Knowing when and how to use debt
Debt often has negative connotations, but it's also an important source of finance for growing businesses.
The trick is to use it for the right purpose.
It can be tempting to borrow when times are good and banks are happy to lend. However, just because a lender is willing to offer you a facility does not mean that it is a wise borrowing decision to accept it. Ultimately it's your responsibility as business owner to understand your current and future business plans, financial position and cash flows and use this information to make sound educated borrowing decisions.
Not properly assessing the whole picture to make an informed decision can lead to financial distress, with other negative impacts including:
- Insufficient cash to meet the business' needs
- A lack of ability to reinvest in additional future expansion
- Reduced product or service quality if you need to trim costs to repay debt
- Increased business owner stress levels
- Poor decision-making influenced by the debt position
- Reduced value of the business and attractiveness to investors, or
- The business becoming insolvent.
To help make sound decisions about lending for your business, there are five key questions you need to ask yourself:
1. When should I use debt?
Debt should be used for two key reasons - to fund business growth and expansion of investments such as plant and equipment, working capital or even to purchase the business in the first place. These activities and investments produce cash flow, which allows you to cover the principal and interest repayments of the debt.
Small businesses will often try to use debt as a means to fund current or past losses. While this is common, it's not recommended. It merely increases your debt without generating any additional cash to pay it off and all that usually ends in tears.
2. Why should I use debt?
Debt has its advantages. If used for the right purpose, it provides a fast way to bring cash flow forward to fund growth opportunities. Doing so allows you to pursue opportunities available to the business now, opportunities that will build the business and provide you with a return on your investment sooner. Debt is one enabler to pursuing these opportunities now, rather than having to wait until you have built enough cash reserves to self fund the growth, by which time the opportunity may have already passed.
Another advantage of using debt is that it is a non-dilutive source of funding. This means you don't have to relinquish any equity. This provides a leveraged return, as you're not tipping in any cash, but instead utilizing the debt to create a higher return than the cost associated with obtaining and repaying the debt.
3. What are the disadvantages?
Using debt comes with some risk. The bank will take security over the assets of the business and possibly the personal assets of its directors. If you default against the loan, the penalties can be hefty in terms of higher interest and additional fees. In a worse case scenario, the bank can call in the loan, appoint a receiver and seek to sell the business and its assets to recoup their funds.
Banks will also set covenants such as interest rate cover, profitability and level of owner drawings, and will require you provide financial reports to demonstrate you continue to meet these covenants.
So while the banks don't own any equity, they can still exert control over the business through their security and the performance covenants they impose.
4. How much debt should I enter into?
How much actual debt you incur, will depend on the ability of the business to meet the repayments. To work this out, businesses should prepare a cash flow forecast. When setting the forecast, you obviously don't want all surplus cash going towards repaying the debt, so you need to factor in a comfortable margin and allow for any variability in your cash flow from month to month.
By taking this a step further, you can improve your position by analysing your cash to cash cycle. Identify ways to make your cash work more efficiently for you, improving it's speed of movement through the cycle and therefore bringing more cash into the business, which can be used to pay down your debts sooner.
5. What should I do before I borrow?
Before you borrow, one of the important things you should do is to get financially organised. There are some basic financial management disciplines that you should put in place. These include:
- Preparing a cash flow forecast
- Understanding the current financial position of the business and its cash to cash cycle
- Implementing a management reporting process to allow you to track your financial performance and to enable timely reporting to the bank
- Assessing whether the cash return on the proposed investment will be greater than the principal and interest repayments of the loan and what the cash flow breakeven point is
- Evaluating whether the business will be able to meet the performance covenants that may be imposed by the bank
If your assessment indicates that you should not take on additional debt, don't despair. An expert review of your financial and cash flow position can often uncover opportunities to better utilize cash within the business. The alternative is to also evaluate and develop a grants strategy to tap into the 650 grants available that are assessed on different financial and business performance measures.
To discuss a grants and funding plan to support your business strategy, contact Marc Peskett or Matthew Murphy at our office on 9869 5900.
For a review of your current loans or for other lending assistance, contact Russell Sharp on 9869 5900 or email us.
