At some point in their journey, every one of my readers has probably faced the question of how to finance a small business. Debt financing is a common practice…which does not make it a simple choice. In today’s blog post, I’d like to dig into that.
Debt is the other four-letter word. It can stir up strong emotions on both sides of the spectrum. And no matter how you feel about debt personally, there’s probably an expert who supports your viewpoint — and another expert who will vehemently oppose you until they are blue in the face.
Here is how I look at it. It is important to limit emotions in business decisions. With a few exceptions, there is no universally “good” or “bad” strategy, because so much of business building depends on the situation. For many business owners, the best place to start is by setting up some guardrails and laying out the conditions that make a certain strategy a good — or a terrible — decision. Because sometimes, you have to put your emotions and beliefs aside to look at a situation or a decision objectively.
With all that said, debt can be a great tool or a great hindrance for a business, depending on how it’s used.
Debit Financing for a Small Business: A Great Tool When Used Wisely
Many experts consider debt to be generally harmful to a financial situation. There is some logic to their view. High interest rates can push consumers further into debt and create a damaging spiral that leads straight to bankruptcy. However, for a business, debt can be used as a tool to fuel growth. It can fund new employees, help you stock up on inventory, or shore up any other area of the business that could benefit from a cash infusion.
Some examples of “good debt” might include:
- Getting a loan to start a new business;
- An equipment loan to expand operations; or,
- A line of credit to free up cash flow.
In other words, any debt that finances growth and additional cash flow may well be worth the interest you will pay on it.
When used wisely, debt is an intentional strategic tool — not a fallback plan. Any time debt is used as a bridge of sorts to make up for poor cash flow management decisions or faulty operations, it will only mask the problem and is not likely to generate useful ROI. So, business owners have to be honest with themselves and recognize when they are reaching for debt as a reactive move.
Keeping the Big Picture in Mind
A study by U.S. Bank found that 82% of businesses fail due to poor cash flow management.
What does that have to do with funding growth? Well, loans aren’t free money. They must be repaid. Before taking on debt, it’s essential to build a plan around how it will affect cash flow and how you will pay it back.
When taking on debt, it’s important to do it with intention. Any new debt you consider should serve a clear purpose and come with projections that demonstrate your likely ability to create a positive ROI. For example, if debt is being used to buy equipment to produce more widgets, then the potential revenue increase should at least cover the cost of the debt (and hopefully surpass it).
Additionally, be sure that you read and understand the terms of repayment and early pay-off.
Some loans impose a penalty if loans are paid off early. Why? Because lenders make their money on the interest they charge you. If debt is repaid ahead of schedule, the lender doesn’t earn as much as they expected to. This may not be the ultimate deal-breaker, but it helps to understand what you are signing up for.
Side note: If you have the ability to pay off debt early and that triggers penalties, it can still make sense to run the numbers on the cost of the debt and the cost of the penalty to see if doing so saves on interest.
Funding Growth: Using Debt as a Business Owner
CBInsights completed a study and found that 29% of small businesses fail because they run out of capital. Debt financing can be an effective way to reduce this risk. And by now, we know that debt can be a great tool when used correctly.
But what are your options for getting debt financing?
Let’s break down some of the more common types.
- Term loans are offered for a set period of time and must be repaid with interest. The length of the loan can vary, but term loans are generally shorter than five years. The interest rates will depend on your credit score, the lender, the amount borrowed, and the length of the loan.
- SBA loans are issued by the U.S. Small Business Administration. They can come in the form of microloans, equipment loans, and more. Heads up, these loans can be challenging to qualify for.
- Lines of credit are similar to loans but with a few key differences. Rather than receive a lump sum that has to be paid back, a line of credit allows you to only tap into funds that are needed at the time. They generally have variable interest rates; however, you’re only required to pay interest on the funds drawn from the line of credit (rather than the full approved amount).
- Equipment loans can be used to purchase tools necessary to run your business. This may be office furniture, equipment, machinery, etc.
To avoid loan defaults, lenders require financial information from the business to evaluate their trustworthiness as a borrower. This could include things such as credit score(s), bank statements, and a balance sheet. The idea is to arm the decision makers to get a better understanding of the business’ liquidity.
Just as with personal loans and credit cards, when paid off on time, business debt can help improve your credit score (which can make getting future loans easier and potentially cheaper).
How to Finance a Small Business: Bottom Line
Using debt to fuel business growth can be a great strategy. However, it must be done strategically and intentionally.
My personal rule is, “Cash for toys, debt for everything else.” Your mileage may vary, but for me this is a good reminder to tap free cash flow for the “nice-to-haves” — and credit for everything else (as long as you’re able to comfortably stay within the limits).
There are many different types of business financing out there, and our team is available to help you evaluate your options and check if your use of debt is staying within the healthy limits for your business.
Also, if you enjoy the kinds of topics we tackle on this blog, you will probably love our new podcast. Find your way to listen by searching “Traversing Entrepreneurship” wherever you listen to podcasts — and join me for more fun and wisdom from Traverse City entrepreneurs and business owners like yourself. Enjoy!
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