Thinking Like a Bank for Your Small Business
At their core, local banks operate on some of the most core principles of finance to make money. Because their business model is relatively simple (borrow money and loan money), it’s the perfect way to understand how and why your business should borrow money to support its operations. So today, we are going to oversimplify how banks make money and how you can learn from it.
How Do Banks Make Money?
Banks generally follow the following process to make money with their regular operations:
Borrow money
Maintain required deposits
Loan money (in excess of the required deposits)
The real key to making money for a bank is the interest rates that they borrow and loan with. Once the bank has verified that they can reliably lend to a borrower, the profit that the bank makes simply depends on the cost of money they are lending for the bank compared to the cost of borrowing for the borrower. To put some numbers to this example, my bank is currently paying me 1% on my “high yield” savings account deposit. This means that they are paying me an annualized 1% interest rate on the money I hold with them. At the same time, the bank has the money that I entrusted to them and they can use it to make loans (so long as they keep the required amount available for me and every other customer to withdraw at any given time). The bank will use my money to help fund a mortgage loan to someone that will pay 3% annualized interest on the loan. While it is likely that the bank will sell the loan to another institution to get cash in hand to make more loans, we will ignore that portion for now. Effectively, the bank is making a profit of 2% of the difference between the rate that they are borrowing money (1%) compared to the rate that they are loaning money (3%).
What Does This Mean for My Business?
It is important to remember that banks are in debt to the individuals and businesses that bank just like your business may be in debt to the bank when using a term loan or line of credit. Therefore, in order to make money using a line of credit, the return on the cash borrowed needs to be larger than the rate at which it is being borrowed. For a business, this is a more complex calculation with floating interest rates and multiple components as a part of the business operation, but the sentiment remains the same. If your business’ rate of return cannot match the interest rate the bank is charging you for a given period, the best course of action is to make payments on the loan from a purely quantitative financial standpoint.
While there are certainly other factors that can influence a Company’s decision to maintain, borrow, or pay down debt, it is crucial to understand the purely qualitative factors noted above. Once you are able to translate the costs and benefits of the borrowing into plain English, the decision making process of whether to borrow or payback is simplified, which will save you time and effort as a business owner.
One last thing for small businesses! This concept applies to credit cards as well as formal loans, and credit cards charge interest at rates that are incredibly high once the balance is past due. In many cases, credit card debt is incredibly hard to leverage into a positive situation past the interest free period. So be sure to pay close attention to credit card balances!