Yesterday, the Bank of Canada announced that is overnight lending rate would stay put at 1%.
On the surface this would appear to be good news, but for whom?
If you’re a consumer with a variable interest rate mortgage, this is very good news as your mortgage rate is not likely going up.
If you’re a business owner that can qualify for low risk credit, your cost of going business isn’t going to increase due to more financing costs.
But for most sources of consumer or business financing, a change in the rate doesn’t really make a whole lot of difference which is where the perception issue comes in.
Because individuals read and hear about the low levels of the prime lending rate, they automatically believe in many cases that this represents the average cost of money or somehow reflects the cost of capital that would relate to them.
The prime lending rate posted by banks is basically a low risk lending rate where there is very little chance of the bank losing their money on a loan in the event of default.
If this is not the case, then the cost of money is appreciably higher to compensate for the relative risk.
So on the surface, a business owner may somehow feel entitled to a lower cost of financing than he or she can find on the market. But in reality, interest rate perception should be more about your cost of doing business and how to reduce it over time.
Let’s take credit cards.
While there are a wide range of credit cards on the market, most carry a pretty healthy, and some would even consider obscene interest rate. And while we all grumble about this, its pretty much accepted as the way things are and unless we are carrying balances month to month, it doesn’t really matter.
But from a business owner’s point of view, certain credit cards charge the vendor a fee for processing their customer transactions, which is a big part of the their profit stream. And this cost isn’t cheap. It can range from 1.5% to upwards of 3.0% of the value of the transaction.
If customers expect to use certain credit cards that charge a vendor fee, then its a cost of doing business which either needs to be built into the price, or paid from the existing margin. If you can’t do that, then you can’t provide the option to the customer.
Similar with asset based financing, most notably factoring, or invoice discounting, where the business can be paying anywhere from 1% to 3% a month on invoices they finance in order to generate more working capital to purchase inventory, pay supplier bills and so on.
If the cost of financing can’t be reduced by some combination of early payments to suppliers, purchase discounts, price increases, then its a permanent cost of doing business that either can or can’t be covered by your margins.
Over time, as your business builds financial strength, cheaper forms of money will likely come available, at which time your cost of doing business will go down.
The key for any business owner is to understand the relative cost of financing for his or her business and then decide whether or not they can compete in the market place with that cost and grow to a size and level of efficiency that can qualify for cheaper credit.
The cost of money is a true barrier to entry as well as business killer if you don’t understand it properly and manage it well.
If the prime rate is relevant to your business, then pay attention to it. If its not, don’t waste valuable time chasing something that you’re not going to be able to get a hold of in the near term.
The prime rate being low is good for the economy as a whole which is likely going to be at least an indirect benefit to most businesses. But that doesn’t mean it going to reflect your personal cost of capital.
As baby boomers inch towards retirement age, those that own small businesses should be considering their exit strategy if they haven’t already.
With a majority government in place, commercial financing loosening up, and interest rates staying at relatively low levels, the current environment for sellers is gaining strength.
On the flip side, you never know when a window of opportunity can close, so putting things off for a couple of years could lead right into a tougher market.
And let’s face it, the last 4 years have not been a whole lot of fund for sellers. Sales have been down, profits are down, and buyers have been struggling to secure the capital necessary to complete a purchase.
But if you own a business and want to take a serious run at selling in the short term, then here are some things you may want to consider.
First, make sure that your business is in a sell-able position or attractive selling position. This is accomplished through three years of accountant prepared financial statements at a review engagement or audited level. Notice to reader statements are not going to cut it for anyone that is going to require financing. Outside of being able to support the numbers and performance, the next big item on being attractive is the ability for the existing owner to exit without causing business disruption. If everything is still flowing through the business owner’s hands and dependent on their direct relationships on customers and suppliers, then the chances of transitional business failure are going to be higher, which will impact price and sale-ability.
Second, be prepared to work with the buyer to come up with a purchase and sale transaction that is going to be win win for all sides, including a third party lender. It’s unrealistic in most situations to just ask for a selling price, collect it, and exit stage right with no further involvement or risk in the transaction. If the transaction needs to financed by a third party lender or investor, they are going to expect that the seller is going to help reduce the risk of loss through transition assistance, meaningful recourse agreements if financial disclosure proves to be inaccurate or misleading, and business financing assistance to at least cover off the value of goodwill built into the purchase price.
Business owners that get properly prepared for selling and actively participate in the process to secure a buyer are more likely to sell faster and for good value than those that do not.
Not too long ago, most of the major lenders still worked under a regional financial model where the bank manager had a significant amount of lending authority and decision making.
Overtime, this proved to be a very dangerous way to operate as individual bias and relationships could skew the decision making process and could ultimately lead to loans being made that were not in the best interest of the lender and the lender’s owners or shareholders.
Similar to most major companies, there is now a clear separation of duties in the organizational and decision making hierarchy of the marketing/sales group, and finance/underwriting group.
Taking it even one step further, while marketing and sales can recommend loans, only underwriting can actually approve or put them forward for approval if a board or higher level of signing authority is required.
Yet, despite this well defined operating structure that has been the standard for close to ten years in the lending world, most business owners still think that their local branch or even regional manager can pull a few strings and get their application approved.
Sorry folks, but that’s not going to happen.
What’s even more confusing to anyone looking for a business loan or business financing facility is that the people you speak to at the bank (marketing and sales folks) will almost always be very interested in speaking with you about your requirements and are prepared to spend time collecting your information, even if there is very little hope of the deal ever getting funded.
Sometimes this is a function of the front line sales team not keeping up to date with what the underwriters are approving, sometimes this due to too much turnover at the sales position where you’re almost always dealing with someone new or fairly green, and sometimes its because the sales force has an incentive to collect applications, regardless of how irrelevant they may be.
So how’s this relevant to today’s post?
As a business owner, you need to be more well aware of the financial parameters of a given lending institution. You may not be able to know exactly what they’re approving at any given time, but its not to hard to get a grasp of their basic lending criteria that is always in place.
Taking any amount of time to “sell” a deal to lender where the fundamentals of the deal do not fit their lending criteria is going to be a waste of time 99% of the time.
Its easy to get caught up in a false reality of who can help you when everyone you come in contact with at a given lending organization appears to be very interested in your deal. But lets not forget, the front line folks can’t lend you money. In fact, its not uncommon that during a business financing application process that the applicant never meets or even speaks to the real decision maker or makers.
And spending too much time barking up the wrong tree can take months and months of time before you realize nothing is likely going to happen, which is another problem in the lending world and that’s a failure to get to “NO” quickly.
When seeking business financing, its important to thoroughly understand the fundamentals of your business financing request and then making your application for financing to a lending source that’s going to be able to lend against those fundamentals.
Spending too much time trying to convince front line individuals how great your planned use of funds is when they work for lenders that aren’t likely to be interested is likely going to be a waste of time.
Have you ever heard a business owner say they acquired asset or entered a market for “strategic reasons”?
Or what about businesses that are build on the foundation of subsidies and market protection schemes?
As one of my old mentors used to tell me, if what you want to invest capital in isn’t profitable then its not very strategic.
As I was reading an article on the failings of Ontario’s Green Energy Act ( here’s the article link … http://opinion.financialpost.com/2011/05/16/ontarios-power-trip-the-failure-of-the-green-energy-act/ ), which by the way is not only quite informative but also written to entertain, I couldn’t help thinking about how this type of misguided approach applies to so many small business failures.
Any time there are any artificial supports present in the market that hold your position or even allow you to compete in the market or cause the market to even exist in the first place, over time the outcome is not likely to be very good.
Even if you’re not dependent on subsidies or some form of industry price protection, market access, etc., there are other things to consider.
For instance look at the Canadian manufacturing sector where may of its members built a business on a $0.75 Canadian/U.S dollar ratio.
But what happens if the dollar moves to parity as it has done before in the past? Not likely going to happen. Right? Wrong.
Instead of getting costs inline to be able to protect against such a movement in a highly dependent variable that makes or breaks the business, many companies choose not to and as a result are out of business today.
And the great thing about the last example is that while the dollar is at $0.75 and you reduce your costs to be able to compete at par, the short term upside is that all the cost savings are profits. Not a bad incentive to making sure you’re competitive.
When I was in the corporate world, the business movers and shakers would always be selling us finance guys a load of crap in terms of their market assumptions for key investments they wanted to make.
As the finance guy, my job was to be the counter balance to the hype and try to ascertain if we were trying to build a foundation on sand or stone.
When the numbers didn’t materialize, costs are now higher, and profits are lower and if that ends up killing you or your project, the next guy comes along and buys the assets at their true market value where money can be made.
Creating any type of business or growing an existing business that is not designed to be competitive on some scale does not make any sense, period.
Sure, you may be able to get away with taking such an approach for a period of time, but in the end things are going to come apart.
The problem for many small businesses is that if it doesn’t come apart in the first generation of owners, its only a matter of time until the next generation or two takes the hit.
I guess one can rationalize that you don’t care if everything falls apart when they are retired or no longer dependent on the business for financial returns. But I say that’s pretty short sighted and a very opportunistic way of thinking, and then when things do blow up, the same business owner starts yelling fowl and want a new form of support to replace their lack of business finance fundamentals.
Getting it right can take some work.
But the alternative is too much like gambling which, in my opinion is why there is such a high level of SME business failure.
If you’re a small business or medium sized business owner then you are both business person and investor.
The process of starting a business and growing it must have a considerable and continual focus on risk management for a number of reasons.
First, without eliminating, identifying, and mitigating risk, you always put yourself in a position to be shut down by events you no longer can control or influence.
Second, you’re ability to attract capital and lower cost forms of capital is highly dependent on your ability to show that you have historically been able to manage risk and that you have accurately identified and mitigated existing risks to a satisfactory level.
Third, you put your own hard earned equity in jeopardy which can set you back years and create a level of stress and disruption that most people would want to avoid at all costs.
I came across this article for managing risk in the Financial Post. http://business.financialpost.com/2011/05/11/no-need-to-dread-investment-risk-just-manage-it/
And while its geared more to a pure investor, the points made apply to SME’s as well.
Its interesting that when I talk to entrepreneurs trying to raise capital, the attitude many times is that you have to take risks and that just comes with the territory.
Their focus is to aggressively market their opportunity, taking the position that the strong upside potential will more than make up for any and all risks they face as a new business or an existing business taking a leap into a new area of business opportunity.
Which is also why start ups and acquisitions have such a high failure rate and why they have such a hard time attracting capital.
Sources of business financing capital, either in the form of debt, equity, or a combination of the two, are certainly looking for opportunities to extend loans or make investments as that is how they make money.
But what they are also looking for is a business model and opportunity that has done a good job of identifying the risks that further capital investment will bring along with a plan to address and mitigate these risks in an acceptable fashion.
There is always going to be risk of loss for everyone involved. But having an approach that demonstrates risk management has a much better chance of raising capital than one that does not.
Let me further add to this last point…
The less focused you are on risk and risk management, the harder it will be to locate and secure capital, the more likely the cost of financing will be higher, the more likely that the terms and conditions of business financing will be more difficult to meet and manage, and the collective result of the above is that the risk of failure has also increased.
During economic times when there is abundance of money that needs to be placed by money managers, the prospects for getting money for the aggressive business owner or entrepreneur could still be very strong.
But right now, we are not in such times, and the more sure path to money is by demonstrating your ability to manage capital and keep it.
And as the article linked to above states, “if it keep awake at night, it’s too risky” should always be factored in before you accept any type of business financing commitment.
Since the start of the 2008 recession, business acquisition financing dynamics have changed considerably and will likely remain in their current state for the foreseeable future.
What state is that you ask?
The ability to close an acquisition requires a greater reliance on cash and higher cost bridge financing, especially for company purchases where a market discount is obtained.
Next to start up financing, major bank or secondary institutional financing for a business acquisition is the most difficult form of financing to secure.
This has only increased over the last three years as banks and other institutional lenders increase their requirements and take their time before issuing any prime plus debt obligations.
The result is that businesses for sale that are well set up for meeting all the lending requirements of cheaper money are typically not in a hurry and are going to command a premium.
If you are looking for value in the market, then a motivated seller is going to be required where things on the inside of the business may be a bit ragged and hard to leverage or gain the confidence of a primary debt provider.
So to go after value in the market without having to pay a premium, the buyer needs to either have the cash in hand to do the deal, or be prepared to access higher cost forms of asset based lending, bridge financing, or short term equity investments to complete the acquisition, improve the performance and transition to cheaper capital in the future.
The leveraged buyout scenario is a difficult game these days due to the amount of time and money it can take to get the deal done. And if there is a market for the play, it may be difficult to keep other suitors at bay before a potential path to closing is laid down.
With the beginning of the last recession three years behind us, there are a growing number of opportunities to be had in the market as companies that have tried to hang on are still going to run out of time, high dollar parity putting other less efficient operators out of business, and baby boomer retirement plans pushing the need to sell.
But the prospects for business financing from the buyer’s point of view has gone the other way in recent years causing a real quandary in the market… more buying opportunity, but hard to finance.
Or at least hard to finance in terms of more recent approaches.
The traditional approach of trying to highly leverage what you’re trying to buy with cheap money is not working in many case, but business owners still are not getting this for the most part.
But the smart ones are.
In fact, for the financially astute, if you can get enough of a purchasing discount, and have enough money to afford higher priced acquisition capital as well as the funds to improve the financial performance of the assets acquired, the economics can still work out in your favor.
It just requires taking a different approach to solve the problem … which very simply is to get cheaper money in place post acquisition and then have it available for a long time through solid business management.
Once again, this may mean max leveraging existing assets, using cash reserves, or utilizing higher cost debt or equity to complete the purchase.
This may not always be the best approach, but its something that should be considered more often these days.
Ok, last week, everyone, including myself, was saying that without a conservative majority or a workable form of government coming out of the election, that the economic sky in Canada was going to fall.
So the conservatives won a majority, and the sky is still above us … now what?
That’s the great and frustrating thing about the world of business financing. Once you have quantified or removed the potential adverse effects of one variable, another dozen or more are ready to take their place.
Just look at this week.
Everyone is speaking positive of the outcome of the election from an economic stability point of view.
But, we still have an economy that is over heating and heavily driven by commodities that are currently on the down stroke.
The Canadian dollar is being pushed down by the commodity markets, but for those needing to hold AAA bonds, Canada and Australia are the best bets which should be positive for the dollar.
The bond market is currently dipping down, but its not expected to last too long either.
In many ways, we are back to the pre election status quo where the Bank of Canada is still going to react to inflation in the near term and will likely keep increasing rates until they see a balancing out of inflation and a stabilizing of the level the dollar is trading at.
Banks and institutional lenders are more likely to continue loosening their purse strings with a conservative majority compared to a less appealing alternative.
So capital should continue to be available at very good rates, but be prepared for it to be some work to secure and also factor in that the cost of money is likely going to be higher as the year goes along.
For project financing with a payback of less than 10 years, fixed interest rates may provide a greater appeal and hedge against interest rate increases as well.
Being that most working capital is priced with variable rates, expect the cost of operating funds to be going up.
At the present time, these trends appear to be fairly clear (at least for the moment). If we had not elected a Conservative majority, the near term projections would likely be very similar, but all bets would be off for the mid and long term period.
All in all, we came out of the election process about as good as anyone could expect or rely on.
This certainly doesn’t solve all problems or remove all risks related to business financing, but it does take some of the noise out the market and allows us to get back to focusing on market driven variables versus politician driven ones.
For the most part I try to keep my comments to strictly financial and financing topics and I will today, sort of, although I plan to go on a bit of tangent.
Even thought the dollar is 5 points above parity today, it should actually be higher right now as the U.S. currency continues to depreciate against all other major currencies at a faster rate.
Why should the Loonie be even higher?
Because the potential outcome of the May 2, 2011 federal election is making the rest of the world nervous, present company included.
Anything less than a conservative majority will likely have some negative impact on the dollar and will also increase the bank of Canada’s intervention with monetary policy to offset the expected increase in fiscal spending if any type of alliance forms among the NDP, Liberals, and Bloc.
Here’s some additional information on the topic as well http://business.financialpost.com/2011/04/28/ndp-gains-might-sink-loonie-or-not/
When we are talking about monetary policy, the only real lever the bank of Canada has is interest rates, and they will be pulling it much harder if required to maintain the status of the currency.
The result will be higher than expected business financing rates.
Any scenario where the NDP would come into power would as the article I’ve linked to states …”could cause the dollar to Wobble”.
The NDP had some well documented disasters trying to run the provincial governments of B.C. and Ontario, and to think they have the expertise available to manage the fiscal policies of the entire country is laughable.
I understand that everyone may not like how the conservatives go about their business and I don’t agree with all the things they do or say either.
But this is the only party capable right now of keeping us going in the right direction.
Hopefully people can see through all the pie in the sky promises that political parties make to try and get into power.
If not, and we get a Conservative minority, or heaven forbid, a NDP minority government, then we are turning the ship into the financial abyss that most of the rest of the world is in right now.
Selecting governance should not be a popularity contest where the unqualified get to be contestants.
Canada is currently held up as one of the strongest economies in the world, period.
Let’s not do anything next week that is going to jeopardize that status, regardless of what you think about Mr. Harper and some of his soldiers.
I’m all for change … if there is a better option. But there’s not.
We can continue to stay ahead of the financial cloud of dust darkening most countries these days, or we can fall back into it like everyone else.
It is a choice and now is the time to pick the party that has the best chance to keep the country on a solid economic track.
The March inflation numbers out showing a month to month increase in inflation for every province and territory.
Here’s all the specific statistics broken down by region http://www.theglobeandmail.com/report-on-business/inflation-across-the-country/article1990894/?utm_medium=Feeds%3A%20RSS%2FAtom&utm_source=Report%20On%20Business&utm_content=1990894
Time to break out Chicken Little…the sky is falling. Or to the bank of Canada Governor, inflation is getting away on us, time to slam on the breaks and increase interest rates to slow the economy down.
As I recall from economics class, there is real and perceived inflation. Real inflation occurs when the available economic capacity of a country starts to deplete, causing pricing pressure on the available resources.
Perceived inflation is when people think inflation is present or think its rising, so they start increasing their prices to allow for what they perceive to be in effect, whether it is or not.
If there is too much continuous talk about inflation being on the rise, then perceived inflation effectively becomes real inflation as people’s actions cause it to happen.
I’m not saying this completely the case right now, but with all the press being directed towards inflation and interest rates these days, perceived inflation is definitely contributing to the rise in inflation to some degree.
The combination of real and perceived inflation would appear to be reaching critical mass in terms of something having to be done about it.
As more and more information is reported on the subject, the more inflation is likely to increase.
If someone wanted the interest rate to move in one direction or another and could control or significantly influence public opinion on the subject, they could potentially create the interest move they were looking for.
More likely this can happen on a follow the herd mentality where the topic gets enough short term press at the right time where everyone jumps on the bandwagon and causes their collective inflationary fears to come true through their actions.
Regardless of how you choose to look at it, it appears that interest rates are likely going to start moving upwards very shortly, potentially as early as May.
Hopefully the make up of the actual inflation is more real than perceived so that the corrective actions likely to be taken are appropriate and produce the desired result with the least amount of suppression to economic growth.
I came across a number of articles today on Canadian interest rates and projections for where they are going and like usual, the prognosticators are all over the map.
But this time at least, I believe its for good reason.
The governor of the Bank of Canada uses interest rates like a gas peddle to manage inflation in the economy. Inflation becomes an issue with the actual production capacity of the country starts to reach the production potential. As production potential is reached, inflation can start to build quickly.
Over the last 6 months, Canada has seen a higher than expected level of growth, narrowing the gap between actual and potential production capacity with experts now saying that capacity could be hit in 2012.
Because it can take a while for the brakes to come on with interest rate moves, it would seem that larger interest rate increases are coming and may need to happen more often which will directly impact your business financing plans going forward.
But then, there’s the other side of the coin.
The recent spike in the value of the Loonie against USD is likely going to slow down economic growth as exports start getting too pricing. And if the Loonie stays above the U.S. dollar for an extended period of time, the economy could very well slow down on its own.
And if you prematurely increase the interest rates, the Loonie could go even higher has holders will be getting a higher return for their money creating increased demand.
For more background on this topic, here is pretty good article you can refer to… http://www.theglobeandmail.com/report-on-business/economy/loonie-could-slow-growth-for-years-bank-of-canada-warns-in-report/article1983484/?utm_medium=Feeds%3A%20RSS%2FAtom&utm_source=Report%20On%20Business&utm_content=1983484
So with all that being said, what is going to happen?
If you leave interest rate increases too long, there may not be enough time to react and you run into inflationary impacts.
If you increase interest rates too soon you could help stall out the economy due to the likelihood that the Loonie is going to stay at a high level for a while, potentially even years.
Because of where we are at right now, its almost a given that interest rates are going up. Inflation can become a run away train that creates the next recession sooner than later, and the Bank of Canada is going to do everything in its power to not let that happen
The questions that remain are how much and how often?
Right now, the experts are calling for modest increases in July.
That could hold.
But an increase could also be sooner and higher than expected as well.
Your guess is as good as anyone’s at this point.