Debt is a bad word, right?[cite::219::cite] There's worry about the $21 trillion U.S. debt. And Business Insider notes that consumer debt — especially in the form of student, auto and, home loans — is on the rise. So it's no surprise that small business owners avoid debt wherever possible. According to Arizona Business Today, businesses like Ballard Truss have fought their way through market ups and downs with a simple rule: If you can't pay cash for it, don't buy it.
The reality? While avoiding too much debt tops the list of small business banking tips, there's a case for taking on reasonable debt to drive capital growth. Here's how.
Debt: Not Always Your Enemy
For small businesses, debt is often seen as a last resort. If cash flow and cash-on-hand aren't enough to purchase necessary inventory and no investors are on the horizon, companies are left with a hard choice: Debt or failure.
The truth is a little more complicated. As noted by Inc., in some instances, debt is the ideal option to boost your business. Consider seasonal companies such as landscapers or Christmas-light installers. During their offseason, money is tight and cash flow is negligible. During their busy periods, meanwhile, they often struggle to keep up with demand. The challenge is prepping for this busy season by purchasing inventory and conducting necessary maintenance on tools and machinery. Here, short-term debt financing makes sense. Take on a loan to cover the cost of materials and maintenance, then quickly pay it back with busy-season profits.
Debt as a tool for your business is one of the least expensive options, especially if you have a track record of company success. At National Bank of Arizona, for example, we've earned a reputation for helping small businesses make smart, debt-driven investments and grow their market share.
Debt or Equity?
Sure, taking on debt is an option, but why not choose equity financing instead? Give up a portion of your business equity — like companies do on Shark Tank and other investment shows — for monetary investment. The big advantage here is that you don't owe anything: Payment is made in the form of partial company ownership.
It sounds attractive, but there are several ways that debt out-performs equity for small business finance, including:
- You Keep Control - Equity financing means you give up a portion of corporate ownership to one or more stakeholders. The result? You're responsible for providing those stakeholders with a profit, and depending on their ownership stake, you may need to take their ideas and preferences into account when running your business. Debt financing means you retain total control over your company.
- Tax Deductible - As noted by FindLaw, interest on borrowed business capital can be deducted on company tax returns, lowering the total cost of debt for your organization. Check with your tax professional to be sure.
- Profit Retention - In an equity financing model, investors are entitled to a percent of all profits you earn, even if you need that capital to drive business growth. Best case? This stagnates long-term business success. Worst case? Your company can't stay in business. Debt financing, meanwhile, only requires you to pay back the loan plus accrued interest, while you keep all the profits.
How Much Is Too Much?
Any discussion of small business banking tips and debt financing needs to tackle the problem of excessive debt. How do you know when you've overextended the company and can't take on any more loans?
Start by monitoring your debt. Use the debt service ratio (your operating profit per month divided by your total monthly debt payments) to see where you stand — most financial institutions will let you borrow if this number is 1.25 or above. Or try the Acid Test. Divide current assets by current liabilities. If the number is 1 or less, more debt is not a good idea. Aim for 2 or higher.
So what happens if your debt gets out of hand and you can't make regular repayments? Your company credit rating may suffer, limiting your ability to get future loans, you may encounter cash-flow problems, or face the threat of bankruptcy.
Calculated Growth: Debt as a Tool for Your Business
Running a small business requires risk to drive revenue and grow your brand. Often, this need for growth doesn't match natural cash-flow increases, leaving you with a choice: Find financing or miss opportunities. Here, careful use of debt can help you develop a growth plan for your business that's both secure and sustainable — and doesn't require a loss of control.
The simple rule? Debt as a tool for your business is ideal with a specific purpose and a manageable repayment schedule.
The Debt Decision
For small businesses, debt represents opportunity — not liability — when properly used. Evaluate current business needs and growth plans to determine your financing needs, make a plan, and then find a lender with a reputation for driving local business success. Ready to get started? Come see what financing with NB|AZ can do for your small business.