Some people think that debt is a dirty word. Whether it be personal debt or business debt, it has some negative connotations. When you run a small business, debt is typically part of your financial life plan. While debt often has a negative connotation, it’s not always a bad thing. Leveraging debt can help you finance growth, seize timely opportunities, and avoid selling off assets to manage through cash-crunched times.
Today, despite recent increases and volatility, interest rates remain historically low, making it relatively inexpensive to borrow for your business. As we speak that is slowly changing. As rates are starting to rise, however, any new debt you take on should be carefully considered, particularly with respect to its expected duration and exposure to rate increases.
In addition, as supply chain disruption and political unrest continue to deliver global uncertainty, understanding how such external factors may affect the operation and growth of your business should be considered as you take on debt. Here are a few concepts to help you leverage debt for growth and manage it through today’s evolving economic environment.
Efficient debt spending
Debt is an extremely useful and efficient tool for your business, but make sure you know how and where to use it to maximize its utility.
For instance, you don’t want to be paying principal and interest on equipment that has outlived its expected useful life. If your equipment is expected to last five years, it’s wise not to take on a seven-year loan to cover its cost. You’ll end up paying for that equipment two years after you’ve stopped using it.
You’ll also want to maintain a solid debt equity base in your business. With the option to finance equipment and vehicle purchases from retailers or dealers, it can be easier to accumulate debt in the business and erode your equity. As a consequence, it can be more difficult to secure lending from a financial institution.
Assess repayment capacity
When taking on debt, it’s important to be confident that your business will be in a position to repay future debt obligations. Forecasting the future cash flow of your business, with debt repayments in mind, can help you understand your capacity for covering the debt down the road.
When we discuss this topic with our clients, an important item we look at are projections. It is often understanding a best, base, and worst-case scenario. In recent conversations, we had a client who was ramping up operations and could share projections with confirmed orders for the next year. Through this, our client was able to take on more operating debt to support making larger orders with suppliers, which in turn allowed them to fulfill their customers’ needs.
This step can be particularly important in a rising rate environment, when future borrowing costs may be higher than they are today. It’s therefore wise to stress test your finances and account for higher debt repayments in your forecast.
Tie debt to goals
Taking on debt to invest in the growth of your business is often a smart move. However, the type of debt you take should match your intended goals. For example, borrowing with term debt to manage day-to-day cash flow can result in a vicious cycle of debt that becomes difficult to repay. On the other hand, financing a piece of equipment that will enable you to work more efficiently, grow your sales and or produce more goods would make good business sense.
It is also important to keep your debt working for you, not against you. When you begin generating profits, a natural tendency is to immediately pay down your debt. Remember, this is taking money out of your cash flow that could be used to buy inventory or further expand sales. Before paying off already established debt, ensure that you can maintain sufficient funds to continue to grow your business and have enough liquidity leftover.
We’ve seen businesses make lump sum payments on their term loans when they have excess cash only to come to the bank later to set up operating facilities to support the next round of inventory.
Your decision to take on debt needs to pay off over the long term. The cost of borrowing should typically be lower than the returns generated by the investment.
Locking in low rates
As you consider future debt, particularly for the purchase of property or equipment, weigh the pros and cons of choosing variable prime-based rate versus fixed-rate borrowing.
Be sure to base your borrowing decision against future interest rate increases. If you have less flexibility to absorb higher repayment amounts, consider fixed rates to minimize the impact of rising rates, or perhaps ladder your maturities so that you are not exposed to a single maturity event.
When you need funds to grow your business, borrowing can be a good way to take advantage of opportunities and move your vision forward. In fact, debt can be a strategic tool to maximize your company’s potential.
Working with an advisor can assist you in understanding some principles of debt management. With our clients, we advise them how to recognize how rate increases may affect the balance sheet of their business. It can help you use debt as a strategic tool versus a crutch to lean on Keeping Life Current.