Given the news in the general media,
many firms are pulling back instead of
being aggressive in the marketplace.
With some banks under fire, credit everywhere is tighter. However, every tough spot
in the market for one business might represent a business opportunity for another.
Smart Business asked Tim Kelly, vice
president with Fifth Third Bank in
Cincinnati, for some tips on balancing risk
and return.
Is this a prudent time to be leveraging
assets?
For many firms, it may not be a prudent
time to take on additional leverage.
However, if by prudent time you mean that
a viable opportunity exists, then it is always
worth taking the time to consider whether
or not deploying capital is appropriate.
Capital is clearly less plentiful today than
12 months ago and is priced accordingly.
That must be considered as part of the
analysis. However, the underlying strength
of the opportunity could be tested in the
event current economic conditions persist
longer than anticipated and must be considered as well, provided satisfactory due
diligence has been completed.
If the expected return on the project or
opportunity outweighs other opportunities
available — plus the cost of obtaining capital — then it would be considered a prudent investment. Companies that have
developed and maintain strong balance
sheets are generally in a much better position during economic downturns to take
advantage of more opportunities. This is
not only because others are not able to pursue such opportunities, but also due to the
fallout of weaker competitors. This is
when having ‘dry powder’ can really work
to a company’s advantage.
What about the cost of capital these days? Is
it good to borrow when money is more
expensive?
The cost of capital is impacted by supply
and demand and, therefore, more expensive today than at times in the recent past.
It is important, however, to note that on a
relative basis, the cost of debt or capital is
still considered low. The prime interest
rate is only 5 percent today while the average prime rate over the past 20 years was
7.5 percent, a significant 33 percent discount from the average. Additionally, the
30-day LIBOR rate, a typical index for pricing commercial debt, is at 2.45 percent
today versus a 20-year average of 4.84 percent. That’s nearly a 50 percent discount.
As long as the expected return for
deploying capital exceeds the costs associated with obtaining the capital or debt, it is
worth considering.
Isn’t leveraging assets a change from getting
loans based on cash flow?
Yes, leveraging or borrowing against
assets is different than borrowing against
expected cash flows. As would be expected, borrowing against assets is less risky
because there is typically underlying or
secondary value regardless of the performance of a company. Borrowing based on
future cash flow that may not occur has no
underlying value, hence it is more risky.
When capital is scarce, less risky or asset-based financing becomes more prevalent.
Which assets are more likely candidates for
leveraging?
Most assets are generally available for
borrowing against, and which asset to be
leveraged would depend on the financing
need/reason. If a company is growing/
expanding, then the likely need for capital
is to support the timing differences associated with carrying additional accounts
receivable and inventory. In this case, these
current or short-term assets would be the
assets likely to be leveraged to support the
short-term nature of the borrowing need.
For longer-term capital needs, such as
equipment, expansion, real estate or even
permanent working capital needs, then
longer-term assets would be the likely candidates to leverage.
Aren’t values of assets like real estate and
many vehicles down?
Generally, real estate values have declined over the past year or so. However,
real estate can still be leveraged based on
current values and current underlying cash
flows that support repayment of capital or
debt. The generally accepted loan-to-value
ratio for borrowing against real estate is
80 percent, assuming there is a sufficient
income stream to cover the debt service or
principal and interest of the loan.
How can I be sure I’m not overextending?
Model future expectations and ensure
that with the most conservative projections, repayment requirements or minimum returns are still achieved. While
entrepreneurs are typically considered
experts in their respective fields, it is generally a good idea to work with your financial advisers to help determine the right
amount of leverage given the company’s
current financial strength and the potential
of various opportunities. Obviously, your
banker or CPA would be excellent experts
to call on to help determine the appropriate capital structure for your situation.
TIMOTHY P. KELLY is team leader/vice president in the Middle Market Commercial Banking Group with Fifth Third Bank in Cincinnati.
Reach him at [email protected].
