Guest blog by James Boorman, Project and Corporate Finance Advisor and Founder of New African Projects and Business Ltd.
In the latest of a series of guest blogs that look at issues around financial management for women entrepreneurs, this week our focus is on understanding how Compound Interest works, and why it is so important to keep your friendly Banker on side.
In my current role I see all kinds of problems and mistakes created by, and tricks played on, sleepy business owners. Usually these are quickly revealed and solutions found, however there is one area that is so dangerous that if not immediately controlled can bring down a business in just a few months with devastating effects on employees, the business owner and their families.
This is Compound Interest.
The sad thing about Compound Interest is that it hides itself behind all sorts of marketing tricks from softly spoken Lending Companies. I have sat with and chatted directly to a number of these companies and their CEOs to understand more their thoughts and sales tactics and they all follow something like this:
“We share in our Client’s profits.”
“We are purely for short term projects.”
“We solve short term Cash Flow problems.”
...but what if you have a delay to your project, if your cash doesn’t come in on time, if a container is delayed at the border, or if one of your clients becomes sick and doesn’t pay or worse becomes bankrupt - then you will begin to see for yourself the dark side of Compound Interest.
Let me show you:
I borrow Kshs1,000,000 at 10% per month, end of the 1st month my loan now stands at Kshs1,100,000 (that’s your 1,000,000 loan plus 10% interest of 100,000). Month 2, I now pay 10% on Kshs1,100,000, which is Kshs 110,000, my loan now stands at Kshs1,210,000 for month 3…
Seen on my trusty Excel:
Don’t have Excel ? Try:
As you can see - a simple 10% per month is not 10x12 = 120% per year, but actually a whopping 213.84% per year! Seriously ? If someone offered you a loan at 213.84% per year in Kenya you would look at the official annual KBRR of 8.54% and walk out. Yet daily, people accept ‘short term’ loans to solve Cash Flow issues in their companies at 10% per month and put at risk their company, their employees and their health. Sadly in the past 4 months I have seen rates ranging from 5% to a massive 15% per month...
KBRR is the interest rate a Kenyan bank charges on riskless lending. Banks will add an amount known as ‘K’ to the KBRR when it lends to us to take into account the extra risk the bank takes on - an annual figure (Not monthly). The amounts banks add on are seen here:
So what has this got to do with your relationship with your bank ?
Please do not view your bankers as the enemy, work with them. Together you are far stronger.
The Bank’s Credit Department decides if you are worthy of a loan, how much and guides the rate. Their mantra is: “No Surprises”, so help your banker have all the information and knowledge necessary to fight on your behalf to get the best deal. You as a client should keep your bankers in the loop, bring them into your office and onto the factory floor. Explain your clients, their payment habits, your Cash Flow (very important, because even a profitable company can sadly go bust if its Cash Flow dries up), your suppliers and their needs.
They say that a Banker will lend you an Umbrella only when the sun is out, never when it is raining - remember that and use it wisely - bring your banker in on your side and arrange excess Cash Flow Lines (Loans) when it is sunny so you can have them at hand to drawdown when it starts to rain, that way you will never be tempted by a ‘kind’ Uncle or local lending house offering to help you out by ‘sharing in your profits’ or to help you with ‘short term cash flow problems’…
Next week: So what should I have in my armory from the Bank and should I shop around ?
James Boorman, 22 years in the Financial Markets in London trading many different products from FX to Interest Rates to Commodities to Futures and Options, before being relocated by Credit Agricole in 2007 to Johannesburg as an Investment Banker, Head of their Financial Institutions Department, sub-Saharan Africa. He now spends his time with his family in South Africa whilst advising on Project and Corporate Finance deals. He adds significant value in the foreign exchange value chain to those companies who do not have the necessity or resources to justify a full time Treasury professional or department, but still need to ensure that their market risks are managed (and their sleep patterns undisturbed). Seen here planting Bamboo in Mozambique.
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