Does the sound of the word “debt” give you a nervous knot in your stomach? You’re not alone—the idea of going into debt is a scary prospect for most of us.
In fact, many small business owners need to take on some debt to grow their businesses. Too much debt is never good but using debt in an intelligent way can boost your business and rev it into high gear.
So, breathe deep, take heart and read on.
When you find yourself flooded with work
Meet Stan. Stan had worked hard for 10 years—six long days a week, 10 or 12 hours a day—to build up his home repair business, and it was paying off. Business was flourishing. Every day brought calls from potential customers who needed their repairs done before the cold weather set in.
He felt gratified and proud.
But now he had a new problem: he had more work than he could handle.
All he could do was take his callers’ names and add them to a waiting list, which he hated doing.
His worries were waking him up at night. Why was he spending good money on advertising? Homeowners were responding to his ads, but they needed their repairs now.
More than a few customers had gone to his competitors rather than twiddle their thumbs. He couldn’t blame them.
Stan knew the answer. If he was going to take on more clients and grow his business, he needed to buy a new service van, and he needed a crew to operate that van. But he just didn’t have enough money in the bank. It would take him two years, he figured, before he’d have enough saved up to pay for the van and its crew.
To take on debt, or not to take on debt?
As a kid, Stan had been warned time and time again by his folks about the dangers of debt in both his personal and business lives, and he’d listened: borrowing money went against everything he’d been taught.
What people often don’t understand about debt is the middle ground: while we have, in the last few decades, been taught that no debt is good and too much is bad, business owners should cultivate a comfort level with manageable, constructive debt.
The taboo around debt has been reinforced time and time again: in the 80’s, when interest rates got as high as 20%, and then in 2008 with “the Great Recession.” My goal is to help my clients learn how to use debt to their advantage.
The initial decision:
For weeks, Stan ran through the dilemma in his head: should he turn away new clients and wait two years until he had the cash to cover the van, or should he take out a loan to buy it now?
We’ll find out shortly what Stan did. But let’s look first at how he got there. (You’ll see some figures and the dreaded “debt” word below, but no cheating. If you skip to the end, you’ll miss the meat and potatoes, the part that allowed Stan, working with TurboExecs, to come to his final decision.)
A few simple factors to consider
Know the difference between constructive and destructive debt.
This is a fairly simple concept, but it can mean the life or death of your company.
Constructive debt is debt that you enter into in an intelligent way, manage responsibly, and leverage towards the growth of your business. This kind of debt can propel you towards your goals.
Conversely, destructive debt happens when company owners take a business loan or open a line of credit as a last resort. They often neglect the numbers required to handle debt responsibly, like the cost vs. their profit and expenses as a company, and quickly find themselves in over their head. Obviously, this is what we help our clients avoid.
1. What’s it really going to cost?
When thinking about a major purchase or expense, make sure to take a good look at all the costs.
First, take some time to weigh low-cost and high-cost borrowing.
Lower-cost borrowing is a great example of constructive debt. This most often looks like a regular business loan for a piece of equipment, or something of that nature.
The converse of that, leaning towards the destructive side, is high-cost debt, which is generally putting things on a credit card at times when you can’t afford them. Credit card debt is a recipe for disaster. Think high-interest loans, loan sharks, and the rest.
Business owners often choose high-cost debt when they’re in a desperate situation, which, in the eyes of the party giving the loan, makes them risky. This leads to high interest rates.
This also usually applies to unprofitable investments. Maybe the business owner in question needs a stop-gap, they’re losing money, and they’ve decided to tap their line of credit. The big issue here is that this kind of debt comes from a reactionary, impulsive decision-making place with very little planning.
The bottom line? Risky, impulsive, high-cost debt can seriously degrade the net worth of your business and negatively impact your credit rating (more on that later).
Up-Front Costs and Beyond
Paying up-front for a piece of equipment (or whatever investment you’re facing) can create a big hole in your business that you must dig yourself out of. This puts you in a hardship position. So, it’s important to weigh the longer-term costs associated with your loan.
In Stan’s case, his new truck was going to cost him about $45,000. But there was also the 5% interest on his loan. He knew that the length of a vehicle loan could vary from 36 to 72 months and that the longer the term of the loan, the lower the monthly payment. Low monthly payments: he liked the sound of that.
Loan: $45,000 at 5% interest (with $5,000 down payment)
But Stan also needed to consider maintenance for the truck, the cost of paying its crew and employee-related costs (health care, Social Security and taxes). Bummer. That’s a lot of costs to consider, and Stan’s estimate for these other costs came to $2,500—more than he’d expected.
2. How long will it last?
Does your new purchase or expense have a lifespan? No one can reliably predict the future (wouldn’t that be great?), but most things—new equipment, for example—don’t last forever.
Now that he had the numbers, Stan needed to think about how long his truck would be in service. How many years could he work the truck—and he knew he’d be working it hard—before things started to need repair?
Five years, he decided, was a realistic estimate. He knew it wouldn’t make sense to finance the truck for longer than that.
Stan estimated the overall operating cost for the truck at $2,500 per month. This is what the loan, vehicle insurance, additional employees, gas and other supplies came to.
3. How much more cash will I earn?
Once you’ve added up the cost side (and taken another deep breath), it’s time for the fun part: calculate how much more cash your new purchase will earn!
Your figure for your sales monthly nut—Stan’s was $5,000—will give you the amount of profit you’ll need to earn each month to break even on your new investment.
In Stan’s case, he needed to earn $5,000 a month to break even. If he earned $6,000 – $10,000 a month (at his gross profit rate of 50%), he’d actually be making enough to put $3,000 to $5,000 in the bank every month.
Could he do it? He was already bringing in $15,000 a month, so he knew he had that going for him. A new truck and added crew would let him take on the jobs of those customers already on his waiting list and to add many more new customers. If he did 10 more jobs, he’d earn an additional $6,000 to $10,000 a month. He felt better already.
Ask yourself if you have potential jobs already in the pipeline. Sit down and make a list of them—you probably have more than you think. Now put yourself in your customers’ shoes and ask how long you’d be willing to wait for service. Two weeks? Three? If you’re looking at longer than three weeks, the answer should be pretty clear: not having that new piece of equipment is costing you a potential windfall of cash.
If you don’t have potential clients lined up, ask yourself how you can make that happen. Do you need to follow up with previous customers for more work? Is it time to think about fresh marketing techniques, including kicking up your presence online?
Build Credit with Credit
Here’s the skinny on loans, and how they affect your credit.
If you handle a loan responsibly (paying on time, paying in full and doing the numbers beforehand, etc.), you can give your credit rating a huge boost, and present yourself as a great – that is, low-risk – candidate to banks and insurance companies alike.
Establishing great credit early on and working on it just like you would any other project in your business will build your credit history up, enabling lower bank loan interest rates and lowering your total cost of borrowing on future loans. Perk: companies also use credit ratings to adjust their pricing, which can only help you down the road.
It all comes down to lowering your risk.
How does the bank decide you’re a good risk? Let’s peek behind the bank’s curtain (okay, really thick doors) for a moment. If you understand how loan officers think, you’ll have a better idea about your chances of getting a bank loan.
The loan officer has a lot of fancy phrases (“debt-to-asset ratio,” for one), but basically, he or she looks at your business’s total assets, your ability to generate enough cash to pay back your loan and how much risk you’re willing to share with the bank.
What You’re Worth. The loan officer looks first at your business’s total assets. In Stan’s case, for example, that would include any money in his business’s bank accounts, the workshop and office he owns and the two trucks he has already.
The officer then calculates a “debt ratio,” which is the debt figure divided by those assets. He or she uses that ratio to determine how much your company relies on its debt to finance its assets.
How Much Money Can You Make? Now the loan officer looks at your business’s ability to generate enough cash to cover your loan payments. He calls this the “debt service coverage ratio” and calculates it by dividing your net operating income by your total debt. Any ratio higher than 1 is considered a good risk for the bank.
What’s Your Skin in the Game? The loan officer is now ready to look at how much you’re willing to put on the line to make your loan happen. The officer calls this the “loan-to-value,” or LTV, ratio. In English, this means dividing the borrower’s loan amount by the value of the asset.
Your loan can supercharge your business
One of the biggest benefits of borrowing money is that you’re leveraging someone else’s money to grow your business. Instead of having a lot of your available cash eaten up by a new purchase, you can use it to move your business forward by making sure that the profits you gain from your purchase more than offset the cost of the loan.
This is what is called a “pay-as-you-go” plan on a loan. Your profits should comfortably exceed your loan payments, instead of pulling your business under. That becomes a big upside.
So, what did Stan do?
He decided to buy the truck and finance it for 36 months. With his new purchase, he was able to bring in an additional $7,500 a month in income, which covered his operating costs, put money in the bank and made him full owner of the truck in just three years, two years ahead of schedule—and long before anything needed repair. Mission accomplished, and then some.
Go for it!
Do you need help deciding whether taking on some debt is the right next step for you?
Patty Lawrence of TurboExecs has helped scores of small business owners make this decision and has taken the fear factor out of the equation. Patty has found that the willingness to risk a reasonable amount of debt has helped her clients propel their businesses into the fast lane—without losing a sense of financial security.
If you’re unsure about taking that next step, let us help. Get in touch with Patty today.