Debt. It’s the word many small business owners hate to hear. It’s a reality for most businesses, however, to incur debt to finance operations, at least in the start up years. Although many small businesses are denied credit in the first few years, others have bankers and credit card companies begging for their business, especially those companies whose owners have substantial personal assets to attach.
I hear the following from small business owners every day:
“It doesn’t matter. I get to write it off.”
“You can’t operate in this industry without a big line of credit.”
“I need a corporate credit card to take my customers out to lunch.”
“You have to spend money to make money.”
All of these arguments are quite superficial and speak more to our penchant for overspending than anything else.
The first statement, “It’s a write off…” is the most tenacious argument of the lot. Many small business owners think that because something is tax-deductible, it’s free. If you look at it on paper, however, you will see the foolishness of the premise. Let’s say, for example, that you spent $1,000 in interest on a loan. The $1,000 is certainly deductible from your income. At a 25% corporate tax rate, this would give you $250 in tax savings. But you still had to fork over $1,000! You are still out of pocket by the difference, or $750.
It’s critical to get a grip on your debt picture and how much interest you are paying. This will help you plan and grow more effectively in the future.
Understanding Debt Service
Debt service represents the amount of money it costs a business to maintain or “service” its debt. It includes both interest and principal payments required for a company to remain on-side with its lenders’ covenants or agreements.
Some of your debt may require interest-only payments while some might be a blend of interest and principal repayments.
The purpose of incurring debt in any business (both the corner store and General Motors) is to generate more revenue. This is called leverage. The theory is that with more capital available to a business, it can buy more equipment or invest in more promotional activities in order to bring more customers in the door. In many cases however, a lack of understanding of these principles hides the fact that debt is simply being used to prolong the agony of an unprofitable business. Understanding your total debt service will help you to determine whether your indebtedness is helping you earn revenues.
How do I calculate my cost of borrowing?
Another useful measure of your company’s debt is to look at the overall cost of borrowing. Comparing the blended cost of borrowing over time tells you whether it is becoming more or less expensive for the company to acquire capital.
You may have financing from several different sources:
Lines of credit
It’s important to understand the total cost of your debt from all sources. You can do this by calculating a blended interest rate from all of your current debt.
Let’s look at an example:
A company has several different sources of financing:
A bank loan with a current balance of $14,912 and an interest rate of 8.5%
A capital lease for computer equipment. Balance $5,387. Interest rate 11.4%
Payroll arrears owed to the government in the amount of $6,754. Interest rate per the statements is 10%
A corporate credit card with a balance of $12,769. Interest rate 18.5%
In order to calculate the blended cost of debt, we simply divide each interest rate by the proportion of its related debt to the total debt. In the above example, it would look like this:
Type Amount % of Total Interest Rate Blended
Bank loan 14,912 37.5 8.5 3.2
Capital lease 5,387 13.5 11.4 1.5
Payroll arrears 6,754 17.0 10.0 1.7
Credit card 12,769 32.0 18.5 5.9
Total 39,822 100.0 12.3
The weighted average cost of debt is 12.3% in this example. So, what does this tell us? Not much, by itself. It’s only when we look at the weighted average cost of debt over time that we are able to see if our interest rates are going up or down. If our blended rate is going up, for example, it could mean that we are beginning to have solvency issues. It means that our newer debt is at a higher rate than our existing debt. Lenders may be more hesitant to lend to us and we may be seeking financing from more unconventional (and more expensive) sources.
The Danger of Leverage
Many “Make Millions with Your Small Business” books will talk about leverage and “good” debt versus “bad” debt. They argue that it takes money to make money and that virtually all companies borrow. “Good” debt (they say) allows you to leverage your funds to earn more income. For example, if you can attract $50,000 worth of new business by buying a $30,000 machine on credit, you would be farther ahead to do so.
What these “gurus” don’t tell you is this simple fact:
DEBT = RISK
Not exactly rocket science, I grant you, but critical information to keep in mind, nonetheless. In our above example, what happens if you don’t get the increase in business you were expecting? The debt is still there. You can’t tell the bank “Sorry, I can’t pay you back until I get this new business in the door.” When your business is indebted to a bank, mortgage company or other lender, there is the risk of default and of the debt being called and company assets seized. Think of it this way: it’s only companies that have debt that declare bankruptcy. If you didn’t have any debt and you wanted to wind up your company, you would simply close the doors.
Another danger that many small business owners don’t think about is that many lenders require the personal guarantees of company owners and may even require you to put up your home as security. Now, not only are your business assets at risk but everything you own personally as well. Clearly, this increases the risk of entering into credit agreements.
I’m certainly not recommending that you never borrow money. However, you need to understand the following every time you engage in credit:
What is the purpose of this borrowing?
Am I getting the best interest rate possible?
What does the revised stream of cash flows look like with the new debt?
Do I have a plan to retire this debt?
Do I have to pledge any personal assets to get this credit?
Once you have satisfied yourself that you have done the required background work to understand your business strategy, then you can enter into the agreement with confidence.