Borrowing money is a necessity of life. This is especially so for business development and personal emergencies. But loans are never free. There is usually a cost element attached to the facility. This is interest factor. The interest rate on a debt is a very important element in determining its suitable or otherwise.
To borrow or not to borrow is not the question. The purpose for which the loan is contracted is the matter. A good loan should generate adequate returns to repay the loan plus interest amount. The loan should be used for a project with a net positive value (NPV) thereby creating enough cash to pay for the project and other associated cost.
Whenever a loan is contracted, it becomes a debt to the recipient. The total amount for any debt is the amount borrowed plus the cost of borrowing (interest payment). The cost of borrowing may include the interest payment plus other incidentals such as loan facilitation fees, default risk premium, account maintenance fees, insurance fees and other fanciful ones which are peculiar to the loan offer. Caveat emptor (Buyer beware!)
IMPORTANCE OF BORROWING
Some form of borrowing is vital to running a company or economy successfully. This is caused by the inadequacy of financial capital to prosecute all projects and programmes within the business time frame. The incidence of the cost of borrowing money makes it important to learn how to borrow more effectively and efficiently.
Borrowing is necessary for undertaking investment projects and to facilitate the operation of business activities. It is mostly used to finance the acquisition of fixed assets like heavy duty equipment or landed property. It is sometimes used to fund and replace maturing loans. It is also useful as working capital when financing short term cash flow challenges.
The sources of finance are usually from personal savings, internally generated funds or borrowings from third parties. Loans could be short or long term. The key criterion for selecting an appropriate funding source for any project is the interest rate. For good financial management, you should borrow money for an investment only if the return on the investment (project) is higher than the interest on the loan. This underscores the maxim that the financial objective of a firm is to maximise the wealth of the owners. It makes sense to take a loan only when the benefit outweighs the cost in either social or commercial terms. Any other contrary decision would be a slippery road to financial disaster at personal, corporate or national level.
INFLUENCE ON INTEREST RATES
The interest rates are influenced by numerous factors relating to the type of loan. They include, the length of time over which the loan is to repaid, the collateral, credit history, the loan maturity period and the lending source. All these could influence the rate charged. There are other external influences like the prevailing economic conditions with regard to inflation, Treasure bill, exchange rates and other government policies.
GOOD LOANS, BAD LOANS
A loan in any form is not a bad thing. Indeed some loans are desirable in the capital structure or a business. It is rather too much of it which could be bad. When you have too much debt, it leads to high gearing. Too much debt could give you financial diarrhoea. The cost of debt i. e. interest payment could bleed your financial resources to the point of financial distress or death, whether personal, corporate or national. The adage is to borrow within your means. Many persons and businesses have gone bankrupt for failing to observe this credo. If you must borrow, then borrow effectively or efficiently.
DOS AND DONT’S
Never borrow to finance expenses, unless it is a temporary measure. A microfinance loan of 6 percent per month is equal to 72 percent per annum.
Never borrow short term for long term projects. Don’ts also borrow long term to finance short term projects. They could all lead to financial mis-match.
Debt is a necessary component for financial activities i. e. projects, but it is best served when the cost (interest rate) is lower than the returns on the investment.
Debt can be very tantalising especially when your back is against the wall. But it could hold you to ransom and slavery when poorly managed. The HIPC program was a good experience. The continuous challenge faced by countries such as Ireland, Italy, Greece and Iceland are hard lessons. The bitter result is usually economic hardship and inevitable bailout.
THE WAY FOREWARD
Borrowing is not the only solution to financial challenges. Occasions for funding could be resolved by evaluating various optional solutions. Adopt other financing methods like leasing and hire purchase. For capital intensive projects, public private partnership (PPP) could take the pressure off scarce resource. Better still, project financing (using future cash flow to pay for the cost of the project) methodologies works. - Johnny Quarshie, The Spectator