Debt & Your Company: How, When & What

Debt can be a scary thing for a small business owner. The trick is to know when and how to use borrowed money. Too much debt can strangle a company, as an owner struggles to make payments and satisfy lenders. But debt can also play a productive and critical role in your company, giving you the leverage you need to grow.

There are two key questions to ask yourself before going into debt. The first has to do with how you’re going to be using the borrowed money: Are you spending the cash on an investment that will make more money for your business? The second question: Are you reasonably sure that you will have the cash flow to service the debt and repay the money? Don’t forget that if you can’t repay a loan on time, your company’s credit score will suffer and it will be even harder to get financing in the future.

Since lenders always require a personal loan guarantee from a small business owner, your personal finances and credit history can take a hit as well. In general, small businesses should consider borrowing for investments that will generate profits and cash flow. Examples include a software application that would increase efficiency and reduce costs, or a marketing initiative that would lead to an increase in sales. In particular, debt is a good tool when a large amount of up-front cash is required for an investment but the revenue (or cost savings) realized from the investment is projected to materialize over time.

Another instance when debt is warranted is to finance rapid growth of a business. Many business owners fail to realize that growth often soaks up cash despite the fact that profits are building. Typically, during rapid growth accounts receivable and inventory will rise and costs like payroll will increase as well. We also advise businesses that debt is OK when it is used to free up cash that is tied up in assets such as vendor deposits or prepaid expenses.

What are examples of bad uses of debt?

The most obvious is borrowing for expenditures that aren’t going to add to the value of your business, such as extra compensation for the owner. Another classic misstep is piling on debt to repay other debt, a situation that brings to mind the old adage “throwing good money after bad.”

In general, debt should not be used when you do not have a firm grip on how you will service the debt with your projected cash flow. So if your company is looking to finance the investment of a new and unproven product line, and your existing business could not service the debt on its own, the use of debt is a bad idea. If your company is projecting losses, debt is a bad idea. Even if your cash flow is simply subject to too many uncertainties and contingencies, debt should be avoided. In cases like these, consider equity financing. (Or in some cases, think twice about the new initiative.)

Debt Options

Although interest rates are rising (which typically tightens up debt markets for small businesses), there are more options than ever for a small business owner looking to borrow, because of a hyper-competitive banking market. Here are a few:

Lines of credit — Some banks and lending institutions will lend up to $100,000 on the basis of a short application; sometimes company financial statements are not even necessary. In addition, you can often get a response within 24 hours. One of the biggest factors in whether or not you will qualify for many of these products is your personal credit score. (Editor’s note: Since many institutions do not charge fees for lines of credit, just about every business should apply. If nothing else, it is comforting to know that your business has access to money should a great opportunity arise or if you have a bad streak and need to meet payroll.)

Term loans — Almost all banks and many other lending institutions offer term loans that involve borrowing a fixed amount with repayment schedules over several years. One advantage to term loans is a fixed monthly payment that can be incorporated into a cash flow budget. Some term loans can be structured with a “bal-loon payment” where most of the money is due to be paid at the end of the term. Often banks want to see that the company has assets such as accounts receivable, inventory, real estate or fixed assets that can be used as collateral.

Leases — Most equipment can be leased, which gives the company the option of spreading the payments out over a period of time (ideally over a period of time consistent with the return produced by the equipment). Business owners need to be very wary of the implied interest rate of the lease, as many leases carry rates in excess of 20%. An alternative is to take out a line of credit or term loan to finance the equipment.

Alternative financing options — There are many companies that will lend you money against your accounts receivable (e.g., factoring) and some that will even lend against a purchase order. While these typically have high fees and/or interest rates, they can be a great alternative when other options are not available.

In general, note that different banks and lending institutions have different requirements (some which they will tell you and some not) for qualification of loans. Other options include getting an SBA-backed loan (typically a term loan), which is available through different lending institutions but guaranteed by the SBA. Also, many economic development corporations and other quasi-government organizations may make loans to businesses that can’t qualify for a loan from a typical bank.

Tips for successful debt management?