Should You Refinance Your Company’s Debt?
Refinancing a company’s debt can help if a company has a debt problem. However, determining if there is a debt problem is not always easy.
Some debt problems are obvious. In some cases, though, debt problems may be just one of many financial problems that the company is facing.
Each financial scenario often requires a different approach. The most important takeaway is that an owner should engage a CPA or the company’s finance team to help determine the root cause of the issue. Hiring a CPA may seem expensive, especially if funds are short. However, not hiring one and going down the wrong path is more expensive.
Four questions for refinancing
An owner can often get a good idea if their company could benefit from refinancing by asking four targeted questions:
1. Are debt payments taking most of company revenues?
One sign that a company has a debt problem is when payments take up a significant portion of revenues. This situation affects cash flow and interferes with the ability to operate a company. It can also hinder the ability to pay expenses, take on new projects or build a cash reserve.
Having significant debt payments further exposes a company to seasonal or market fluctuations. While debt payments are fixed, revenues are not. A drop in revenues, for whatever reason, could trigger a cascade of financial problems.
2. Does a company have too many cash advances?
Merchant cash advances are short-term loans with very high interest rates. These advances have become popular in recent years because business owners can get them easily and quickly.
Unfortunately, some companies misuse this type of financing. They apply a cash advance to manage situations that cannot be resolved with an advance. Misusing cash advances ultimately creates an even greater financial problem.
This unfortunate cycle can repeat itself if the company gets additional advances in an effort to fix its growing problems. Consequently, the company ends up with multiple advances. Having multiple cash advances is called “stacking.” Stacking is a serious situation that often leads to a company’s downfall.
3. Is the company juggling debt or supplier payments?
Companies with debt problems often have to juggle payment dates, for both lenders and suppliers. They use this tactic to ensure they have enough money on specific dates to make debt payments. Juggling payment dates is a symptom of cash flow problems. It could also indicate a debt problem.
However, the problem could be elsewhere, for example, in accounts receivable. This type of situation requires a careful review to determine the root cause of the problem.
4. Is the company’s interest rate very high?
Lastly, a very high interest rate often indicates that refinancing could be beneficial. Keep in mind that the concept of a “very high interest rate” can be a matter of perception. Compare rates against market rates (for the same product) and determine if new financing is cost-effective.
Advantages and disadvantages of debt refinancing
The most important advantage of refinancing debt is that monthly payments will be lower. This is because the new loan will have a longer term, a lower rate or both. Lowering debt payment has an immediate, positive effect on cash flow.
Additionally, managing debt payment should be simpler, especially if a business consolidates multiple loans into a single loan.
There are also some potential disadvantages to refinancing. The main disadvantage is that the business could end up with a longer payment term.
This outcome was listed as an advantage, but it may also be a disadvantage.
Extending the payment term affects the total amount of money paid for financing. This total is calculated by multiplying the amount of each payment by the total number of payments in the loan. In some cases, the total payment may be higher than it was for your previous loan.
Lastly, debt refinancing may be used for the wrong reasons. Refinancing can help fix past bad financial decisions. However, it cannot fix a broken business model.
Refinancing options and processes
In principle, a company can refinance any kind of properly executed debt.
The most common types of debt that can be refinanced are:
- Cash advances
- Term loans with balloon payments
- Equipment loans
- Shareholder loans
- Corporate real estate.
If a company needs to refinance up to $5 million, the best option is to use a Small Business Administration-backed loan. Otherwise, the owner can also consider a conventional bank loan.
SBA-backed loans have very attractive rates and can be structured to meet most of a company's needs.
The only drawback of using this solution is that loans require some paperwork. Lower rates and better terms require significant due diligence by the lender. In turn, this effort requires more information (documents) from the owner.
The first step in the process should be to meet with a lender to discuss the specifics of the situation. The lender should give a good idea of what they can provide.
If an owner decides to move forward, most lenders will ask for the following:
- Personal tax returns
- Personal financial statements
- Business tax returns
- Business financial statements
- Business debt schedule
- Projection of future sales (sometimes)
- Payment history for loans being refinanced.
As noted above, lenders will ask for personal financial information. This is done for two reasons.
First, lenders consider how owners manage personal credit as a proxy for how they will manage company financing. It is not a perfect measure, but it works reasonably well. Fortunately, the SBA guarantees loans specifically to help folks with less-than-perfect situations. So, don't let that be discouraging.
The second reason lenders look at personal finances is because the owner will be a loan guarantor. Contrary to popular belief, SBA-backed loans require personal guarantees. The SBA is only the guarantor of last resort if the lender is unable to recover from the borrower.