Business Debt Consolidation Basics

debt consolidationIt’s not unusual for companies to accumulate different loans as they grow. Sometimes, these loans become difficult to manage. They may have different payment dates. Their terms may not favor your company. Or, maybe they were not the right option for your company in the first place.

If your company has this problem, you may be able to solve it by consolidating your debts. In this article, we discuss how debt consolidation works and explain the basics of this solution.

What is debt consolidation?

Debt consolidation allows you to combine multiple loans and replace them with a single loan. The new loan is designed to be better suited for the company’s needs. It has a lower monthly payment, lower rates, or both.

Does your company have any of these problems?

Determining if a company needs to consolidate its debts takes financial analysis. I recommend you work with a CPA or financial expert to do the analysis. However, you can make an “easy” determination by asking yourself four simple questions. An answer of “yes” to any of these questions could indicate a problem with debt.

1. Are loan payments taking away most of your company’s money?

This is the most noticeable symptom for companies that have a debt problem. Keeping up their existing loans takes a large part of their available cash. This leaves them unable to meet other obligations or grow the business. Loans that can cause problems include:

  • Loans with high interest rates
  • Multiple cash advances
  • Short-term loans (in some cases)
  • Loans with a balloon payment

2. Are your interest rates incredibly high?

Some companies pay too much for their current financing. This can happen in companies that have cash advances or old financing with bad terms. Companies with this problem may benefit from consolidating their loans.

3. Are you unable to pay suppliers or employees because you have no funds?

It’s not unusual for companies to run low on funds from time to time. This can signal that you need to improve your collections or better manage your payables. However, if your receivables and payables are OK, it could signal that your debt payments are too high. If this is the case, consider consolidation.

4. Do you need additional equipment but are overwhelmed with debts?

Companies that have made bad debt decisions in the past can find themselves unable to buy new equipment. Buying new equipment is something that can be done as part of the debt consolidation process.

Actually, many lenders prefer you get additional equipment. It increases their collateral assets. Obviously, you’d only want to buy new equipment if the underlying business is solid.

Typical company profile

The previous section listed symptoms that could indicate a problem with your debt. In this section, we discuss the typical loan profile of the company that uses this type of financing.

Most companies that need consolidation have one, but usually more, of the following products:

1. Merchant cash advances

Merchant cash advances, often just called “cash advances” are a form of short-term, high-interest financing. Cash advances are known for being easy to get and very expensive. This can make them dangerous if used incorrectly.

Having more than one cash advance open at a single time is called “stacking.” Stacking cash advances is usually a sign that the company is in financial trouble. Most companies that stack advances do so to pay earlier advances. Ultimately, this practice leads to a financial tailspin.

2. Loans that don’t match the needs of the business

Companies may also have loans that don’t meet their needs. These could be loans with too short a term, too high a rate, or with a balloon payment.

If you have a single loan that is not well-suited for the company, you can fix it by simply refinancing it. If you have multiple loans, debt consolidation may be the better solution.

3. Equipment loans

Companies can also have multiple equipment loans, making these loans unwieldy to manage. This becomes an administrative challenge if each loan has a different payment date.

What are the advantages of consolidating debt?

Debt consolidation can provide a number of advantages to your business. Here are six advantages:

  1. Provides affordable monthly payments
  2. Improves your cash flow
  3. Simplifies payment management
  4. Allows you to focus on growth
  5. Lowers interest rates and/or extends loan terms
  6. Can be structured to support future growth

Are there any disadvantages?

The product has some disadvantages. The first one is that business owners sometimes consolidate debts for the wrong reason. Consolidation helps a business that has made bad financing decisions. However, it does not help a business with a broken business model. Underwriters try to prevent this from happening through their due diligence. It doesn’t catch every situation though.

The other potential disadvantage comes from extending the loan term. If your requirements include existing equipment, you must ensure the term does not exceed the usable life of the equipment.

Lastly, by extending the term, you usually increase the amount of money you will pay over the life of the loan. This is a trade-off of consolidation.

How is debt consolidation different from refinancing?

Business owners often use the terms debt consolidation and refinancing interchangeably. However, each term has a different meaning. Consolidation, as its name implies, refers to grouping a number of loans and replacing them with a single loan. If you are buying additional equipment as well, consolidation includes a loan increase.

Refinancing, on the other hand, involves replacing a single loan with another one. The new loan has better terms than the old loan.

What is the best structure for these packages?

Most lenders structure their financing packages as a single consolidation loan. When doing this, there is an assumption that cash flow needs will be taken care of by improvements from the consolidation package. Read the last sentence again – it’s important. It’s one big assumption.

There is one potential drawback with this strategy. Getting additional financing after getting the consolidation loan is very hard. This is because the new financing often needs a subordination from the existing loan. The existing lender has little incentive to provide it since it increases their risk.

My preference is to address this issue while working on the consolidation package. We review projected cash flow needs and split the package into two financing tiers.

Consolidation tier

This tier consists of the consolidation loan. It is used to pay off existing financing, and (if necessary) to buy new assets. To learn more, read “How to get a business debt consolidation loan.”

Growth and cash flow tier

The growth tier covers some potential cash flow shortfalls that may occur due to subsequent growth. Depending on the size and financial maturity of the company, you can use:

a) Factoring

Factoring improves a company’s cash flow by financing invoices from slow-paying customers. This improves cash flow and puts you in a better position for growth. To learn more, read “What is factoring?

b) Asset-based financing

Asset-based financing also allows you to finance receivables. Unlike factoring, it operates using a borrowing base. It is available to more mature companies that have a finance department and keep their accounting records current.