Should you take on debt to grow your business?
Debt can be a double-edged sword for entrepreneurs, particularly when it comes to funding business growth.
On one hand, taking on debt can provide the capital you need to expand operations, invest in new equipment, or launch innovative products and services.
On the other hand, it adds financial risk and the burden of repayment to your business.
The decision to take on debt shouldn’t be taken lightly. But it shouldn’t be hard.
In this issue, I'll walk you through my 10 step approach to decide if debt is right for your business.
- What is the purpose of debt?
Clearly understand why you need the debt and how it will contribute to the growth of your business.
This is the first question every lender asks when you decide to apply for the loan.
Whether it's for expansion, inventory purchase, hiring new employees, or investing in technology, the debt needs to align with your business goals. You also need to be extremely meticulous in how the debt will be used.
If there is no a clear purpose for the debt, you’re not ready for debt financing. If you do, let’s move on.
- Have you exhausted other forms of capital?
The first form of capital for businesses come from the owner’s savings. Bootstrapping the business is a noble endeavor, but personal savings is limited (for most people at least). Once this runs out, what other forms of capital do you have?
Reinvesting the profits of the company is the next natural progression. Retained earnings are used to buy more inventory to generate more sales. When done right, the effect compounds over time. But sometimes, when the business just doesn’t grow as fast as you’d like, you may need more capital.
If you don’t have any more, let’s move onto the next step.
- Are you willing to dilute your ownership?
There is a whole other world of capital available through venture capital or equity financing. The downside on these forms of capital is that it will dilute your ownership. You will need to give up a piece of your company in exchange for an equity injection.
Not only do these options mean you will give up some control of the company, it also means losing a share of the profits, extreme pressure to grow rapidly to satisfy VCs and PE firms, and having to work with another shareholder.
If this doesn’t work for you, onto the next step.
- Is the company profitable?
This is a simple question with lots to unpack.
If your business isn’t profitable at its current state, debt financing won’t be a good fit. Bringing on debt will add additional strain to the business. At the bare minimum, interest payments need to be made. If the business isn’t profitable now, it’ll be a hard sell to any lender on how the debt will be repaid. While lenders want to make interest income, they can’t jeopardize the capital lent out.
If the business is profitable, can it support the additional debt without the business changing one bit? This assumes all the cash proceeds from the loan have been used without any benefits realized. A company who is ready for debt will be able to support the projected interest and principal payments, and stay on top of any financial covenants that come into play.
If this is you, let’s keep going.
- Do you have financial controls in place?
Financial controls are the cornerstone of effective governance. It’s what keeps all the accounts balanced.
Two key components of financial controls is having financial reporting completed regularly (bare minimum requirement: monthly) with a financial budget in place. Financial reporting is a backward looking tool that confirms whether the business is profitable and performing according to expectations. The financial budget is a forward looking tool to understand the direction of where the company is going.
If you have these tools in place, you are ready to understand the impact of the debt to be onboarded.
- Do you have a plan to repay the debt?
Debt should be a temporary means to a greater end. Lenders always need a plan for the debt to be repaid.
When using a line of credit, debt balances will fluctuate based on the incoming and outgoing cash within the account. If the company is profitable, cash accumulates over time and the line of credit is gradually repaid.
For a term loan, the debt is repaid through instalments over a fixed time period.
Understanding the debt obligations will help prepare you for the next step.
- How does the debt impact cash flow?
Calculate the impact of debt obligations on your cash flow. Since you have a financial budget (from step 5), plug in both the interest and principal repayments into the model. If the company doesn’t generate enough cash to service the debt, hit the brakes. Remember, debt is intended to grow the business, not to handcuff if. If the debt obligations strain your working capital to the point where you can't cover essential expenses or take advantage of growth opportunities, it’s not a good fit.
Another item to consider is how the invested debt contributes to additional cash flow. For example, if you buy new production equipment, you will make more products, faster, cheaper, which lets you sell more at higher margins. Understanding the full cycle of how invested debt can generate additional cash will determine whether its worth taking on the debt. The investment may not generate new revenue immediately so there may be some lead time to realize its benefits. If the additional cash flow isn’t enough to cover the debt obligations, is it still worth it?
If so, let’s continue.
- Do you understand all the risks involved?
Assess your risk tolerance as a business owner. Taking on debt introduces financial risk, so consider how comfortable you are with the level of debt and factors that increase risk (i.e. fluctuation in interest rates, changing market demand, and etc.).
It’s important to know that a default on the loan can potentially lead to the loss of your business. Lenders have the ability to liquidate the company’s assets to recoup their loans. Once this happens, the company will be put into receivership, meaning you will likely lose everything within the company. Worst case scenario, you may also have to file for bankruptcy.
Is this a risk you’re willing to take? If so, let’s keep going.
- Do you have a back up plan?
By now, you’ve done all your due diligence, crunched all the numbers, and have thought about all the possible scenarios that may play out. However, there’s always a chance that something beyond your control happens and your worst nightmare becomes a reality. To be safe, you should have a back up plan to recover or continue the operations, which includes paying off the debt.
A back up plan can be additional personal or business savings that have been set aside. It can also be other assets that you can leverage or sell (i.e. real estate). You may have business acquaintances who may be willing to form partnerships to help you through.
It’s never a good idea to put all your eggs in one basket. If you have a back up plan, let’s go to the last step.
- Do you have a trusted lender?
When you are borrowing money, you want to borrow from a reputable lender. Understanding the lender’s risk appetite and history are important factors in deciding whether you should borrow from them.
Some lenders are more risk averse than others. You can test them by asking questions such as how they view businesses within your industry. Is there a minimum size of business before they can lend to? How much experience do they have lending to businesses like yours? What is their outlook on the industry? If there are any red flags that pop up, this may lead to trouble as they manage your loan going forward. In these instances, you should look for another lender.
Conclusion:
Once you have gone through the 10 questions and still feel comfortable using debt to grow the business, it’s time for you to apply.
To help you get started, read through this guide and prepare a business plan.
The decision to take on debt for business growth requires careful consideration of various factors.
Using these 10 steps has help you weigh the risks and rewards carefully to see if you are ready for debt financing.
That’s all for today. See you next week.
Cheers!
Lawrence
That's it for this week. Thank you for reading Financing Journey. See you next Saturday.
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