Previously we discussed why debt financing is a useful tool for your business and what obstacles you should expect as a start up company. Today we will have a closer look and practical issues of debt finance in financial models. So what should you think of when modeling debt into your financial projections? Here is couple of practical steps.

Source: Feanut.com

Long-term vs. short-term

First of all, you have to decide how much debt do you want to introduce into your capital structure in different periods of your financial plan. That's and obvious one. Then you should start thinking what is that debt going to be used for. Is it to be used to finance the acquisition of plant or property, or is it to be used to re-finance the inventory? That's an important question, because it determines the term of your loan. The rule is that long-term assets should be financed by long-term borrowing and short-term assets by short-term borrowing. In addition, you have to distinguish between long-term and short-term debt because you may need to show it separately in your projected balance sheet. Your potential investors may be interested not just in your overall planned debt, but also in its structure.

Type of debt

Debt can have several forms. You as a owner can borrow money to your own company. Or you can take a bank loan, or issue bonds or subordinated debt. Different debt tranches have different seniority levels. That means, if the company goes bankrupt, different debts will have different priority in terms of the settlement. Therefore it is useful to differentiate the type of debt in your financial model, so that the potential investors can see the seniority of your planned debt and assess its structure and associated risks.

Installments and maturity

Further step is to determine in what installments the debt is going to be repaid and what is its maturity. This impacts the modeling of your cash flows over time - i.e. when you are going to receive the money and when and in what amounts are you going to pay it back. Maturities can vary from up to one year for short-term debt, up to 5-7 years for medium term debt and up to tens of years for long-term debt. Extra long maturities are common in infrastructure related investments. In terms of installments, you can have monthly, quarterly or annual installments (typical for bank loans) or you can have a single debt re-payment at the date of maturity (typical for bonds). In Feanut Financial Model you can simply select these options from the drop-down list in the debt financing worksheet and the model will automatically calculate the debt repayment schedule.

Interest

Interest is the price of borrowed money. In Feanut Financial Model you simply provide the annual interest rate percentage and the model calculates the associated financial costs that is reflected in your projected income statement. You should determine the expected interest rate for different types of debt for your start up business. A good source of information on average debt interest rates is the statistics provided by national banks, specialized financing websites, commercial banks or annual filings of other companies that can mention debt financing and interest rates in the notes to financial statements. In some countries, however, only publicly traded companies provide extensive notes to their financial statements and their interest rates are likely to be way off what the financiers would provide to a start up company. In many countries, however, you can access financial statements of private companies as well, which will allow you to define a peer group of comparable companies and determine an average interest rate. Remember, any extra effort in justifying the assumptions used in your financial model will increase its credibility.

Next time we will talk about yet another important financing feature that should be incorporated into your financial model - revolving credit facility. So stay tuned.

In the meantime, if you want to know more about building financial model for start-ups, you can still use the offer to join our Startup financial modeling online course with a discount for first 100 students.