Wednesday, October 14, 2015

Julie's Yoga Studio - Financing the expansion

In our “The Always Small Business” series we’ll continue with challenges facing Julie’s Yoga Studio. Julie’s Yoga Studio has already determined how many clients she’ll need to break even for the new location. Now she needs to figure out how she will pay for the new location.

We also itemized some of the expected expenses in the previous post. Just for fun let’s add in a Miscellaneous category for any unforeseen expenses that always seem to creep in.

Renovations - $15,000
Equipment - $9,000
Miscellaneous - $1,067
Rent - $1,600/mth
Manager $$3,333/mth
Total Opening Cost = $30,000

Julie will need this amount upfront to get the new location open and running for the first month. There are generally two standard ways most, but not all, small business’ source their funds. One way is through the owner’s personal savings that are contributed to the business, and the other is through loans received from a financial institution. Julie has saved her money over the years to the point she has $125k in various savings and brokerage accounts.  Julie is comfortable using that money as she already lives well below her means, but she’s not sure it's the best use of cash. Her local banker is offering her an unsecured loan of $30,000 for 7 years at 9.5% interest calculated monthly.  The interest rate is pretty competitive as the banker has a good working relationship with Julie, and knows she’s responsible with her personal finances which the bank manages a portion of.  

Which option should Julie choose?

We’ll use a simple review to see which option is better.

Her banker’s offer might sound high, but unsecured loans come at a higher interest rate since there are no assets they can reclaim to sell and cover the loan.  If Julie takes this offer her monthly payment would be $490. Sounds pretty reasonable.  The total interest the business will pay is $11,186.  That brings her total cost of the loan to $41,186.

If Julie decides to use cash from her savings or brokerage accounts let’s see what she’ll forfeit in lost earnings. Let’s assume she will forfeit an expected 7.5% return on her money with interest compounded quarterly.This is comparable to what most major pension funds expect for their yearly investment return. Plugging the numbers into a financial calculator we find Julie will have $20,467 in forfeited investment returns. That’s a total of $50,467 for 7 years.

WOW pretty astounding to see considering at first glance it appears the higher interest rate loan would be a bad choice. Also don’t forget that the interest paid by Julie's Yoga Studio on the loan is deductible as business expense on the yearly tax return.  This can enhance the return on the loan even more.  Julie’s personal finances and the studio will be surprisingly better off by choosing the loan.  This simple analysis has saved Julie and her business $9,281 over the next 7 years! Now adding debt is not always advisable, and it should be avoided if possible with any small business. However prudent financial management can make small amounts of debt advantageous to a company. It's when you keep adding debt that makes it dangerous. In Julies scenario if she could pay off the loan early she should take all necessary steps to do so as she'd benefit from the reduced interest expense.

Now every situation is different and the numbers for your business challenges can require a different set of options and analysis. No worries as they are always easily solved. If you have any questions never hesitate to contact us. We love helping out everyone.

Stay tuned for more informative articles, including the challenges facing Chris and his bicycle shop.

No comments:

Post a Comment