Borrowing for profit and wealth

The current lending rates of banks and other financial institutions are at a record low, between 8 percent to 11 percent, and from 12 percent to 14 percent from other financial companies. These are good times for companies and individuals that have to borrow for their operations and capital acquisitions. Over the years in my career as a commercial banker, investment banker, entrepreneur, and as a businessman, I have noticed that quite a number of businessmen and a lot of other people do not really know how to borrow, when to borrow, where to borrow, or if they should borrow at all. In fact, in the Asian crisis years of 1998 to 2004, the companies and individuals that got into serious trouble were those who over-borrowed or borrowed in the wrong currency, or for the wrong reasons.

In my present positions, as a member of the committee or the board, I am jointly responsible for evaluating loans and credits which amount to P3 billion to P4 billion a year. These are in amounts as low as P200,000 to as high as P100,000,000, but they are all evaluated in the same criteria and approved or rejected for very similar reasons. In my early career years, I had also been a loan administrator and a loan officer. Looking back, I can now see the reasons why certain loans turned bad or uncollectible, and the clients in trouble. I have also experienced running a mining company, a property company, a manufacturing company, and a finance company. I found myself on the other side, as a borrower, and I learned my lessons well.

Many borrowers get into trouble because they are borrowing for the wrong reasons, or they do not understand the reason why they are borrowing. There are only three legitimate reasons why one should borrow. One, is for investment, i.e., we want to buy, build or invest in something that we believe we can sell at a profit, or start a business that will give us a stream of future earnings. Two, we have an ongoing business and we need additional funds to augment working capital and/or facilities and equipment capital expenditure, which will increase the future earnings of the business. Three, we need funds to provide for the consumption needs of the family, for food, clothing, shelter, school needs, or a vacation.

Now that we are sure of the reason why we are borrowing, we have to determine how much and how long should our loan last. If it is for investment, we have to be sure how long we have to hold on to the investment before it can be converted to cash, how much interest and other carrying cost can our present cash flow absorb before the investment will provide its own cash flow. Knowing these will tell us how much and how long we can pay the loan.

If we want to borrow for working capital or capital expenditures for an existing business, we must know our business, the additional inventory and receivables that have to be carried, then the length of time it should be carried would be easy to determine. If it is for capital assets, the additional cash flows from the improvement or expansion capacity you would have studied carefully, and made certain. Then we would know how much to borrow and for how long. A number of unpaid loans that lead to foreclosures is due to an overoptimistic and unrealistic assumptions of the expected cash flows from the investment or the business, making them unable to pay the loan.

The third reason for borrowing, which is for personal and family consumption is called a consumer loan. It has to be paid from the existing cash flows of the borrower because most of the time the loan is not used to increase additional cash inflows but to satisfy an existing need, be it a car, a house, a wedding, or any personal need. But this may still be a good loan as long as the existing cash flows have enough leeway to absorb the payment of the loan.

Given all of the above, we can see that the primary determinant in getting or granting a loan is the cash flows and not necessarily the collateral. Whether it is a small loan or a huge loan, it is the source of the cash flows that will make or break a loan. The micro lending of the Grameen type banks for small entrepreneurs, have a 95 percent repayment experience even if these are lent to what are considered as marginal borrowers, because they have definite cash flows and are disciplined to use the borrowed funds to generate the cash flows and not divert them to unproductive use.

Borrowings are needed to make a business grow, because it will take time to generate the funds for investment or expansion. One cannot rely on all internally generated funds. Besides, the opportunity may not be there by the time we have accumulated the funds from internal sources. Leveraging one's equity is important to optimize one's capital. The Henry Sys, the Gokongweis, the Ayalas,and the Lucio Tans would not be that big if they did not borrow. They are mindful of their Debt to Equity ratios, their debt service coverage, and utilize leveraged lease and leveraged buyouts to expand, acquire assets (e.g. airplanes), and acquire companies. In my teaching days as a Professor in Finance in the University of the Philippines School of Business, we used to analyze the borrowing strategy of the local conglomerates (the Taipan companies), and we figured out what worked and what did not. But this is another story and I usually get paid a lot of money to tell this particular story!