Do you completely understand debt, how it differs and how to match it to your business to help avoid the risks?
You’ve no doubt heard people say “avoid debt at all costs”, but what does that mean to business owners trying to grow or stay afloat? Does avoiding it mean not closing a cash flow gap from slow paying customers to fund growth or not buying a piece of equipment to earn new revenue from a new contract?
Or could it mean taking on a high-interest rate loan and playing catch up due to the erosion in profits because of an uneducated decision, taking on the wrong debt that wasn’t matched to your need?
Below are some key points to help you understand your own situation and help you tackle your debt challenge:
The gist of bad debt vs. good debt
Good debt is often related to taking on working capital for some kind of investment that will produce a return to the business. You take on this debt because you don’t want to deplete your own cash or sell (liquidate) any of your existing assets. Good debt has a healthy low impact to margins and can be sustained for long periods of time without any growth impact to profit margins.
Bad debt usually includes any debt you’ve taken on that’s either high-interest rate debt, that you can’t afford or isn’t necessary to fund growth of your business.
Borrowing can be a smart decision if you are using it to finance the growth of your business. Just remember that you should always plan in advance to make sure the type of debt and repayments closely match your cash flow cycles and only borrow what you need.
What do you need the money for?
Most growing businesses need an investment of capital to grow and scale. If you’re using the capital to invest in inventory or new staff that will support the growth of your business, then you are borrowing for the right reasons. If you are borrowing money to solve a cash flow problem because your margins are slim or you didn’t keep up with tax payments then you will run into more issues finding a lender or finding affordable debt that won’t compound your problem.
Taking debt to purchase equipment and debt to buy stock are two completely different things and you can also encounter inefficient tax strategies if the wrong choices are made leading to lost profits come end of year.
What security can you offer (or want to)?
Generally, the more business assets you can offer as security, the better your borrowing rates with be.
If you run a business with few assets, then consider carefully what you can afford to put on the line. If you are using unsecured loans that require a personal guarantee or loans that require your house as collateral, the personal risk is obviously much greater if your business fails.
Alternatively, you may want to consider using your account receivables as security as you can generally borrow up to 80% of your on-going invoicing. The invoices are an asset in the business which can often be overlooked a solid asset to obtain funding.
If you are taking out a loan and the lender does not require personal guarantees and/or security over the business then careful investigation into the cost of the loan should be looked into.
How long do you need it for?
The amount of funds and loan terms will have a huge impact on your repayment ability. Always give yourself a realistic buffer for repayment and resist the temptation to take on a loan that your not 100 confident you can repay in the timeframe.
For larger purchases that will take longer to pay back, long-term financing is generally a better option. Leases and bank loans are safer forms of long-term finance, and a lease may be preferable if you will be using the capital to fund equipment or technology that becomes out-dated quickly.
As a basic rule, fixed terms loans are best suited to equipment purchases and lines of credit are best for working capital for advertising, inventory and other items that will turn into cash quickly (or generate future revenue like sales staff), allowing you to repay a line of credit to reduce your interest charges without penalty.
Which repayment types match your cash flow?
Fixed term, revolving credit, monthly, daily and weekly are just some of the repayment options you’ll be faced with. Understanding how and when you get paid as well as the length of time a borrowed dollar takes to convert into cash flow needs to be understood before taking on any new debt.
Let’s say you’re borrowing to buy some stock that will turn into cash flow within ninety (90) days. It would make sense to take the line of credit option that you draw down and pay your supplier. Once it turns into cash you can repay your credit line and stop the charges. Now if you were to use a fixed term option you might get stuck repaying debt over 6 – 12 months and be locked into the interest charges for up to 9 months more than you needed.
The above are just a few examples to consider, as with all decisions you should try and consult a professional or associate to help plan your next business funding decision.