Business Debt Comes in Two Flavors: Good and Bad
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As a subscriber you can listen to articles at work, in the car, or while you work out. Subscribe NowOwners of growing businesses commonly misunderstand the role — and the value — debt can play in their companies’ health. Many of us were raised to cast a wary eye when it comes to borrowing, and that reluctance may limit opportunities for success.
Being too conservative with finances can prevent a business from realizing its potential. When talking about personal credit, financial experts will tell you there’s “good” debt and “bad” debt. The same concept applies to business borrowing.
A great example is the entrepreneur who worked for a window-washing company after college. He took pride in helping building owners make their facilities more attractive and was eager to call on prospective customers. He lived modestly, saved his money, and eventually used those savings to establish his own window-washing and sweeping business.
It’s no surprise his new venture was a success and he quickly built a roster of loyal clients. The business grew, but not as much as he wanted. Raised with the belief debt was fundamentally bad, he only made business investments he could cover with cash. When he hired a CPA to help him handle taxes and prepare financial statements, he shared his frustration about the company’s limited growth. After explaining how the owner could use prudent financing to support an expansion of the business and enhance its profitability, the CPA introduced him to a local banker.
The banker financed purchases of capital equipment that allowed the company to work more productively. A line of credit created flexibility the owner used to offer clients credit terms and grow his workforce. It didn’t take long for the entrepreneur to see how his careful use of borrowing fueled growth and helped him make the business more profitable. He continued to leverage the bank’s financing to secure growth opportunities, eventually acquiring similar companies in neighboring cities. Today, his company posts more than $5 million in annual revenues and serves clients in a dozen markets.
Successful business owners generally understand it doesn’t make sense to spend all their cash or tie up all of their working capital to achieve growth objectives. Using outside financing to supplement their own resources preserves cash and working capital for their companies’ day-to-day needs. Leverage is a tool that allows them to accomplish more than they could on their own.
A well-thought-out financing approach allows companies to capture business opportunities and inject new potential into operations. It might seem strange to consider financing as a method for expanding the company’s headcount, but if those new employees generate additional revenue far above the cost of the debt, it’s a sound investment.
Outside financing can make expansion possible. Whether that involves expanding the current location, building a facility that offers room to grow, or buying an existing site from another company, a strong relationship with a lender improves the likelihood you’ll be able to turn those goals into realities.
Those relationships also make it possible to act more quickly. Suppose a business owner learns that a competitor in a nearby market is considering a sale. That established relationship allows the owner to respond with a solid offer before other companies learn about the opportunity.
I’ve shared my thoughts about the healthy side of debt, so what about the bad kind? One of the biggest mistakes businesses make is obtaining long-term financing for short-term needs or short-lived situations. Obtaining a ten-year loan for a piece of equipment you’ll likely use for five years makes as much sense as taking a 30-year mortgage on your home to buy a used car. Something like a short term loan makes far more sense. For operating expenses, a line of credit is the preferred financing vehicle.
Another example is using business financing as a way to remove equity from the business. When the value of a property increases, you may be tempted to borrow against it and take the money as a withdrawal. But if the increase proves to be a real estate bubble that bursts, or if the economy takes a serious dip, you may find yourself upside-down.
Successful business financing requires knowing your risk tolerance. If taking advantage of a great opportunity demands borrowing in amounts or with terms that interfere with getting a good night’s sleep, you may be better off waiting for a different opportunity.
One last point: if you find yourself in a situation in which economic downturns or other situations have you anxious about your company’s debt, don’t panic. Contact your lender right away and share your concerns. They can help you structure a plan to get through the rough patch. Banks and other lenders want to see you succeed, because you’ll be able to pay off what you’ve borrowed this time and borrow wisely again in the future.
Karen Gregerson is President & CEO of The Farmers Bank, a locally owned and operating bank with 10 banking offices in Central Indiana.