Still borrowing at 5% and up?

Question: Can you help? I have a single proprietorship for which I asked dear friends for funding. I had promised to pay them 5 percent interest a month. It was a great idea back then because the proceeds from my sales were to be collected in one month, in time to pay the monthly interest… Unfortunately, my receivable collection period lengthened, not just because my clients asked for it but also because I had to initiate the extension to fight competition. My business grew, but so did my receivables. I was compelled to get financing elsewhere but at higher interest rates, at times at as much as 10 percent a month from informal lenders. I even resorted to 5-6 loans. Now, I have reached the point where my business cannot anymore settle even just the interest payments. —asked at “Ask a friend, ask Efren” free service at www.personalfinance.ph, Facebook and SMS.

Answer: There are many people who make a living by lending to individuals and businesses informally. With not much documentation except for a promissory note, you can expect interest rates will be high. How high?

Here’s the thing, when people compute interest on loans from informal lenders, they tend to do two things: focus on the low quoted monthly interest and become overconfident they can repay the interest within one month. On the second, you have related how you have learned the hard way about the pitfalls of such thinking.

On the first, you simply have the multiply the monthly rate by 12 to see how expensive the interest is. Credit cards, which charge a monthly financing rate of 3.5 percent, implicitly charge an annual rate of 42 percent. A 5 percent monthly rate is equivalent to 60 percent a year.

A 5-6 loan that charges the nominal 20 percent of the loan amount in interest but collects both principal and interest daily over a short period of time charges 332 percent a year. Such computations do not count any loan processing fees charged upfront that reduce the loan proceeds and effectively increase the interest rate further.

You started your business with debt. Even in an industry where the cost of funds are low, like banking, such a practice is not acceptable. Ideally, you would want only a maximum of 50 percent of the assets of your business, like your permanent working capital, funded by debt. The rest you would want funded by your own money or shareholders’ investments that will require high returns but no immediate cash payments. It is therefore only sensible for each budding entrepreneur to plan his venture well, not just the production, marketing and people aspects but also the money side (PMPM). Part of this money side requires that contingencies be provided like a larger permanent working capital to fund a certain level of operation.

If your business is still humming along nicely with stable clients, it would be foolish to just close it and declare insolvency, especially if the remaining collections will not be enough to liquidate the outstanding debt. The problem with debt from informal lenders is that the lenders are not yet covered by strict regulations on collecting bad debts that apply to licensed ones, such as banks and credit card companies. It is more difficult to ask for restructuring from unlicensed lenders. Plus, they can create a ruckus.

You will need to look at what assets you can liquidate to reduce your liability or get loan refinancing from licensed creditors (provided your credit standing is still good), restructure any unpaid loan and continue running your business as efficiently as possible to repay whatever loan remains outstanding.

Get an adviser to help you manage your business. He can be your accountant, close friend or even a professional one. Finally, never borrow from unlicensed lenders again.

There is always a solution to every problem. Sometimes the solution hurts, but it only does so to make us stronger.