Business debt, when used strategically for income-producing investments and managed responsibly is a valuable tool for growth and profitability.
Primary Implication
The viability of any loan will always come down to the ability of the business to repay the loan from the profits of the business. The safest business debt to take on is an income-producing debt.
Fail to earn more money due to the loan than the cost of the loan and you will have problems.
Overview
Debt enables individuals and companies to live beyond their means. For example, personal debt is primarily used for consumption purposes. It piles up fast for those who struggle with the principle of delayed gratification. Those who can’t wait to buy too often borrow money they don’t have to buy things they can’t afford.
Don’t apply the logic of personal debt to your business debt. Business debt makes sense when it is used for increasing a business’s net worth, or value, not for paying operating expenses. It is particularly beneficial if the debt is used to change the business’s asset dynamics, resulting in an influx of more profitable business.
The hard reality with business debt is you must have a plan to pay down your debt. Too many business owners end up with too much debt hanging over their heads, holding them back from enjoying their business because they are always scrambling to make their loan and lease payments.
If an opportunity presents itself to increase your bottom line, and you don’t have sufficient cash flow to fund the opportunity, turning to a loan may be your best option. The safest business debt to take on is an income-producing debt. Below are the various types of debt that may position your business model to be more profitable and, thus, more sustainable:
Supplier Debt: borrowing money from your suppliers in terms of the time between when you receive goods and when you pay for those goods is the equivalent of your supplier functioning as a bank. When your supplier extends your payment terms versus you cutting a check upfront to your supplier, it gives you the flexibility to use that money elsewhere in your business for an extra 30 to 90 days, depending on the payment terms. While there is typically no cost to this form of debt, you do have an obligation to pay them what you owe them when it’s owed. Supplier debt managed correctly can be the difference between having to go to a bank or not.
- Credit Cards: enable the holder to draw on a credit limit approved by the card issuer. When you use a credit card, you’re borrowing money from the credit card’s issuer to make the transaction, and then repaying that loan at the end of each billing cycle, either in part or in full. You are essentially getting a free loan by paying the bill in full each month because you will avoid interest charges. If you can’t pay your balance in full, at least make the minimum payment required by the due date to avoid damaging your credit score. The challenge with using business credit cards for cash back, points or miles for every purchase made is how easy it is to pay the minimum when cash is tight. The next thing you know, you are paying significant amounts of interest as you fight to pay down your credit card debt.
- Line of Credit (LOC): the line of credit is a longstanding “floating” sum of credit that your business can access, much like a credit card. You can spend money using this credit; paying it back with interest gradually or all at once allows you to borrow money against your line and pay it back repeatedly. The key is to use a line of credit for short-term expenses only. The idea is to use the line and pay it off, use the line and pay it off. The goal is to eventually build up your cash reserves in your business account to the point where a line of credit is seldom used.
- Installment Loans: installment loans are the most “conventional” type of loan. A lender extends to you a pre-defined sum of capital, which you must pay back in monthly installments that cover portions of the principal and interest. Rates, terms, and conditions vary significantly, but all of them follow a basic model. Depending on the specs of the loan, there may be penalties for early payments or extra fees to pay.
- Equipment Leases: too many businesses get in trouble with borrowing money for equipment they deem necessary only to find out the lease or loan payments are more than the anticipated increase in profits for a poorly timed asset purchase. The key to this type of debt is to match the equipment loan term to the equipment life. Then, work to pay off the equipment before it becomes obsolete. If you aren’t 100% sure you can cover the cost of the new equipment through higher sales and profits, you are better off focusing on the equipment you already own to continue growing your business.
- Asset-Based Loans (ABL): represent a ready line of defense when money is needed quickly. These loans involve the pledging of particular assets in your business as collateral for borrowing money. For example, a lender might lend you 60% of the value of your accounts receivable balance, and 50% of the cost of your inventory. The challenge with repaying these loans lies in collecting your A/R and selling your inventory. Fail to do this, and an ABL loan repayment becomes very difficult.
- Alternative Financing: high-risk business loans are last-resort financing options for businesses that are considered too risky by traditional lending standards. The problem with these types of loans is the lender will charge high interest rates, require frequent payments, have interest rate hikes at default, and are collateralized with a personal guarantee because the risk of loan default is considered high.
- Business Purchase Debt: used to acquire another company to help your business grow. Should the business acquisition double or triple the size of your company, then using business debt is often a good tactic for growth.
- Real Estate Loans: real estate loans are essential tools for business owners to build long-term equity in their businesses. The hard reality for most small business owners when they go to sell their business is that the land their business sits on is often more valuable than the business itself. When dealing with business real estate loans, it is often best to make the down payment as low as possible and finance your terms for as long as possible. This allows you to leverage your cash—meaning instead of tying up all of your cash in a short-term loan, you can deploy your cash strategically throughout your business.
- Personal Loans: if your business can’t qualify for any credit of its own, you can take out a personal loan to cover your business investments. The primary risk is that non-payment by the business will harm your credit score. The downside is repayment of a personal loan does nothing to help you establish your business credit.
Loans are also categorized and modified based on the following variables:
- Secured Loan: includes a predetermined piece of collateral of comparable value to the principal of the loan, which the bank can reclaim in the event of non-payment.
- Unsecured Debt: it is much like a credit card in that unsecured loans can be very expensive because there is no specific piece of collateral securing the loan.
- Term Loan: maybe for a period of a month to several years or anything in between.
- Balloon Loan: are much like installment loans, but throughout the monthly payments, you only pay interest on the principal. On the final day of the loan, you will be required to repay the principal in full. It’s ideal if you want to minimize your monthly expenses for as long as possible.
It is often possible to build the perfect loan for your situation, assuming you qualify for the loan, are getting the loan for the right reasons, and are timing your move correctly. The viability of any loan will always come down to the ability of the business to repay the loan from the profits of the business. Fail to earn more money as a result of the loan than the cost of the loan and you will have problems.
