In theory, your business's debt is an investment in its future prosperity. Learn to differentiate between debt that will advance your company's objectives and debt that won't.
By John Mulligan
Nobody starts a business with the intention of owing money, yet debt is a fact of life for most business owners. Unless you are independently wealthy, you will probably need to borrow money in order to make money. “Debt may be unavoidable when you start a business,” says Patricia Stallworth, president and CEO of PS Worth Associates in Suwanee, Ga.
That isn’t necessarily a bad thing, according to Stallworth. Borrowed capital can open up a lot of possibilities for your business, and debt on loans or business credit cards is tax deductible, she says.
Just because debt is inevitable, however, doesn’t mean you don’t need to be cautious with it. “Small businesses are notorious for defaulting on debt,” says John Fair, a Houston-based financial advisor for AXA Advisors. The key is to distinguish between debt that will help you to accomplish your goals and debt that will hurt you.
Generally speaking, good debt is debt that will ultimately create more profit than what it will cost you to pay it back. “You go into business because you want to make a profit. If the debt will help you do that, it’s good,” Stallworth says.
The primary way in which debt creates profit for your business is by allowing you to pursue business opportunities that require more resources than you currently possess. “If you are using other people’s money to grow your business and can pay them back, that can be a good thing,” Stallworth says.
Fair says he worked with a hazardous waste company that borrowed money solely to hire one employee. “They realized they lacked a certain degree of scientific expertise necessary to take the company to the next level and land a different kind of contract than what they had been getting,” he says. The company took out a loan to cover the large salary of the expert they needed and consequently landed a contract they otherwise would’ve lost out on.
Fair cautions that the company did a substantial amount of research and developed financial projections before taking out the loan, to feel confident that the move would pay off. Make sure the debt you are taking on is good debt by performing a cost versus benefit analysis, Stallworth says. “Is the return on investment going to be worth what you must pay in interest?” she asks.
The simplest way to ensure a loan’s return on investment is to focus primarily on the return, only taking out loans earmarked for specific projects that you are confident will generate income. However, it can also pay to take advantage of good terms when you find them, regardless of whether you have an immediate need for the money. “If you can get an interest rate lower than your rate of return, get it,” Fair says. “Borrow as much as your business plan dictates and what you reasonably anticipate that you will need.”
Fair says that many times businesses underestimate their needs and find themselves undercapitalized down the road. However, if you go back and try to borrow more money when your business is in trouble, you may find that you are no longer able to get it. “It pays to be able to anticipate financial needs in advance,” he says.
Borrowing money you don’t yet need can be risky, however, unless you are able to refrain from spending it until you find a project that will generate a sufficient rate of return. “You really need to have a reason for the debt, and a sense of whether you can pay it off,” says Stallworth.
Overspending on space and equipment are two examples of common mistakes that lead to bad debt, Stallworth says. Spending extra money on a space that is bigger than what you need means spending more on interest too. “Keep expenses as low as possible until the business can catch up,” she says.
Fair agrees. “It may not be smart to use a loan to buy brand new equipment,” he says.
Another common mistake is to assume that an infusion of capital will pick up your business, without knowing specifically how that borrowed money will help. “A lot of times people assume money is the answer,” Stallworth says. “If they had more money, their business would do better. You have to look objectively and make sure that there aren’t other problems with your business.”
And regardless of how promising an investment looks, you want to be careful about getting too far into debt. “While every industry is different, you don’t ever want to be highly leveraged,” Fair says. “I’d say 30 to 40 percent [leveraged] is playing it safe.”