Fifth Third Bank balances risk and return Featured

8:00pm EDT August 26, 2008

Given the news in the general media,

many firms are pulling back instead of

being aggressive in the marketplace.

With some banks under fire, credit everywhere is tighter. However, every tough spot

in the market for one business might represent a business opportunity for another.

Smart Business asked Tim Kelly, vice

president with Fifth Third Bank in

Cincinnati, for some tips on balancing risk

and return.

Is this a prudent time to be leveraging


For many firms, it may not be a prudent

time to take on additional leverage.

However, if by prudent time you mean that

a viable opportunity exists, then it is always

worth taking the time to consider whether

or not deploying capital is appropriate.

Capital is clearly less plentiful today than

12 months ago and is priced accordingly.

That must be considered as part of the

analysis. However, the underlying strength

of the opportunity could be tested in the

event current economic conditions persist

longer than anticipated and must be considered as well, provided satisfactory due

diligence has been completed.

If the expected return on the project or

opportunity outweighs other opportunities

available — plus the cost of obtaining capital — then it would be considered a prudent investment. Companies that have

developed and maintain strong balance

sheets are generally in a much better position during economic downturns to take

advantage of more opportunities. This is

not only because others are not able to pursue such opportunities, but also due to the

fallout of weaker competitors. This is

when having ‘dry powder’ can really work

to a company’s advantage.

What about the cost of capital these days? Is

it good to borrow when money is more


The cost of capital is impacted by supply

and demand and, therefore, more expensive today than at times in the recent past.

It is important, however, to note that on a

relative basis, the cost of debt or capital is

still considered low. The prime interest

rate is only 5 percent today while the average prime rate over the past 20 years was

7.5 percent, a significant 33 percent discount from the average. Additionally, the

30-day LIBOR rate, a typical index for pricing commercial debt, is at 2.45 percent

today versus a 20-year average of 4.84 percent. That’s nearly a 50 percent discount.

As long as the expected return for

deploying capital exceeds the costs associated with obtaining the capital or debt, it is

worth considering.

Isn’t leveraging assets a change from getting

loans based on cash flow?

Yes, leveraging or borrowing against

assets is different than borrowing against

expected cash flows. As would be expected, borrowing against assets is less risky

because there is typically underlying or

secondary value regardless of the performance of a company. Borrowing based on

future cash flow that may not occur has no

underlying value, hence it is more risky.

When capital is scarce, less risky or asset-based financing becomes more prevalent.

Which assets are more likely candidates for


Most assets are generally available for

borrowing against, and which asset to be

leveraged would depend on the financing

need/reason. If a company is growing/

expanding, then the likely need for capital

is to support the timing differences associated with carrying additional accounts

receivable and inventory. In this case, these

current or short-term assets would be the

assets likely to be leveraged to support the

short-term nature of the borrowing need.

For longer-term capital needs, such as

equipment, expansion, real estate or even

permanent working capital needs, then

longer-term assets would be the likely candidates to leverage.

Aren’t values of assets like real estate and

many vehicles down?

Generally, real estate values have declined over the past year or so. However,

real estate can still be leveraged based on

current values and current underlying cash

flows that support repayment of capital or

debt. The generally accepted loan-to-value

ratio for borrowing against real estate is

80 percent, assuming there is a sufficient

income stream to cover the debt service or

principal and interest of the loan.

How can I be sure I’m not overextending?

Model future expectations and ensure

that with the most conservative projections, repayment requirements or minimum returns are still achieved. While

entrepreneurs are typically considered

experts in their respective fields, it is generally a good idea to work with your financial advisers to help determine the right

amount of leverage given the company’s

current financial strength and the potential

of various opportunities. Obviously, your

banker or CPA would be excellent experts

to call on to help determine the appropriate capital structure for your situation.

TIMOTHY P. KELLY is team leader/vice president in the Middle Market Commercial Banking Group with Fifth Third Bank in Cincinnati.

Reach him at