Debt can be a valuable tool. Here are five key factors to consider
Diverse small business owners can be more reluctant to take on debt — whether it’s due to a bad personal experience with borrowing or not wanting the burden of debt repayment. But before you write off using debt, consider its potential to help your small business grow.
Debt, or debt financing, can allow you to take advantage of a business strategy known as leverage. That means you use a loan to increase the return on the investment. Simply put, your debt may help you make more money.
That may seem counterintuitive. After all, taking on debt comes with a cost — typically a monthly payment that will include interest and in some cases fees. While you might be reluctant to add another expense to your books, debt financing might make more sense than you think if you crunch the numbers— as long as there’s a reasonable expectation you can get favorable loan terms and repay the money. One advantage of debt financing is you keep ownership and control of the business. This is in contrast to equity financing, in which you sell a portion of the business in return for capital.
Keep in mind that while a loan may not be a solution to create additional profit on a single project, it can be a powerful tool that allows a business to keep more cash on hand. And that cash can be put toward additional investments that could ultimately drive long-term growth and future profits.
Let’s compare two small businesses to see how a business can use leverage to potentially create more available cash to drive growth.
Uses cash to buy $100,000 worth of inventory
Uses $50,000 of cash + a $50,000 installment loan to buy $100,000 worth of inventory
Resell at $160,000 for $60,000 in profit
Resell at $160,000 for $60,000 in profit
$60,000 cash on hand to invest in growth
$105,000* cash on hand to invest in growth
* There is an interest repayment of $4,500 as well as the principal repayment of $50,000 on the loan.
While both businesses turn the same initial profit on this project, it leaves ABC with much more cash to invest in future growth. That’s because ABC only used $50,000 in cash to purchase the inventory, compared to XYZ’s $100,000 in cash.
Although there’s obviously risk — because there’s no guarantee ABC would resell the inventory immediately — this example shows how debt gives a business more opportunities to create growth by having more available cash.
5 questions to ask yourself before taking on debt for your business
While debt can be a tool to boost growth for many businesses, that doesn’t mean it’s the best solution for everyone. Here are five essential questions to ask yourself to help determine if taking on debt is right for your business.
1. What are my immediate and long-term business goals?
You should know exactly how you will use your loan. One common use is to stabilize cash flow. Some additional possibilities might include:
- Buying inventory (immediate)
- Supporting operations (mid- to long-term)
- Purchasing property (long-term)
Without a clear purpose for the money you’ll borrow, you risk spending it in a way that won’t support your business growth objectives. Whenever possible, tie your loan to an expense that has a specific, measurable revenue outcome.
2. What is my plan to repay debt?
You should know exactly how you will use your loan. Some possibilities might include:
- Selling additional inventory and/or services
- Leasing out space to help service the debt
- Reducing overhead costs to increase profit margins
3. How will debt payments affect my present financial situation?
This question will help you assess if your current revenue will support debt payments or cause undue strain on your cash flow, especially if the debt won’t add to your business income immediately.
Suppose you’ve crunched the numbers and have found that adding a debt payment would cause financial strain. This just means you have to go back to the drawing board. For instance, you can find a way to accelerate or increase your revenues, consider borrowing less money, or pressing pause on your plan to borrow money until you can comfortably afford the repayment.
4. What business risks do I face?
Specifically, you want to identify any risk that could prevent you from repaying the loan, such as a sudden decline in revenue, increased operational costs, or staff shortages. To address these issues, you may consider adding more income streams to your business model, researching backup suppliers, or building redundancies into your staffing plans.
Be as thorough as you can to address any risks that could prevent you from meeting your debt obligations. Defaulting on loans could prevent you from using debt as a tool to grow your business in the future, so it’s worth assessing all of these details.
5. Do I have a backup plan?
You’ve asked the questions and crunched the numbers, but there’s still a chance something beyond your control happens to your business. To be safe, you should have a plan to recover or continue operations — including covering your debt payments.
Your backup plans might include having additional cash reserves in the form of personal or business savings. You may also explore strategic partnerships or joint ventures to help you through setbacks. Many businesses also find success in modifying their business model or pivoting when faced with emergencies that could affect cash flow.
Take the next step
If it looks like debt financing might benefit your business, you can start by looking into various lending products and preparing an application. Even if you aren’t ready to take on debt today, knowing your options can be helpful for future planning.
Have more questions? Make an appointment to speak with a banker.