Opening (and maintaining) a small business is a pricey endeavor. Most entrepreneurs have to take on some debt in order to get their business started or keep it afloat. After all, overhead, equipment, and payroll all cost money, and borrowing might sometimes be the best option to pay for it all.
Unfortunately, debt can also seriously hurt a small business. Too much debt is one of the major reasons why 80% of startups fail within the first 18 months.
This seems to lead to an untenable Catch-22: too much debt can kill your business, but avoiding debt can kill your business. So how does a modern entrepreneur determine the sweet spot for borrowing money?
Here is what you need to know about taking on debt as a small business owner:
Ask the Right Questions
Hitting a financial snafu in your new business can often lead to frantic questions like “Where am I going to get the money to cover this?”
But this is the wrong path. Instead, you need to slow down and ask the questions that will lead to the best financial health for your business. Questions such as:
Can I Bootstrap This?
The first thing you need to ask yourself is just how badly you need whatever it is you’re thinking of going into debt for. For instance, if you are opening a new office, is it really necessary to spend money on brand new office furniture? Or can you make do with what you can scrounge for free or very little?
Holding off on a purchase until you have enough revenue to pay for it with cash is known as bootstrapping. This sort of purchase delay is common in household budgeting, but small business owners may find it a little more difficult. If you have a vision of what your business should look like, it can be tough to recognize that it will take time to get there safely.
Will the Borrowed Money Directly Lead to Profit?
If you are taking on debt for an asset that will generate revenue, then borrowing is a good idea. For instance, if you are starting a woodworking business, purchasing the power tools on credit makes sense, since you’ll immediately start crafting salable items with them.
In addition, using credit to purchase inventory that you know you can sell quickly can also be a good idea. This will leave your cash liquid, while still giving you the opportunity to pay off your debt and make a profit on your inventory.
If, on the other hand, you are borrowing money to pay for something that will not directly lead to profit—such as payroll—then you need to be certain that you know how you will pay back the loan before you take it.
What is the Debt Time Frame?
A common mistake among business owners is the habit of turning to plastic to finance any hiccup. While there is certainly a place for credit card debt in the running of a small business, it’s a bad idea to finance a long-term purchase—such as equipment or furniture—using a credit card. You are then stuck with the high rates on credit card financing.
According to Nat Wasserstein, an expert in business crisis management,
“it’s a matching game, where you want to make sure your long-term debt is matched with your long-term assets and your short-term debt is matched with your short-term assets.”
That means that you should get financing from a bank in order to pay for necessary assets that will be with your business long-term. Only use plastic when you will be able to quickly convert those assets to cash.
Know the Signs of Default
My mother owned her own business for nearly forty years, so I know from personal experience that worrying about your business (and your cash flow and how you will find new leads and how much inventory you need…) just goes with the territory. Unfortunately, feeling worry in both good times and bad can make it more difficult to recognize when you really are in trouble.
Sageworks, Inc., a financial information company that advises banks on lending, has come up with the five best predictors of business loan default. Not only will knowing these predictors help you understand what to work on if you are denied a loan, but they will also help you to know when to step up your game and improve the financial health of your business:
- Low ratio of cash to assets. If you don’t have much liquidity, you’ll have trouble handling problems as they crop up.
- Low ratio of EBITDA (earnings before interest, taxes, depreciation, and amortization) to assets. This metric shows how efficient your business is, and you can improve the ratio by either raising revenues or cutting costs.
- Low ratio of EBIDTA to long-term debt and interest expenses. Again, if you owe more than you are bringing in, then you need to find a way to raise your revenues or reduce your expenses.
- High ratio of liabilities to assets. How many of your assets are financed through debt, rather than profit? Reduce your debt to reduce this ratio.
- Low profits. This is defined as your net income compared to your sales. Find ways to lower your production costs or increase your high-profit sales.
The Bottom Line
There is no one perfect approach to debt for small businesses. Being a small business owner means having to find the right balance of debt and cash flow for yourself. Ultimately, it’s important to remain proactive in handling your business finances—rather than reacting (or overreacting) to every financial difficulty.
Photo Credit: Simon Cunningham