Debt is not something most people like to talk about. But as a small business owner, you need to be savvy about debt. We asked Jeanna Barrett at Kabbage to give us some insight into debt. When is it a good idea, and when is it a very very bad idea.
Debt doesn’t have to be a dirty word: leverage debt for your business
In personal finance, debt is almost always the enemy. Sure, you might take on a loan for school or a house or vehicle. But even then the best policy is to pay it off as quickly as possible. This is such a truism that debt payment coaching is a thriving industry.
In business finance, debt is different. Business, especially small business, is about spending money that brings in more money. Inventory, payroll, rent, and utilities are all examples of this. And so is debt, as long as you’re smart about it.
The personal finance rule applies: less debt is better than more debt. But there are some specific ways that taking on debt can help your business grow and succeed.
Debt smoothes the lows and highs
Cash flow is neither guaranteed nor steady in most businesses. Seasons come and go, and the economy reduces or raises spending. A line of credit or other access to debt could make the difference. It could mean paying your employees, suppliers, and other expenses even when the cash register isn’t opening as often as you’d like.
For example, a surf shop goes into the red every winter. That means they can’t exploit the late spring rush because there’s no cash in the accounts. A loan in March could increase summer sales to the point that they have cash reserves to easily survive the winter slump.
Leverage this debt by maintaining a line of credit or quickly approved loan access. This was you can “dip in” to those reserves during the lean times.
Be careful of taking on debt for operations without an end in sight. Recognize the difference between a seasonal slump and a downturn. A downturn means you need to permanently cut costs.
Debt has built-in incentives
Your interest on debt is deductible from the 25 percent to 39 percent federal tax rate, which is among the highest in the world. Further, debt you pay this year qualifies you for better loans in the future. Both of these combine to make you fully prepared when the next big opportunity pops up in your future.
For example, a chicken wings restaurant used a loan to buy some supplies. If they paid the bill on-time each month they would later qualify for a larger loan. That loan would come in handy when the time came to open a second location across the street from the city stadium. And they’d get a tax break to boot.
Leverage this debt by keeping a line of credit open with a small balance so you can establish a history and claim some tax deductions year after year.
Be careful of taking on debt just to benefit from these advantages. Debt should have an immediate and compelling driver, with these factors serving as icing on your financial cake.
Debt displaces risk
If things go bad, you share the risk of having borrowed money that you owe a lender. This can make for uncomfortable Christmas dinners if you borrowed that money from your in-laws. But for a bank or online loan provider, it’s business as usual. For these entities, part of the money from interest and fees goes toward lessening the impact of lost loans.
For example, a local yoga studio takes on $40,000 in debt to renovate their facility so they can cater to more upscale customers. A national chain moves in across the street and the studio goes out of business. The $36,000 remaining on the loan gets serviced by a portion of the closure sales. But the owner owes nothing on the balance.
Leverage this debt by using loans to fund growth and expansion opportunities. Be duly responsible and diligent. But moving forward is the only way to keep your business competitive.
Be careful of taking on personal debt for your business. If everything goes south and you have to close doors, that debt will follow you even after the company dissolves.
Debt is an alternative to equity
Equity investing is one of the most popular ways of funding growth or expansion in a company. Especially among those who are reticent to take on business debt. But equity is more expensive over the long-term than most forms of debt. Once the loan is paid off, you own what that loan built. With an investor, you have to share it for the life of the company.
For example, adding a new product costs $50,000 a company worth $500,000 doesn’t have. Borrowing it at 10 percent interest over five years costs $12,500. Taking on an equity investor for the life of the company means paying 10 percent of profits annually for the rest of the company’s life.
Leverage this debt by building a solid credit history. Or you can establish access to a flexible credit line. This way you can invest in your business without selling parts of the company to do it.
Be careful of taking on wild risks because you have the credit access to do it. Debt instead of equity is a long-term game, so be sure your company will survive long enough to profit from it.
Just like with personal finance, debt will never be better than no debt. If you have the cash reserves to run your business as profitably as possible, you should. But chances are, this probably doesn’t describe your business. It’s normal for small businesses to leverage debt to grow, expand and fill cash flow gaps. Instead, you should view debt as another tool in your shed to make your business thrive.
Jeanna Barrett is Head of Inbound & Content Marketing for Kabbage. Kabbage pioneered the first financial services data and technology platform to provide fully automated small business loans. Unlike other lenders, Kabbage looks at your business data, not just a credit score. Kabbage has grown to become the #1 online provider of business working capital and is a Forbes Top 100 Most Promising Company.