Debt is frowned upon in our society, as it’s an indication that you don’t know how to manage your finances. But what if I told you that debt and success go hand in hand? Yes, that’s right, debt is necessary for success — good debt that is.
How Much is Too Much Debt?
According to a 2016 study conducted by the credit reference agency Experian, the average small business owner has accumulated approximately $1,195,000 worth of debt. It sounds like a lot, but debt can be an asset when it is used in the right way.
Every business is different, and what’s considered too much debt for one company will be just right for another. Some organizations need a lot of capital to get off the ground, which means the debt can be instrumental in creating business success.
You also need to consider the fact that it’s much more beneficial to use other people’s money to invest as opposed to using your own.
The Benefits of Debt
Some debt will help a business stay afloat; without it, there is a possibility that they won’t be able to survive. You can build the credit score of your business by borrowing money and making full repayments on-time.
This will make it easier for you to gain access to funds from vendors, lenders, and suppliers in the future. You should also take into consideration the fact that the interest loan principal can be taken out of your business taxes which will save you money. Additionally, when your growth and debt are financed instead of equity, you maintain control and ownership of your business.
Debt Is Cheaper
Debt is a much cheaper way of financing than equity. To begin with, equity carries a lot more risk than debt. Since there is no legal obligation for a company to pay dividends to common shareholders, they expect to receive a certain rate on their return.
For the investor, debt is not as risky because the firm has a legal obligation to pay it. Also, when a company goes bankrupt, the first people to lose their investments are the shareholders. Additionally, the majority of the return on equity is locked up in stock appreciation, this means that a company will need to increase their revenue, improve their cash flow, and make a profit. Because of these risks, an investor wants a minimum of 10% returns. On the other hand, this rate is a lot lower for debt.
Keep What Belongs to You
At some stage in your business, you are going to need more money, whether it’s to buy inventory or to expand the business. When the bank account is getting low, a lot of entrepreneurs choose to take equity out of the business by selling a part of it to a new partner. This is a terrible idea because it means that the investor will get to profit from all your hard work. You may not have any debt, but you are now stuck with a business partner for the rest of your days who has the right to tell you what to do with your business.
When you compare this to a loan, you won’t relinquish any control over your company unless you default. In the meantime, all you will be paying back is the interest and the principal over time. Having said that, even if there is the slightest chance that you will default on the loan, don’t take one out.
The wonderful thing about debt is that once you pay it back; that’s it, the loan is gone, never to return unless you take out another one. And you are free to continue running your company the way you want.
These facts make debt a good thing, it would make no sense to fund a public company purely on equity. That is a very inefficient way of getting a company off the ground. Looking at other companies from this perspective, you could say that Google is inefficient because they are a $22 billion company and they don’t have any debt. However, Google is in a much better financial standing than other companies. They’ve got such strong profit and cash flow that they can afford to finance their business with retained earnings.
The Negatives of Debt
If your business falls into too much debt and then ends up at a tipping point, and you are struggling to pay it back, this will harm your cash flow which leads to a downward spiral of decline.
A study conducted by the Journal of Marketing found that companies that are overburdened financially find it difficult to provide a good service to their customers, which ultimately leads to reduced customer satisfaction.
One of the biggest obstacles to business growth is cashflow. Therefore, your business must find a good balance between debt and cash flow. In short, make sure that your debts are paid back on-time, and keep an eye on your finances.
Pay Attention to Your Finances
Your debt to equity ratio must be maintained. You can find out what it should be from your bank, they will provide you with a recommended amount. Banks pay close attention to leverage, and they typically stipulate a clause in a loan contract stating that if you exceed their set leverage amount, they can default you on the loan.
The debt-service ratio is an effective method of monitoring debt. At the very least, a business should be generating 1.25x the cash flow needed to pay off all debt.
It is important to prioritize when taking on debt. Focus on activities or purchases that are going to grow your business like marketing. If you need better equipment to improve your service, then invest in that. You should always take into consideration the expected return and the cost of capital.
Now that you are aware of the benefits of debt, we are in no way suggesting that you go and start taking out thousands of dollars’ worth of loans. However, if your company can afford it, and you know that it will be an effective way of growing your business, go ahead. Just make sure you speak to your bank and get some good financial advice before signing on the dotted line.
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