The role of debt in scaling your business
Debt has long been considered a four-letter word in the world of personal finance, and this mindset often carries over into the business realm. Many small to medium business (SMB) owners cringe at the thought of incurring debt, associating it with risky financial behavior and potential failure. However, this one-dimensional view of debt can be limiting. The reality is that, when used judiciously, strategic borrowing can serve as a catalyst for your business's growth.
Good debt vs. bad debt
Good debt: This is the kind of debt that can generate a positive return on investment (ROI). For instance, taking out a loan to buy machinery that will increase production capacity and sales can be considered good debt. If the expected ROI is greater than the cost of the loan, it's a strategic move.
Bad debt: This is debt that doesn't improve your financial position or increase your business's value. For example, borrowing money to fund daily operational expenses without a clear strategy for revenue growth can lead to a financial quagmire.
How to identify opportunities for good debt: Search for instances where the borrowed capital has a direct potential to enhance growth or streamline operations. This ideally should result in elevated revenues or decreased operational costs over an extended period. Thoroughly research and evaluate your prospects. Collaborate with your trusted advisors to verify predictions and underlying assumptions. And importantly, always have contingency plans in place by conducting stress tests, ensuring your business can withstand unexpected challenges should Plan A falter.
Strategic uses of borrowed capital
Expanding physical locations or digital presence: Whether it’s opening a new branch, or amplifying your online storefront, borrowing can facilitate these expansions, putting your products or services in front of more potential customers.
Investing in technology and automation: Technological advancements can streamline operations, reduce manual labor, and improve customer experiences. Investing in them often requires capital up front, but the payoffs can be substantial.
Hiring talent and expanding teams: Talented individuals can drive business growth. If hiring an expert will lead to increased sales or efficiency, it might be worth the initial investment.
Diversifying product or service offerings: Borrowed capital can finance research and development, helping SMBs to diversify their offerings and tap into new markets.
Maintaining a healthy debt-to-equity ratio
Importance of balancing owner’s equity with borrowed funds: A balanced debt-to-equity ratio indicates that a business is not overly reliant on external lenders. This can make it easier to secure future financing at favorable terms, and can also be attractive to potential investors.
How this ratio affects creditworthiness: A high debt-to-equity ratio can signal to lenders that your business might be a high-risk investment, potentially leading to higher interest rates or declined loan applications.
Quick reminder, equity refers to the ownership interest in the business, representing the value of what's left after you subtract liabilities (what you owe) from assets (what you own). It's essentially the residual interest in the assets of the entity after deducting liabilities. In simpler terms, think of equity as your stake or share in your business.
Monitoring and refinancing
Keeping an eye on interest rates and loan terms: As market conditions change, so too can interest rates. Regularly review your existing debt agreements to ensure they remain competitive.
When and how to consider refinancing for better terms: If interest rates drop or if your business’s credit profile improves, it might be time to consider refinancing. Refinancing can lower monthly payments, reduce the overall interest paid, or both. It's crucial, however, to weigh the benefits against any potential penalties or fees.
Parting thought
For SMB owners, the financial landscape can be daunting. Yet, debt, often viewed solely as a liability, can be a potent tool in your arsenal. Like any tool, its value is determined by how it's used. Strategic borrowing can propel your business forward, driving growth and innovation. It's all about understanding the nuances, weighing the risks, and making informed decisions that align with your business's long-term goals.