Posts Tagged ‘interest rates’
How the New Fed Reserve Interest Rate Cut Will Affect Your Business
Wednesday, April 2nd, 2008
The Federal Reserve again cut the short-term interest rates to 2.25 percent, which is three-quarters of a point lower than it has been since the end of 2004. The thought was that the decision was made due to the $30 billion in financing it gave to JPMorgan Chase for the acquisition of Bear Stearns. The question that remains is that will this move help the economy in any way?
The Fed’s decision is to help keep consumers spending and borrowing, which is good for businesses. The lowering of the short-term interest rates will also keep asset prices higher. However, the long term effect will lower the dollar which is the exact opposite of what the nation needs. The decrease in the value of the dollar had led to the rise in inflation, particularly energy.
Unfortunately, the nation is already underway into a recession, which means the country needs to focus on high-saving and low-spending-opposite of what the country is used to doing at this time. Going through a recession will force people to make that change. Lowering the short-term interest rates will only prolong the inevitable, dragging out the process.
The reason that lowering the short-term interest rates are not a good idea is that people are already stretched as it is. If the Fed’s take steps to promote consumer spending, then the consumers will become even more stretched which will hurt worse in the long run; thus reducing consumer spending is what is needed.
Additionally, mediating an orderly reduction of asset prices, such as homes and bonds will help the economy sooner rather than later. Home prices could potentially fall another 15 to 20 percent. Unfortunately, investors will have lost many millions of dollars due defaults and write-downs of residential mortgages, corporate debt, commercial mortgages, credit cards and other loans, once the dust settles after the recession, this is provided that any de-leveraging does smoothly, which probably means that the loss could be upwards of two to three times any estimated loss.
The loan that JPMorgan Chase received from the Federal Reserve is surprising and somewhat concerning because of the dicey mortgage loans, which totaled upwards of $46 million. This is one of the reasons why JPMorgan Chase offered $2 a share, which is about 20 cents on the dollar. This could pose a problem and the Federal Reserve will need to take the lead in ensuring and enforcing that the accounting practices are in compliance.
Credit card debt is not as much of a concern because there is not a 90-day window for defaults to occur as with mortgages. Plus credit card companies, since they have been dealing with low-quality borrowers for a long time, have developed policies where the interest rate is raised, anywhere up to 40 percent interest on the balance. Even with this, it is the high-risk or subprime lending mortgages, as well as the high amounts of loans people could take out which has raised the consumer-debt bubble. People are so overstretched that they are taking hardship withdrawals from their 401(k) plans or selling off stocks, just to pay the mortgage.
In essence, while the lowering of the short-term interest rate may be good in the short-term, it only prolongs the economical problems that the country is going through, which could be even more devastating; thus worse for businesses.
Tags: economics, federal policy, federal reserve, federal reserve interest rate cut, interest rates, larry Slusser
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Calculating Your Cost of Borrowing
Monday, January 14th, 2008
In part one of this article, "Managing Your Small Business Debt", we looked at debt service and the role it plays in your business’s finances. In this article, we’ll look at how you can calculate your cost of borrowing in order to save your business money.
Another useful measure of your company’s debt is to look at the overall cost of borrowing. Comparing the blended cost of borrowing over time tells you whether it is becoming more or less expensive for the company to acquire capital.
You may have financing from several different sources:
* Bank loans
* Lines of credit
* Credit cards
* Capital leases
* Suppliers
* The government
It’s important to understand the total cost of your debt from all sources. You can do this by calculating a blended interest rate from all of your current debt.
Let’s look at an example:
A company has several different sources of financing:
* A bank loan with a current balance of $14,912 and an interest rate of 8.5%
* A capital lease for computer equipment. Balance $5,387. Interest rate 11.4%
* Payroll arrears owed to the government in the amount of $6,754. Interest rate per the statements is 10%
* A corporate credit card with a balance of $12,769. Interest rate 18.5%
In order to calculate the blended cost of debt, we simply divide each interest rate by the proportion of its related debt to the total debt. In the above example, it would look like this:
Type | Amount | % of Total | Interest Rate | Blended
Bank loan | 14,912 | 37.5 | 8.5 | 3.2
Capital lease | 5,387 | 13.5 | 11.4 | 1.5
Payroll arrears | 6,754 | 17.0 | 10.0 | 1.7
Credit card | 12,769 | 32.0 | 18.5 | 5.9
Total | 39,822 | 100.0 | 12.3
The weighted average cost of debt is 12.3% in this example. So, what does this tell us? Not much, by itself. It’s only when we look at the weighted average cost of debt over time that we are able to see if our interest rates are going up or down. If our blended rate is going up, for example, it could mean that we are beginning to have solvency issues. It means that our newer debt is at a higher rate than our existing debt. Lenders may be more hesitant to lend to us and we may be seeking financing from more unconventional (and more expensive) sources.
The Danger of Leverage
Many "Make Millions with Your Small Business" books will talk about leverage and "good" debt versus "bad" debt. They argue that it takes money to make money and that virtually all companies borrow. "Good" debt (they say) allows you to leverage your funds to earn more income. For example, if you can attract $50,000 worth of new business by buying a $30,000 machine on credit, you would be farther ahead to do so.
What these "gurus" don’t tell you is this simple fact:
DEBT = RISK
Not exactly rocket science, I grant you, but critical information to keep in mind, nonetheless. In our above example, what happens if you don’t get the increase in business you were expecting? The debt is still there. You can’t tell the bank "Sorry, I can’t pay you back until I get this new business in the door." When your business is indebted to a bank, mortgage company or other lender, there is the risk of default and of the debt being called and company assets seized. Think of it this way: it’s only companies that have debt that declare bankruptcy. If you didn’t have any debt and you wanted to wind up your company, you would simply close the doors.
Another danger that many small business owners don’t think about is that many lenders require the personal guarantees of company owners and may even require you to put up your home as security. Now, not only are your business assets at risk but everything you own personally as well. Clearly, this increases the risk of entering into credit agreements.
I’m certainly not recommending that you never borrow money. However, you need to understand the following every time you engage in credit:
* What is the purpose of this borrowing?
* Am I getting the best interest rate possible?
* What does the revised stream of cash flows look like with the new debt?
* Do I have a plan to retire this debt?
* Do I have to pledge any personal assets to get this credit?
Once you have satisfied yourself that you have done the required background work to understand your business strategy, then you can enter into the agreement with confidence.
Tags: Accounting, Angie Mohr, budget, cost of borrowing, debt, Finance, Finance and Accounting, interest rates, loans, Numbers 101 for Small Business, small business loans
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