Question 1
What’s the APR when you use free cash flow to buy more inventory?
Question 2
What is the APR of a Shopify Capital loan where you make daily payments of a set percentage of your sales?
Question 3
You receive pricing for $100,000 self amortizing loan to be paid back over 12 months in monthly payments from two capital providers. Both lenders claim a 12% APR. Lender A will charge $12,000 in interest over the term ($12,000 / $100,000 = 12%). Lender B is going to charge you $6,274 in interest over 12 months. Which is the correct APR?
These are all trick questions.
For the first question, you have an IRR, not an APR.
The second question is also a trick question because you will only know the APR (which will actually be your IRR) after the loan is fully repaid, but what you can easily do before taking the loan is calculate your expected IRR based on your sales projections.
For the third question, it depends. The scrupulous answer is Lender B. But is Lender A based in California or New York? Are you based in either of those states? How much does Lender A feel the need to comply with the state regs? The point is this. It’s your responsibility to calculate the price of capital. You can’t leave it to the lender.
My goal with this post is to help brand leaders make better capital decisions and a key part of that is understanding the price of capital. I also stress using IRR, not APR, when weighing capital options. It sounds wonky, but it’s important.
Full disclosure: Elephant Herd Capital provides inventory financing to exceptional brands. We believe we have the best product for financially sophisticated brands so it’s in my interest to have more financially sophisticated brand leaders.
What’s your goal?
Your primary consideration is determining how much growth each capital option enables. You need to consider this not just now but into the future because your capital choices today will dramatically enable or restrict your growth options tomorrow.
This is true even if you are borrowing for a dividend recap because you want to know how much borrowing today for a distribution will block your ability to raise capital in the future.
Focus on determining future growth enabled or blocked.
There are 3 critical steps.
- You first need to determine how much you need and when. Can you get the amount you need when you need it?
- Next you want to understand how well the required repayments align with your ability to generate cash. Timing mismatches are deadly. A bullet loan is awesome up until the moment you have to pay it back. Quick MCA’s are awesome, but if you have paid back half the loan before the inventory arrives in your warehouse, they aren’t looking as great.
- With one and two satisfied, the price of the capital then helps you understand how well the capital aligns with the return you expect from using it and helps you have an apples to apples metric to compare options.
Why you shouldn’t use APR.
#1 APR is a consumer borrowing concept being applied to commercial lending.
APR came out of the Truth in Lending Act of 1968 which was focused on helping consumers understand the total cost in terms of interest and fees of consumer loans such as mortgages, car payments and installment plans. Legislators decided to focus a metric on annualized cost not total cost.
#2 The APR calc is an artifact of pre-Excel calculator limitations
Today, calculating an IRR in a spreadsheet is dead simple. In 1968, calculating an IRR was an iterative exercise in mechanical calculators, rate tables and actuarial charts. Simple, it was not. Think Hidden Figures.
The legislators were going for an IRR concept but because of the consumer focus and calculating constraints, they compromised on the APR language. It closely approximates the IRR, but isn’t exactly the same.
Today we have spreadsheets. So ditch the artifact and just use IRR.
#3 Don’t let the lender tell you the price of capital.
It’s your responsibility to calculate the price of capital.
Think of it this way. If someone gave you a bunch of gold bricks, would you wander into a pawn shop and ask them to weigh it for you and then give you a price? Or would you carefully weigh it yourself before looking for a buyer?
As noted above, the laws, standards and enforcement vary. Lenders have an incentive to win deals and create as low of an APR as they think they can get away with. How the APR is calculated is going to vary with each lender.
Why you should use IRR.
#1 You are judging the capital on your ability to use it.
You don’t borrow money at 40% to invest it at 5%. You don’t take out a loan on your credit card to invest in a CD. So don’t do that with your business. If you think you will earn a 30% return on buying and selling that inventory, don’t borrow money at 40%.
Your most important consideration is how much the capital helps you. In order to answer that question, you must know your expected return from your use of the cash. I invest X today and get payments of Y back over Z periods. IRR gives you that answer.
#2 Cash impact is what matters. IRR informs this better than APR.
You are trying to determine how much future growth a capital option enables or blocks. What you really care about is when the cash comes in and when and how much goes out. Those are your net cashflows. IRR uses the net cashflows. It’s money in; money out.
APR, depending on how someone is using the term, is focused on telling you the price of the capital in terms of interest and fees. It cares about principal, interest and fees. APR can give you a sense of the timing, but it can be manipulated by lenders based on how they decide to calculate it.
#3 IRR allows you to standardize across your use and all capital options
I am repeating myself here, because it’s an important point. Because you are doing the calculation, only the IRR calc allows you to come up with one standard number and standard methodology.
What you should do
- Before focusing on price, understand what your capital needs will be in the future and how much of those capital needs a capital option will provide. This is a question of borrowing capacity in the future.
- Understand how repayments align with your ability to generate the cash needed. The ideal is cycle matched payments.
- Use IRR to understand your own rate of return from the use of cash. Then run your own IRR’s for each capital option. Monthly, weekly even daily payments are easy to normalize with an IRR calc (here’s a spreadsheet with lots of lenders pre-baked) so you can be as close to apples to apples as possible.
Email partnerships@elephantherdcapital.com to learn more about Elephant Herd Capital’s Inventory Finance. We are looking for brands with strong repeat purchase dynamics, more than 3 years of operating history, sales between $5 million and $25 million and a knowledgeable finance function.