For many small businesses, debt is truly a four-letter word — not that it has mattered lately since lenders have been downright Scrooge-like about extending credit of any sort.
But now the purse strings seem to be loosening. And, say experts, going into debt can be a prudent decision for many small businesses, provided it occurs under the right circumstances.
Not all debt is the same; taking it on comes down to its cost of capital and how you plan to use your borrowed funds. If the conditions are right, this leverage can help you preserve cash and put an otherwise illiquid asset to work to build your net worth.
Here’s how to make debt work for your business:
Get a great deal on your debt
One obviously attractive feature about taking on debt is the cost. Interest rates are scraping rock bottom, making the expense more affordable not only for small businesses taking on debt for the first time, but also for those looking to retool existing debt.
But skinny interest rates alone don’t mandate a mad dash to the bank. Do’t take on a debt in hopes of righting a small business that’s struggling. While the infusion of cash may offer a short-term boost, subsequent revenue may prove insufficient to meet repayment obligations:
The right conditions would include a healthy business that remains appealing to their bank’s view of a prudent risk, has positive trailing trends and has good prospects for continued growth.
Nor, for that matter, are banks turning a blind eye to small businesses looking for debt to stabilize volatile finances. Although lenders are being more generous than they have been in the recent past, their most attractive candidates remain businesses with a history of solid finances and an eye on growth instead of on patching financial leaks.
“Banks are looking for those businesses that are well managed and have proven this by adapting as necessary to their evolving situation,” says Craig Calafati, senior vice president of national sales at Celtic Bank.
“This means having maintained necessary liquidity, close supervision of expenditures, and any other measures taken that show a good understanding of the current business climate.”
Approach debt with caution
Even healthy businesses should exert caution when it comes to considering debt. Rather than assuming large debt in hopes of spurring major growth, Financial planner Julie Murphy Casserly suggests just the opposite — a debt load that will be manageable even if conditions take a turn for the worse. “Decide what you can afford in a payment that still gives you wiggle room if sales decrease,” she says.
If circumstances and your financial prospects are solid, consider next what form of debt might work best. As a rule, Casserly encourages fixed-rate loans. Fixed rates are historically appealing since any possible interest-rate movement is taken out of the equation. That makes growth and loan-payback planning much more reliable.
Although long-term loans may seem the most obvious choice, Green suggests investigating revolving lines of credit as well. They offer greater flexibility in terms of accessing cash and subsequent payback.
The caveat is that they’re best suited to businesses with a reliable cash cycle and a focus on using the funds for a specific purpose rather than trying to generate a cash cow. Without a predictable cash cycle, making payments can prove dicey.
The fine print
Before you scramble to take advantage of cheap debt, consider the risks. Like corporations, individuals who accrue low-cost debt levels today may be forced to refinance them at higher rates in the future, which could have a negative impact on future cash flow.
Rising interest rates can also affect income, as well as the value of the assets used as collateral, especially if they trigger an economic downturn.