Adapted from content excerpted from the American Express® OPEN Small Business Network
For a growing business, having a manageable level of debt can be an effective way of doing business. While some small business owners are proud of the fact that they’ve never taken on debt, that’s not always a realistic approach. Growth often demands considerable capital, and getting that money may require you to seek a bank loan, a personal loan, a revolving line of credit, trade credit, or some other form of debt financing.
The question for many small business owners is: How much debt is too much? The answer to this question will lie in a careful analysis of your cash flow and the specific needs of your business and your industry. The guidelines below will help you analyze whether taking on debt is a good idea for your company.
Explore your reasons for borrowing
There are a number of scenarios when it may make sense to take on debt. In general, debt can be a good idea if you need to improve or protect your cash flow, or you need to finance growth or expansion. In these cases, the cost of the loan may be less than the cost of financing these moves through ongoing income. Some common reasons for seeking a loan include:
- Working capital – when you’re looking to increase your company’s work force or boost your inventory.
- Expanding into new markets – when companies enter new markets, they often face a longer collection cycle or must offer more favorable terms to new customers; borrowed funds can help weather this period.
- Making capital purchases – you may need to finance new equipment in order to move your business into a new market or expand your product line.
- Improving cash flow – if you have less than 10 years left on an existing long-term debt, refinancing can improve cash flow.
- Building a credit history or relationship with a lender – if you haven’t borrowed before, taking out a loan can help in developing a good repayment history and can help you obtain financing in the future.
Before taking out a loan or any other kind of debt financing, you should spend time planning your capital needs. The worst time to take on any kind of debt is during a crisis. A sudden loss of trade credit, the inability to meet a payroll, or other emergency could force you to take on debt immediately, and that can result in highly unfavorable terms. A plan will allow you to forecast your cash requirements, allowing you to determine what you will need and when you will need it. This will give you the extra time to explore all possible borrowing sources and negotiate the most favorable terms. A capital plan should consist of a complete review of your balance sheet to help you analyze cash flow, assets and liabilities. You’ll also want to construct a pro forma statement, which is a projected balance sheet for the coming 1-3 years.
Examine short-term vs. long-term debt
Just as you need to be certain you’re taking out a loan for the right reasons, you also need to make sure you’re taking out the right kind of loan. For example, taking out a short-term loan when a longer term loan is required can quickly create financial problems since you may be forced to take unnecessary measures (such as selling a piece of the business) to meet the obligation.
In general, use short-term loans for short-term needs. This will help you avoid higher interest expense and more restrictive conditions of longer-term borrowing. For instance, if you experience a temporary rapid increase in sales — such as that brought on by increased seasonal demand — then you should look at a short-term loan. If the growth will continue over a long time, take a look at longer term options such as an expanding line of credit based on sales, accounts receivables, or inventory ratios The term of your debt will have no impact on your debt-to-equity ratio. However, you will see changes in liquidity indicators such as your current ratio, since current liabilities include only the debt that must be repaid within one year, not debt due at later dates. So longer term loans can positively affect your liquidity ratios.
Base new debt on current needs
When interest rates are low and money is cheap, you may be tempted to take out loans to buy equipment or make other capital purchases. If that’s the case with your business, be sure to base your decision solely on your current needs. The possibility of rates increasing is not a rationale for spending money on something you don’t need. For example, if your business needs additional computer equipment, you might want to take out a loan to buy it. But buying additional computers now because they’ll be more expensive next year is not ample justification. You can end up getting stuck with equipment you don’t need and debts that you are still obliged to pay off.
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