The belief that debt is bad for business has been long held and the idea isn’t without merit! Debt, when not properly managed, can get out of control and cripple even the most stable businesses. However, when carefully chosen, business debt can position your business to take advantage of certain opportunities that you would otherwise have to give up. In this article, we dispense with a few common myths about business debt and demonstrate how you can use debt to grow and advance your business.
A case study:
Take two business owners, Jim and Job, who are in the same line of business. Their businesses both have a monthly net profit of $10,000, and they are presented with an opportunity to acquire equipment worth $100,000 to double their production capacity.
Job decides to save his monthly profit towards this acquisition, meaning that he’ll be able to buy it in 10 months. Jim opts to use his monthly net profits as leverage to get a loan for the amount and buy the equipment immediately. This will allow them to produce at double capacity immediately and hence double their profit. The extra amount will go towards loan repayment for the next ten months, and their normal profit will not be affected.
In ten months, Job’s business has saved up the $100,000 and wishes to buy the equipment. However, inflation has caused a 10 percent price hike, meaning that they’ll have to wait another month before they can buy the equipment. Meanwhile, Jim’s business has been getting $20,000 in profits, less the cost of the loan (assume 3-year loan at 8 percent interest = $3,000). They therefore have $170,000 in the bank.
Ten months later, who has the better business?
By acquiring the new equipment earlier, Jim’s business has earned $7,000 more every month for ten months compared with Job’s business. The equipment not only pays for itself, but it has provided new profits that can be used to avail the business of even more opportunities.
Every profitable business can trace their success back to a time when they used financial leverage to achieve growth. The opportunities don’t have to be the same; it could be gaining working capital to increase stock levels, opening up a new branch/product line, applying for debt consolidation meaning you’ll pay less interest and fewer lenders, etc.
Provided the funds eventually pay for themselves, debt can be a great way to finance growth while maintaining your own business’s cash flow. In the above example, Job had to save his entire profit in order to afford the equipment – he couldn’t spend the profits to do what he normally did. Meanwhile, Jim still had his $10,000 to do with as he normally did.
As you have seen, debt can be used to raise your competitive edge and increase your business bottom-line. The trick is to know how to use it, for instance, for purchasing business assets whose returns exceed the total cost of asset maintenance and debt repayment.
Types of debt for business advancement
The trick to getting the right debt facility is to properly research on your funding options. If you’re looking to raise your working capital, the right time to begin your search is a few months before your business won’t be able to meet its expenses. This will allow you to adequately consider all options without the pressure of mounting expenses clouding your judgement. Below are types of loans to consider depending on your business circumstances:
- Revenue-based loans (RBLs)
These loans are ideal for growing businesses that have yet to acquire as many hard assets against which they can borrow. Usually, lenders will give an ‘advance’ of about 10 percent of their previous year’s revenue. The lenders will be paid every month based on a schedule according to monthly revenues; more is paid in months with higher revenues and less is paid in months with lower revenues.
Revenue-based loans are ideal for companies that have a sortof fixed earning potential such as software, internet and technology providers and film producers that get royalties or licensing payments. Most lenders require that the gross profit be at least 50 percent of total revenues in order to qualify candidates for RBLs.
- Asset-based loans (ABLs)
These are the easiest and most commonly secured loans for capital expenditure for businesses. There is a broad range of options for business owners in search of asset-based financing, so take your time to sift through all options. If you’ve been turned away by big banks, you can look for non-mainstream asset-based lenders such as debt consolidating companies who can give funds with your inventory, accounts receivable and/or fixed business assets as security.
The amount of funds that your business can raise depends on a pre-agreed upon percentage of the calculated value of collateral assets, usually 50 percent of inventory for sale (finished goods) and 70-80 percent of qualifying accounts receivable (it is common for lenders to research your accounts receivable and only pick those with good credit scores and good repayment histories). The interest on the loan also depends on your financial position and credit rating.
A disadvantage of this type of loans is that they commonly attract due diligence fees that will increase the effective cost of the loan. Larger institutions may also require personal guarantees from the business directors/owners/founders. They may also require that you transfer your banking relationship to them if you’re not already a customer.
- Factor loans
These are almost similar to ABLs in that they provide secured funds based on your accounts receivable. Naturally, your own creditworthiness should be supplemented by a very stable customer base. A factor directly buys your qualifying accounts receivable so that your debtors will arrange to pay them directly through a ‘lockbox’.
Factors dominated the garment trade industry since it was the most prevalent business after World War I, but today factors are available for a wide range of industries. Be careful about the quotation of interest; some may quote 1 percent per month to lure you into thinking they’re cheap. However, this is just 12 percent per annum, which is really not cheap.
Conclusion
Here is the bottom-line when it comes to borrowing for business purposes. Debt can be good, but only if you’re careful about when to take out a loan, how much to borrow and how you use it. Talk to other business owners once you’ve decided to apply for a loan. You can also use your accountant and other professionals in your business and social network. There’s no substitute for in-depth research.
Isabella Rossellinee
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