Debt is often perceived negatively. Debt can be “evil”, “crippling” and an “unforgiving master”( the last one from the Google query “Debt is…”;). It can suggest a lack of sufficient cash flow and an inability to fulfil your funding requirements. It also an indication of increased risk, as if you are unable to service your debt repayments, it could have dire consequences for your business (see American Apparel). There is however another side to debt. The majority of large corporations have some level of debt. It can be a great way for individuals to earn a return on their investment. And of course it is an integral part of the engine that drives the world economy. For small business owners, debt can actually provide some great benefits as long as it is managed responsibly. Some of these are discussed below:
1. Debt can help you grow your business:
One of the primary ways to grow your business is to take on debt. Many small business owners find themselves at a crossroads when facing rapid growth as they are not able to finance their expansion on their own. At this time, access to debt can be a great boon.
2. Debt is cheaper than equity:
This is a fundamental concept in a finance class when discussing the cost of capital. One the primary reasons for being in business is to earn a higher rate of return than investing it something else (after building in a risk premium). This means that as a business owner you expect a return on equity that is higher than the cost of debt. More debt allows you to have a lower equity base resulting in a higher after tax profit/equity return rate. This is especially meaningful when you are calculating earnings per share.
3. Government sponsored debt programs:
Both Canada and the US have numerous government loan programs for small business. This allows small business owners to borrow money, at competitive interest rates. If the business is unsuccessful, often the debt is forgiven or substantially reduced.
4. Mitigates your risk:
It is rarely a good idea to put all of your proverbial eggs in one basket. Borrowing money can help you mitigate your own risk and reduce your asset exposure in the event that your business venture does not succeed. And although bankruptcy is rarely a good thing, it is sometimes inevitable.
5. Suggests confidence in your business:
If someone is willing to lend your business money (other than perhaps your adoring family members) it suggests that they believe that your business has potential. Applying for debt can be a fairly rigorous process that requires business plans, projections and an in depth understanding that is an extension of your knowledge and abilities.
6. Helps you build credibility and maintain discipline:
In the same way that credit cards help you build a credit profile, debt helps you build relationships with financial institutions and other debt holders. Others are more likely to lend to your business when they see that it isn’t the first time. If you continue to make your payments on schedule, it is much easier to expand your credit facilities. Finally since most debt agreements have reporting and financial covenants, it helps you to stay disciplined.
7. Interest is tax deductible:
The cost of debt is actually less on an after tax basis than the interest rate suggests. If your interest rate is 5% and your business tax rate is 20% then the cost of your debt is actually only 4%.
It goes without saying that there should be careful evaluation of your business circumstances prior to taking on debt. There are many businesses (service based) that have low capital requirements and do not require much in the way of additional funding. And of course debt should not be used to replace fiscal discipline. Caveats aside, debt can be an excellent way to grow your business and improve your return on investment.