Many of our small business clients have negative preconceived notions about debt: it’s either risky or unnecessary. There is some truth to both, but it is imperative that owners take an objective look at their capital needs, and understand how debt can make a difference in creating value and decreasing capital costs.
Let’s undercover some truths and demystify the myths of debt.
Debt Is Risky, But Not Necessarily in a Negative Way
By definition, any capital investment in a business has inherent risk and upside potential. Capital investments come in the form of equity and debt. Equity is riskier and more costly than debt. From the perspective of the equity investor (or in this case small business owners), owners are the last to get paid in a business. Therefore in tough times, small business owners take-on all the downside risk of the business. However, owners benefit from limitless upside when a business thrives. Conversely, debt is less risky than equity. To minimize downside risk, lenders look for collateral and strong cash flows to ensure the payback of the loan. Corresponding with limited downside risk, the upside risk of a lender is capped at the interest rate of the loan, costing the debt holder less money to grow his/her business when compared to equity. Furthermore, interest paid on debt provides a tax shield to owners, resulting in incremental cost savings not available with equity. So in fact, debt is a less risky and less costly for owners.
While debt is cheaper than equity, too much debt can result in high costs of financial distress during periods of low cash flow generation. The trick is finding the right balance between equity and debt. We know this sounds intuitive, but a small business owner should never take on more debt than the business can pay back. For instance, a small business should only take on a $1 of debt (and interest obligations) for every $1.25 the company generates in cash, leaving the business with enough cash flow “cushion” to pay off lenders during down times. With the right balance of debt and equity, small business owners can optimize the cost of their capital structure.
Debt has Benefits
So you think your business has great cash flows and doesn’t “need” debt to finance its day-to-day activities. Your business may even generate some excess cash flow to finance growth initiatives. There are three BIG benefits of debt to the small business owner. First, debt is a cheaper way to accelerate the growth of your business. Access to debt increases the capital available to reinvest and accelerates the growth of your business, while also benefiting from the cost benefits outlined above. Second, debt is a great way to relieve cash “stuck” in working capital. Too often, cash is stuck in your business in the form of inventory, employee payables and accounts receivable.
Debt is a great way to relieve unnecessary cash flow restraints and redeploy capital in growth opportunities. Last but not least, debt is a great way for the small business owner to diversify their investment portfolio outside of their core business. Too often we see small business owners cutting checks from their personal accounts to grow their business. Remember what we just said about equity being expensive? If a small business owner is truly confident in the upside potential of a certain growth strategy, why not raise debt to fund growth at a limited cost? Sometimes is better to keep your personal money outside of the business as a diversification strategy to save for a rainy day, or another limitless opportunity.