When a business receives an investor’s funds it normally falls into what we are calling the capital trap. This a trap in which business fails to pay back the business loan or investors funds as required. Let us suppose a business receives a business loan of 100 million dollars at an interest rate of 20%, which must be paid back after one year. We are using a simple example in order to make this easy to understand.
At the end of the year the business is expected to pay back 120 million dollars which is principal +interest. Again this is a simple view with a few assumptions to properly illustrate how this works. The business managers can go excited and spend on the following
• Vanity marketing in which they market projects which are not effective
• Vanity projects which have no return in that year
• Vanity renovations to add new colors
In doing this the business spends 40 million on the vanity affair and hence effectively has 60 million dollars to actually invest in a project that will bring it an effective rate of return. Vanity business projects are based on ignorance and ego not on business sense. Again keeping it simply we shall assume another rate for capital return but concentrate on the interest return, if the business was to invest in a project that would bring it back 20% interest with the required principal payback, then the business would expect the following from the 60 million.
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Amount from the 60 million can be calculated as follows
• (60m*20%) +60m=72million
This means that at the end of the year the business can only pay back 72 million and is short by 48 million which now needs to come from somewhere.
With this dilemma this business will start using money that was supposed to pay for creditors to fund its loan repayments and ends up with a 48 million creditor position. Now, because the project that was used to invest the 60 million is not covering the loan obligation the business will head for a loss and be shocked and management will not understand how this happened.
What the business forgets to understand is that if it is now left with 60 million (again in simple terms) it now needs to make up for the 120-60 million gap with a high percentage in return. This would require (120-60)/60=100%.
The business hence needs to make up for the vanity spending with a 100% rate of return at the minimum to pay back the interest assuming it makes enough to make up the principal which is another simplification that we have taken.
Looking at this as simplified as it is, it’s no wonder that businesses that receive huge capital loans then struggle and eventually scale down to shut down. There are a lot of vanity projects in business from which money is splashed to because the companies think that they are making money. Every dollar in a loan must have a value return; it must be invested in something that gives back return to the company. Impaired loans are normally because the companies which took loans are failing to pay back the interest and principal because they invested in projects which are non performing projects. At the end of the day these loans will result in the company having the following
• High risk profile
• High creditor risk
• High liquidity risk
• Low performance risk
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It is important that loan funds should have a concrete plan on how they will be used to give a return to the business to pay back for the loan.