When you come into the business world, it can be hard to get away from the personal finance mentality that debt is “bad.” While consumer debt can sometimes be a bad idea (especially when it comes from living way beyond our means, or causes undue personal stress), business debt can often be a positive thing and something you can use to great advantage.
Even if you’re an entrepreneurial shop of just a few people (or even a shop of one!), thinking as a business may mean considering taking on strategic debt.
When to Use Business Debt
You should consider business financing (also known as debt) when you can use it to help you increase your profits by more than the interest expenses.
For example, say you have an old and inefficient widget-making machine. A new machine could cut your costs by $20,000 per year, but it would cost $100,000 you don’t have today.
Under the personal finance mentality, you would start putting aside extra money until you have the $100,000. This means no interest, but it also means $20,000 per year in lost cost savings.
Instead, you need to look at the numbers.
Let’s say borrowing the $100,000 would cost you $8,000 per year in interest over the next five years. The new machine would also last ten years. That gives you a total cost savings of $200,000 ($20,000 x 10) minus $40,000 ($8,000 x 5) in interest minus the $100,000 machine cost. Let’s say, for example, that it would otherwise take you a whole year to save that much money. If you took out the equipment loan, you’d end up $60,000 ahead.
The numbers will vary based on your exact situation, but often times, you just need to do the math.
Are There Other Things to Consider Before Taking On Debt?
Taking on business debt is largely a numbers game, but it’s still an investment, and as with any investment, there is some risk. Risk is not necessarily a bad thing, but you do need to manage it responsibly.
Here’s what you should consider.
Time to Increase Revenue
You may feel certain that you’ll increase your revenue, but watch out for gaps between when the revenue starts coming in and when your payments start. If you have to start loan payments before you get the added revenue, you could find yourself in a cash crunch leading to a loan default. Have a plan in place to make these early payments or structure the loan to delay when you start repaying.
The Certainty of Your Forecasts
When you compare your potential revenue increase, it’s very rarely a certainty. Even with a firm order contract in place, your projections are simply estimates until the revenue actually hits your bank account.
Some factors to consider include:
- Do you have contracts in place, or are your forecasts based on potential new sales?
- How stable are your current and potential customers?
- Is your business heavily influenced by market cycles?
- How much internal or external data do you have to back projections based on business judgment?
Your Own Risk Tolerance
When you’re looking at your forecasts, you need to decide your risk tolerance. Do you want to be conservative and take a minimal risk, or are you willing to bet the business?
A conservative approach might involve using worst case sales numbers and borrowing no more than you can repay using current cash flows. A very aggressive approach might use optimistic sales numbers and borrowing an amount that will require you to hit those sales numbers to repay the loan on time.
Your Credit Score
Taking on additional debt will have an impact on your credit score. As you may already know well, the amount of debt you have as a percentage of your total available credit is one of the factors that go into calculating a personal credit score.
While you may work hard to keep your business and personal finances separate, this can still have an impact on your business later on, especially if you try to get more financing. Most lenders will look at both your business credit score and personal credit history if you apply for a loan or other type of financing, so it’s important to take care of those scores and consider the impact of any new debt you take on.
Debt’s Not a Dirty Word
When you’re running a business, borrowing money can often make you more money even after you pay interest. However, you need to carefully review the numbers and use your judgment to decide whether your investment will pay off. It’s good to keep in mind that debt isn’t always a dirty word. Sometimes, it’s just what you need to grow.