So, you took out a line of credit, but you forgot about the 30 day annual payout requirement on the line when you signed the commitment letter. You don’t have the cash to pay the line in full. So, what’s next? Maybe you took out a term loan for a piece of equipment. Cash flow is really good and you’re thinking about prepaying the loan to save interest expense. Good idea or bad idea? Well, it depends.
In both of these examples, either you or the bank might restructure the debt. If your line of credit has a 30 day annual payout and you don’t have the cash sometimes the bank will term out the line of credit and you can make monthly payments. In the second example, you’re thinking about accelerating the amortization by prepaying the loan. While you’re not signing a new note, indirectly you’re restructuring the debt and paying it off in a shorter period of time. To determine if debt restructuring for you is a good idea or a bad one, here are three things you should know.
- When making loans, bank matches sources and uses. What I mean by that is banks determine whether the use of funds is short term or long term. When the banker asks you what the loan is for is you’re borrowing money to carry your accounts receivable or inventory that’s considered a short term use (1 year or less), so a line of credit is used. If the loan is being used to purchase equipment, real estate, or acquire a business, that’s a term or mortgage loan because the term is longer than a year.
- Banks will attempt to match the depreciation schedule of the asset and the loan amortization so that the loan is paid out as the asset is fully depreciated. Generally, this is 3 to 7 years on equipment or other fixed assets and 15-25 years on real estate. The one exception to this is business acquisition loans. Amortization of good will can sometimes be longer than 10 years, but most business acquisitions through banks are funded with an SBA 7a loan. That loan has a maximum term of 10 years.
- If the use of funds for the loan changes, then the debt may need to be restructured. This occurs all the time in a line of credit. You initially intended to use your line of credit to pay expenses before your receivables came in. This is called temporary working capital (you borrow the money and pay it back when the receivable comes in). But what if your business is growing and you can’t pay the line back? Or you need that money for payroll or some other purpose? This is called permanent working capital. As your business grows, the amount of receivables you have grows with it and you can’t use your cash to pay back the line you need for growth. When this occurs, your line of credit can be restructured to a term loan. Many banks will term out lines of credit for this purpose on terms ranging from 2 to 5 years. Other purposes could be you used the line to purchase equipment, fund losses in your business or fund special projects that may not have an immediate payoff.
There’s nothing wrong with restructuring debt if needed. The things to keep in mind are:
- How will this decision impact my cash flow? Is there more or less cash required for debt service?
- How will this affect profits? Am I paying more or less in interest expense overall?
- Is the decision to restructure my debt in line with my overall business strategy?
