When it comes to your business, the thought of taking on debt can be intimidating and risky. What happens if you run into a financial situation in which you can’t pay back what you owe?
No matter what type of business debt you take on, you’ll be putting your personal assets and personal credit on the line. That’s a lot of responsibility that can be tough for a small business owner to manage.
But, think about the flip side to this perspective—the intangibles of running your business. Depending on what you’re bringing to market, paying an interest rate might be worth it. Let’s say that you’re creating software, and you noticed that changing a feature would instantly double your revenues. You need working capital to increase the speed of your engineering efforts.
“Debt financing is one of the most efficient methods that business owners can use to kickstart their businesses or spur growth”
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explains Edith Muthoni, investments writer, trader and personal finance coach at Leanbonds.com.
“Proper planning for its utilization and repayment should be done as well. That is
the key ingredient to proper debt management in a business.”
Business debt, Mutoni elaborates, gets a negative reputation due to poor planning, noting that many businesses fall short on effectively and sustainably utilizing a surplus of funds..
Small business owners can take the following steps to borrow and manage funds responsibly:
Conduct a financial cost/benefit analysis
Businesses have a variety of debt financing options, ranging from business credit cards to varying types of business loans that are both unsecured and government backed. To borrow money, business owners must spend money. When is it the right judgment call to take on small business debt?
“A business owner should take on debt only when it’s clear that the debt will generate returns that are higher than the cost,” explains Priyanka Prakash, lending and funding expert at Fundera.
“For example, let’s say you’re considering a loan with a 10% interest rate. If the loan will increase your revenue by 20%, then it’s probably worth taking on that loan.”
Typically, debt makes the most sense to jumpstart a new venture, or to ignite an already-growing small business. Otherwise, taking on debt can put your business in a hole.
“Typically, debt can sustain growth only for a growing business,” says Prakah. “If your business isn’t doing well, then debt might cause you to sink further into a hole. Remember, you’ll be obligated to make periodic payments with interest, and that will eat into your business’s cash flow.”
Piling on debt to pay off other debt is a “recipe for disaster,” she elaborates.
You need to make sure that your cash flow—both short-term and long-term—can support the repayment of your own principal and interest.
“To calculate whether your cash flow supports a healthy debt repayment strategy, use a formula called Debt Service Coverage Ratio (DSCR),” says Prakash. “DSCR is equal to the business’s annual net income divided by the business’s annual loan payments. The result should be approximately 1.2 or higher. This indicates that you’re cash flow positive and have money left over to put in the bank or reinvest after making monthly payments.”
Too much debt can hurt you. Be sure that you have a clear plan—and path—towards an upside. No amount of debt is worth the stress of not being prepared to manage it.
Get smarter about your money
One of the biggest challenges that businesses face is cash flow management. Fluctuations in payment cycles represent the norm, rather than the exception. It’s tough to manage an accounts receivable that is unpredictable. For this reason, taking out small business loans or establishing a line of credit can help you manage your cash flow more strategically.
“Some businesses have times of low cash flow, followed by high cash flow,” explains Rob Stephens, CFO consultant at CFOperspective.com. “Lines of credit can smooth out their cash balance. Investing for future revenue includes major purchases like land, buildings and equipment. Debt allows the owner to gain precious cash for growth without diluting their ownership.”
With a stronger handle on your finances, you can make longer term investments towards your small business’s growth. Remember that the penalties of missing payments such as payroll, from an underfunded bank account, can hurt your business and personal credit score, too.
“The best way to manage debt is to always have a cash flow projection to anticipate cash shortfalls and identify times when you have extra cash to pay down debt, make more investments or provide cash to owners,” says Stephens.
Being smart about your money means having a clear plan to paying off your debt.
Be clear about your goals
Business debt is a resource for growth—never a tool for simply paying the bills. It’s important to have an exact plan for how you’re going to use your funds and how this investment will translate into a path to revenue.
“Have 3 versions of this plan: best case, worst case and likely case, ”explains Roy Ferman, an experienced entrepreneur who is now CEO at Seek Capital.
In some cases, taking on debt will help your business increase its profitability by decreasing costs.
“One of our best situations was when we negotiated a bulk deal with a supplier and the offer was to buy 3 months of inventory upfront in exchange for a 25% discount,” says Ferman.
“The deal sounded great, but we didn’t have the cash on hand. We called both our credit card companies and were able to get our limits extended on both the business credit cards, and, from there, we were able to take advantage of the deal and save 25% on 3 months worth of inventory. For us, that meant a savings of over $50,000.”
If you’re not sure how to manage your debt, don’t be afraid to let the opportunity pass. The last thing you want is to take on more responsibility than you can manage.
“Very rarely do businesses starve from a lack of opportunities; they usually fail due to trying to take on too much,” says Ferman.
Make debt work for you
Debt can be a powerful resource to help you grow your company’s long-term revenue. To take on business debt responsibly, make sure that you have a clear plan in place and assemble a team of advisors to guide you through the process.
If your financials are already struggling, it can be tempting to seek out extra cash. Instead, find new potential ways to generate revenue,such as opening up a new line of business.
Focus on repaying your debt with cash so that you’re not in a perpetual state of owing money. Your goal should be to get out of debt as soon as possible, using borrowed funds as an opportunity to propel your growth forward.
Don’t be afraid of business debt. But, don’t be overly trusting, either.
This article was produced by the Quickbooks Resource Center and syndicated by MediaFeed.org.
Featured Image Credit: DepositPhotos.com.