with long term loans. They will invariably be secured loans carrying more favorable interest rates and/or deferred payment terms. A disadvantage is the penalties imposed if you try to settle these loans earlier than as scheduled in the contact. As such, long-term loans should never be taken for short term funding requirements, and especially for those of a seasonal or short-term recurrent nature.
  • Rolling the total interest payable over a loan’s entire life into the principal converts it to a bulk amount to be repaid over a specified period in equal installments. It makes the repayments easier to manage and work with. Additionally, it spreads the total cost too, uniformly over the life of the loan.
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