Rundu Hardware: Bank Loan or New Partner?
Rundu Hardware is a partnership with annual revenue of N$1.8 million, gross margin 28% and operating expenses of N$320,000. It holds inventory for about 90 days, collects receivables in 45 days and pays suppliers in 30 days. The partners want a N$600,000 extension to add building materials. Option A is a five-year bank loan at 16% annual interest, repayable monthly. Option B is a new partner contributing N$600,000 for a 30% share of profits. Current capital employed is N$1.15 million, of which N$450,000 is liabilities. The cash-flow forecast shows an average monthly surplus of N$18,000 before any new finance cost. The bank requires gearing below 55% and interest cover above 3 times. The new partner wants a say in purchasing and a dividend of at least N$60,000 in year one. Decide which option to recommend.
1. Calculate current gearing and the gearing and interest cover under the bank loan. Test the loan against the bank's conditions.
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Current position
- Gross profit = N$1,800,000 x 28% = N$504,000
- Operating profit (EBIT) = N$504,000 - N$320,000 = N$184,000
- Equity = capital employed N$1,150,000 - liabilities N$450,000 = N$700,000
- Gearing = debt / (debt + equity) = N$450,000 / N$1,150,000 = 39.1%
With the bank loan
- New debt = N$450,000 + N$600,000 = N$1,050,000
- Capital employed = N$1,150,000 + N$600,000 = N$1,750,000
- Gearing = N$1,050,000 / N$1,750,000 = 60.0%
- Interest = N$600,000 x 16% = N$96,000 per year
- Interest cover = N$184,000 / N$96,000 = 1.92 times
Test: The loan fails both conditions. Gearing of 60% is above the 55% limit, and interest cover of 1.92 is below the required 3 times. To reach 3 times cover on current profit, EBIT would need to be at least N$288,000, which is N$104,000 more than now. The extension may add profit, but the partners cannot assume that before the bank approves the loan. Monthly repayment would also be about N$14,600, leaving only about N$3,400 from the N$18,000 surplus.
2. Assess the financial and non-financial implications of the equity option.
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Financial implications
The equity option avoids N$600,000 of debt, so gearing stays at 39.1% and interest cover is not weakened. There is no fixed interest or repayment burden, which protects cash flow during the building-materials launch. That is important because the monthly surplus is only N$18,000.
However, the new partner takes 30% of profits. On current operating profit of N$184,000, that is N$55,200. The partner wants at least N$60,000 in year one, which is more than 30% of current profit. Paying N$60,000 would leave the original partners with N$124,000, less than their current N$184,000. The extension must therefore increase profit substantially to avoid dilution.
Non-financial implications
The partner wants a say in purchasing. This could improve supplier negotiation, but it also creates decision-making conflict and slows responses. The original partners lose absolute control over a business they built. If the partner brings building-materials expertise or customer contacts, that may be worth the dilution; if not, the control loss is a serious cost.
Overall, equity is safer for cash flow but expensive in profit-sharing and control. It is not automatically better than debt.
3. Recommend which option the partners should choose, with conditions.
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Recommendation: Choose neither option exactly as offered. The bank loan fails the covenants, while the equity offer is too expensive in profit share and control.
The partners should first improve working capital. Inventory of 90 days is long for hardware; reducing it to 60 days would release roughly N$108,000. Reducing receivables from 45 to 30 days would release about N$75,000. Stretching payables from 30 to 45 days would add about N$54,000. These steps could reduce the external funding need and improve the bank's view.
They should then negotiate either:
- A smaller loan, for example N$400,000 over a longer period, with the rest funded internally; or
- An equity partner at 20% with a dividend capped at about N$35,000 in year one and a limited advisory role in purchasing.
If the bank still refuses and the partner insists on 30% plus N$60,000, the partners should delay the extension. The current cash surplus is too thin to support a loan that leaves only N$3,400 monthly, and the equity terms would reduce the original partners' reward before the new venture has proved itself.