Taking On Debt:
“Neither a borrower nor a lender be…”William Shakespeare
If you haven’t yet, it’s almost inevitable that one day you’ll be faced with the question: Should you or shouldn’t you borrow money for your business?
No disrespect to the Bard, but answering this question isn’t quite so cut and dried, especially when it comes to business borrowing. Used wisely, debt can be a valuable tool to help you grow and expand your business.
“Every small business I’ve ever known has had to borrow money at some point,” says Jim Blasingame, host of the nationally syndicated radio and Internet program The Small Business Advocate show and author of the book Small Business Is Like A Bunch Of Bananas. “Borrowing money for your business is not a bad thing to do, but it must be done judiciously.”
Good versus bad debt
So, how do you know what is “good” debt versus “bad” debt? According to Blasingame, the biggest mistake most small businesses make when it comes to debt is in their allocation of borrowed funds. In other words, how you use debt is just as important as whether you borrow money or not in the first place.
In general, Blasingame explains, it’s a good idea to borrow to finance capital items (plant and equipment, fixtures, computers, etc.) that you will use for more than a couple of years — even if you have the cash to pay for them. This is especially true in today’s low-interest-rate environment. “You don’t want to deplete your operating cash to buy large capital items,” says Blasingame. “When you finance capital expenditures, this frees up your operating cash flow to fund the day-to-day working capital expenditures of your business or take advantage of other opportunities, like maybe investing in training or purchasing additional inventory at a good price.”
Put another way, operating cash should be used for capital to run your business, not as capitalization to purchase long-term assets. These are usually better financed via a bank term loan, which should be structured to match the useful life of the asset being financed. For example, if you’re borrowing to finance high-tech equipment that you expect to last three to four years, you wouldn’t want to pay for it with a five-year term loan.
Jim Horan, president of The One Page Business Plan Company and author of the best-selling book The One Page Business Plan, agrees: “It’s fine to borrow money for capital expenditures,” says Horan. “But before borrowing, a company should have a solid business plan in place with strong financials. The owner needs to think through how the money will be repaid and understand the potential impact of servicing the debt on cash flow and the bottom line.”
Or, as Blasingame puts it, “Borrowed money accrues interest to the lender and must be repaid, which creates an incremental drain on the company’s liquidity. The business has to be able to generate the cash flow to make these payments. And the only way to know whether or not this is feasible is to build a yearly cash flow model based on your operating statement.”
Such a cash flow model can be used to help you see if your business can generate enough cash flow to service debt. Aside from servicing a loan, it can also help you see if there will be any temporary cash flow shortfalls throughout the year. This leads into the second primary use of debt for small businesses: funding working capital, or daily operating expenses.
“Your cash flow model will give you a picture of your projected cash position at the end of each month for the next 12 months, so you can see clearly when you’ll need cash and for how long,” says Blasingame. For each month, project your income and expenses and estimate how long it will take you to collect receivables versus how quickly you’ll have to pay your invoices (the difference here defines your cash flow cycle). Now plot all this on a 12-month financial timeline. “A negative number at the end of any month represents a working capital shortfall you’ll need to make up via debt, investment capital or retained earnings in the business,” Blasingame explains.
To cover this type of cash shortfall, you may apply for a short-term working capital loan or a line of credit. A line of credit is one of the most common and useful financing tools used by small businesses. It allows you to borrow funds as needed to meet routine operating expenses and working capital needs or cover temporary cash shortfalls. Once approved, you can borrow up to your predetermined credit limit at any time, usually simply by writing a check. A home equity line of credit, secured by the equity in your principal residence, is an attractive option for an increasing number of self-employed professionals and home-based business owners.
Alternatives to debt
While debt may be preferred for funding capital expenses, it shouldn’t be viewed as an easy fallback for bad financial management or wasteful spending. Before heading to your banker for a loan to cover cash shortfalls, first look for ways to manage your finances more efficiently or maybe even cut costs.
“Bootstrapping” is a term used to describe generating more cash within your business by doing just this. For starters, says Horan, tighten your credit and collection policies and stretch out your payables as far as possible (within your vendors’ terms) to try to shorten your cash flow cycle.
“Shortening your cash flow cycle by 10 to 15 days could eliminate the need for short-term financing completely,” he says. “Also, take a close look at what might be frivolous or wasteful expenses. A slick, full-color marketing brochure, for example, might be nice, but a simpler piece you design and print yourself using a template and your ink jet printer might be just as effective.
“If yours is a professional services business, make sure you’re charging enough for your services,” Horan continues. He notes that self-employed professionals, especially those newly self employed, tend to undercharge for fear of losing business. “Find out the standard rates and terms in your industry, and don’t hesitate to ask for half of a project upfront. Not only can this provide a big boost to cash flow, but it also is a good indication that your client actually has the money to pay you.”
Blasingame offers another caution: “Be careful not to grow yourself out of business. Success begets growth, and growth adds tremendous pressure to your working capital. Leverage can be a wonderful tool for a small business, but you can’t borrow yourself into success. You have to be able to fund your cash flow cycle, and if this means borrowing, you have to be able to service your debt. If you can’t, it’s entrepreneurial suicide.”
Horan offers a few more words of wisdom when it comes to small business debt:
- Don’t borrow to pay your salary.
- Don’t make permanent investments in equipment if you can borrow or lease the equipment or, better yet, subcontract the work.
- Be very careful about assuming debt if you’re in a new business partnership.
- Don’t borrow more money than you can reasonably expect to repay.
So how much is too much?
With the right information in hand, your banker can help you determine how much you may need to borrow and the best way to structure the debt. So before approaching your banker with a loan request, do your homework by making sure your business plan is current, you have a good idea of why you need to borrow money (e.g., to purchase capital assets or finance working capital), you are prepared to discuss collateral, and you’ve prepared a cash flow model (as discussed earlier).
“Entrepreneurs are optimistic by nature, but you can never expect your banker’s zeal to match your own,” Blasingame cautions. “Also, you must keep your banker informed, of both good news and bad. Remember this: An uninformed banker is a scared banker — and no one ever got any help from a scared banker.”
Types of business loans
The most common types of small business loans include the following:
• Line of credit — Allows you to borrow funds as needed to meet short-term operating expenses and working capital needs or cover temporary cash shortfalls. Once approved, you can borrow up to your predetermined credit limit at any time, usually simply by writing a check. May be secured (by collateral) or unsecured, with home equity lines of credit becoming increasingly common for home-based entrepreneurs.
• Term loan — A loan of a specific amount of money, usually at a fixed interest rate and with a fixed repayment term. May be short (less than one or two years) or long term, and usually made for a specific purpose, such as to finance equipment, property, acquisitions or major business expansion. Repayment schedule will be structured to match the useful life of the asset being financed.
• Construction loan — A long-term loan used specifically to finance the purchase of land and construction of owner-occupied buildings or investment property.
• Government loan programs — A variety of state and federal programs can help small businesses secure financing. The Small Business Administration (SBA) helps banks make loans to businesses that might not qualify for traditional commercial financing. Through the SBA’s MicroLoan program, for example, small firms can secure short-term loans of up to $35,000.
• Credit cards — Their wide availability makes credit cards an increasingly common source of financing for small and start-up firms. Business credit cards offer helpful features such as detailed financial reports and extensive business and travel services.
Don Sadler is an Atlanta-based writer and editor specializing in issues of interest and relevance to small business owners. Reach him at don@media3pub.com.
