Debt often has negative connotations, but it’s also an important source of finance for growing businesses.
The trick is to use it for the right purposes.
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It can be tempting to borrow when times are good and banks are happy to lend. However, just because a lender is willing to offer you a facility, does not mean that it is a wise borrowing decision to accept it.
Ultimately it’s your responsibility as a business owner to understand your current and future business plans, financial position and cashflows and use this information to make sound borrowing decisions.
Not properly assessing the whole picture to make an informed decision can lead to financial distress, with other negative impacts including:
- Insufficient cash to meet the business’ needs,
- A lack of ability to reinvest in additional future expansion,
- Reduced product or service quality if you need to trim costs to repay debt,
- Increased business owner stress levels,
- Poor decision-making influenced by the debt position,
- Reduced value of the business and attractiveness to investors, or
- The business becoming insolvent.
To help make sound decisions about lending for your business, there are five key questions you need to ask yourself:
1. When should I use debt?
Debt should be used for three key reasons: to fund business growth and expansion of investments such as plant and equipment, working capital, and to purchase the business in the first place.
These activities and investments produce cash flow, which allows you to cover the principal and interest repayments of the debt.
Small businesses will often try to use debt as a means to fund current or past losses. While this is common, it’s not recommended.
It merely increases your debt without generating any additional cash to pay it off and that usually ends in tears.
2. Why should I use debt?
Debt has its advantages. If used for the right purposes, it provides a fast way to bring cash flow forward to fund growth opportunities.
Doing so allows you to pursue opportunities available to your business now, and provide you with a return on your investment sooner.
Debt enables you to pursue these opportunities now, rather than wait until you have built enough cash reserves to self-fund the growth, by which time they may have already passed.
Another advantage of using debt is that it is a non-dilutive source of funding. This means you don’t have to relinquish any equity.
This provides a leveraged return, as you’re not tipping in any cash.
Instead, you’re utilising the debt to create a higher return than the cost associated with obtaining and repaying the debt.