There’s a pervasive myth that no debt is good debt. Whenever we’re talking about owing money these days, it’s almost always in a negative light. You hear it every day: homeowners are underwater, the national deficit is surging, consumers are saddled by shortsighted credit card spending, the nation’s graduates are buried under student loans.
For businesses, the truth about debt is far less ominous. As the high finance set understands, not all borrowing is bad. For small business owners who might not have a masters degree in finance, keeping the following four things in mind will help them use debt to gain leverage, rather than getting weighed down.
1. Debt is usually less expensive than giving up equity.
This is the most noteworthy of the following four points. When raising funds for your business, giving up equity is almost always more expensive in the long-run than taking on debt. Equity costs you a portion of your business, forever.
Think about it like this: when starting out, your small business needs inventory and equipment and to make payroll. Investors are going to help you with capital, but you’re sacrificing future profits indefinitely to fill a short to mid-term need. With debt, you incur interest costs, but it is temporary and capped. Once you pay it back, your equity remains intact.
There are very few situations where giving up a piece of your business works out to be the cheaper option. How do you know? If the sum of the expected cash flow (on a discounted basis) you’d be giving up for an equity investment are greater than the costs of the debt, then you are better off getting debt.
2. Debt can be cheaper than your opportunity cost.
Suppose you’ve just opened up shop and must fulfill your first order, but you lack the capital to buy inventory. The wholesale cost of this inventory is $10,000 and the product would sell for $30,000. Should you borrow $10,000 at a cost of $2,000 to fulfill the order? Taking the time to calculate the APR on the loan, you’d learn that if it were a one-year loan, it’d represent a 20 percent APR, while if it were a two-week loan, it’d represent a 520 percent APR loan.
As a smart businessperson you’d recognize that even paying the absurdly high 520 percent APR is good business (assuming no cheaper debt alternatives) because the ROI on this investment is so high. In absolute terms, you’re making an $18,000 profit. In this case, the opportunity cost of avoiding $2,000 in interest is $18,000!
Who wouldn’t be willing to pay $2,000 to make a $18,000 profit? That’s math anyone can understand.
If the opportunity is right, debt is often the better strategic choice. You can profit from debt and open up new growth channels. Here’s the key question: “Is the return from this investment higher than the cost of the debt available to me?” Whenever the return is higher, the debt is worth it.
3. Paying interest on debt reduces tax burden.
Many entrepreneurs aren’t aware of this surprise benefit of borrowing. The cost of interest reduces your taxable profit and, therefore, reduces your tax expense. The effective interest you’re paying is lower than the nominal interest because of this.
It is this lower cost of capital that should be factored in when calculating the return from taking on debt. Leveraged buyout firms have used this strategy for ages to rake in the dough. Small businesses, too, can use it to improve their company’s finances.
This further sets borrowing apart from selling equity as a means of financing your business growth. If you get cash from equity, you’re paying off that equity holder with cash from your business with no benefits to you, whereas debt gives you the benefit of lower taxes.
4. Debt encourages discipline.
This is common knowledge among private equity firms, but is something that small businesses generally overlook. Debt brings with it a discipline about spending and investing that can help your company, especially in its formative and growth years.
While you wouldn’t take on debt just to increase your discipline, you can consider it a positive side effect of taking on debt.
The reason is this. The incentive to optimize every dollar fades when you have a lot of cash on hand. A psychology of excess is a threat to growing companies that need to continually sharpen their focus and stay scrappy. With cash sitting around, it’s easy for spending to expand from necessities to nice-to-haves. However, when cash is tight, the bar for spending is higher because each decision and transaction must be financially justifiable.
In virtually every case, this creates a cultural expectation of thriftiness throughout the organization. Because every employee takes ownership and responsibility for squeezing value out of each stage of production, the discipline induced by debt can ultimately help put your company on track for better margins.
There are many situations when it doesn’t make sense to go into debt. However, if you go about it the right way, it isn’t anything to be afraid of. On the contrary, it can be used as a strategic tool for growing a business and is often a much cheaper financing option than the alternatives. Due to the competitive environment today, more than ever, you must be savvy about using all the tools in your arsenal to help your business reach its full potential.