When a company borrows money, whether it is to finance an expansion, to cover working capital needs, or to acquire another business, preparation is required. It is important to understand that payments of principal and interest will often be required each month.

1. Interest payments are a tax-deductible expense and will appear on the income statement. Repayments of princi pal are not an expense, will not appear on the income statement, and are not tax-deductible.

2. Only the principal portion of the unpaid balance will appear on the balance sheet; it will appear as a current liability if it is due within one year or as a long-term debt if it is due in more than one year, or it may be split between the two categories. Interest is never a liability on the balance sheet unless a payment is overdue. This will be referred to as an accrued liability.

3. As previously mentioned, the key issues to be negotiated when arranging a loan are:

The amount: When the company is planning the project, a cash flow forecast is necessary, both for analytical purposes and also to present to the bank. Don’t ask for less money than you really need. This may impair rather than improve your negotiating ability. Some people believe, incorrectly, that asking for a smaller amount will enhance their chances of having the loan approved. However, being inadequately funded will hurt the project and may require you to cut back at a time when you are trying to build the business. This is very counterproductive.

The interest rate: Evaluate the issue of a fixed rate versus a variable rate. A variable rate may be tied to the London interbank offer (LIBOR) rate or the prime rate. For example, it may be quoted as ‘‘prime _ 2,’’ which means two percentage points above the prime rate. If it is tied to a prime rate, make sure that you know whose prime rate will be used. Will it be your bank’s prime rate or the rate quoted by the large money center banks, such as Citi, Chase, or Bank of America? Understand that when interest rates are moving higher, they generally move quickly. This is in the bank’s best interest. When interest rates are declining, they are often ‘‘sticky,’’ meaning slow to move.

The years of payments: The questions involved here are, ‘‘What is the maturity date of the loan?’’ and ‘‘Over how many years will the loan be amortized?’’ The first of these questions indicates how many years of principal and interest payments you will have to make. Make sure that the project being financed will achieve its potential before the maturity date of the loan. Also, if the project is projected to achieve a positive cash flow in three years, where will the company get the cash it needs to make payments in the first and second years? Payments must be scheduled (read minimized) in such a way that they are very low in the early years and then increase in the latter years. This permits the loan to be repaid with the cash flows generated by the project itself. If the maturity and the number of years of amortization are not the same, a balloon payment will be required, as mentioned previously.

Fees, compensating balances, and restrictions: Incorporate all fees into the loan. That saves cash for the project and postpones the payments over the life of the loan. Remember that a compensating balance reduces the amount that is actually available for the project.

Collateral: Keep it to a minimum. Try not to pledge all of your assets. Doing so restricts your future flexibility and creates greater vulnerability should cash flows not grow as fast as expected. Banks usually have loan/collateral formulas. Find out what these formulas are early in the discussions.

4. When negotiating, use your banker as an adviser. Her advice is free, and she is often very knowledgeable. Bankers’ conservatism serves as a protective mechanism. Your company has needs and will make substantial profits after your project succeeds. The bank has needs, as well. But its upside profitability is limited to the interest rate it can achieve on the loan.

5. Learn how to use the amortization schedule. An example follows:

Loan Amount $100,000

Time to Pay 5 years

Interest Rate 8.5%

The monthly payment will be $2,051.65. Total payments over the 60 months will be $123,099, broken down as follows:

· Principal $100,000

· Interest 23,099

· Total $123,099

The payments during the first two years will be mostly interest. In fact, after the first year, the amount of principal still owed will be more than $83,000.

The number of years of amortization can be more critical to success than the actual interest rate. If the same $100,000 loan has an interest rate of 9.5 percent (100 basis points or 1 percentage point higher) but is for a seven- rather than a five-year term, the monthly payment will be reduced to $1,634.40. To improve cash flows during the early years, a higher interest rate but longer term will be beneficial.

Consider a twenty-year amortization with a seven-year balloon. This means that the monthly payments of principal and interest are calculated as if this were a twenty-year loan. If this loan had a 10 percent interest rate, the monthly payment would be reduced to $965.02. What this means, however, is that after seven years, the principal amount will still be $84,072.45, and this balloon payment is due at that time. This could be dangerous if the company has the cash to repay the loan in the early years but diverts the funds to other uses rather than preparing to repay. When the balloon comes due, the company’s negotiating power is limited or nonexistent. The best strategy might be to arrange the twenty-year amortization and then begin to prepay after a year or two. The company can also prearrange a schedule of two years of reduced payments and then extra payments for years three through seven, after which the loan will be fully paid off.

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