When a business owner looks at an income statement, it is quite clear what elements affect the cost of doing business: payroll; rent; utilities; inventory purchase price; etc.
What’s harder to see is what business accountants and consultants call “opportunity costs.” The World English Dictionary defines opportunity cost such as: “money or other benefits lost by pursuing a particular course of action rather than a mutually exclusive alternative.” In other words, if you decide to go Option B, you lose any benefits that would have increased from Options A or C.
As an executive or owner, you want to minimize opportunity costs. You do this by weighing the benefits and drawbacks of EACH of the options before you. This allows you to get a clear picture of each possibility and allows you to select the option that best meets your immediate (and possibly medium-term) needs. Once that decision is made, move on.
For whatever reason, when it comes to business financing, evaluating opportunity costs are overlooked by most owners and top executives. Why? I think it’s because they tend to weigh the definable cost of money more than all the other costs associated with business financing.
Let me explain. Opportunity costs are not limited to monetary or financial costs. They also legitimately include:
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Non-pursued sales (because there is no cash available to cover associated costs, resulting in lost profits)
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Discounts from suppliers not taken (which generate lost profits)
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Lost time (time spent searching for a financing alternative when a different alternative could have been consumed more quickly; this means that the executive’s time is wasted, which can result in lost profits)
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Emotional impact on owner (s), family of owners, employees and their families (the stress associated with business financing issues has implications on many levels)
These are very real but not tangible things, and since they are not tangible, the tendency is to ignore or discount their impact on the financial health of the company. That is a huge mistake, but understandable.
It is understandable because virtually all financial institutions (both traditional and non-traditional) will focus on the numbers when entering into a transaction. They should do it because they are assessing the risk. So it makes sense for the borrower to focus on “the numbers” as well. That is, the tangible cost of money.
Unfortunately, focusing only on the numbers almost always means overlooking opportunity costs – costs that can be substantial. I’ve seen too many homeowners procrastinate for weeks in an attempt to save a quarter of a percent on the cost of money. Often times, the delay resulted in a loss of revenue and profit of an order of magnitude greater than the cost of money. To use an old adage, they were wise with a penny but dumb.
It is not necessarily easy to assess the opportunity cost in a financial situation. That is because most banks / finance companies will not help the analysis. After all, they want to close the deal to present the advantages of their specific course of action, regardless of whether it is the optimal solution for you at the time.
It is up to the owner / executive to evaluate their opportunity costs. The optimal decision might mean paying a slightly higher cost of money to get funds early enough to take advantage of an opportunity. After all, what good is saving $ 1,000 in cost of funds if you lose $ 10,000 in additional earnings?
There are quite a few options for business financing. They include:
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bank loans (direct or SBA guaranteed)
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personal credit (credit cards, home equity, etc.)
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borrow from friends and family
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sale of company shares (dilution of share capital)
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invoice factoring
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financing merchant account
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fundraising
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various forms of asset-based loans
Some of these can be immediately ignored based on an understanding of your situation in the credit world. For example:
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If your company is less than 2 years old, you will not get a bank loan
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If your business offers a consumer product or service, you will not have accounts receivable to factor
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If your personal credit is bad, your chances of borrowing are slim or nonexistent.
Once you can determine which options are available to you, it’s time to evaluate both the hard cost and the opportunity cost associated with each option to determine which one gives you the most immediate advantage. Once you know that, make the choice and build your business.