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Whether a business needs financing to purchase inventory, hire staff, or expand facilities and infrastructure, owners may face tough decisions about how to pay for these investments.
Debt is one option to consider. But how can a business effectively leverage credit for growth without going underwater?
Why an Owner May Consider Taking on Business Debt
Businesses often take on debt for one of several reasons. The first is to fill a cash flow gap, which essentially allows them to stay in business through challenging financial times. The second is using debt financing as a way to stimulate growth.
Leveraging debt in an attempt to stimulate growth requires a clear plan and an understanding of how much of a return on investment (ROI) a business is likely to generate. If a business won’t earn more than it spends on interest and financing fees, then taking on a new debt might not make sense.
What to consider when using debt to grow a business
A business owner may ask themselves the following questions when considering financing growth:
- How much money is the business borrowing?
- Are there fees?
- What’s the interest rate?
- How will the funds be spent?
- How much will revenue likely increase because of the investment?
- When will the business start to see a return on the investment?
- Does the timeline for the revenue increase align with the loan payments?
Essentially, the business needs to assess whether the projected revenue increase will be higher than the fees and interest expenses. Even if the numbers work in the long run, the cost of financing in the short term could trigger a cash flow crunch.
Ways to Use Debt to Grow a Business
There are many ways a business can use funding to grow. Consider these options and how they might align with the enterprise’s goals:
- Purchase inventory: Buying inventory and supplies ahead of a busy season or at the start of a marketing campaign might help prepare the business to satisfy an increase in demand.
- Buy or upgrade equipment: New equipment could make the business more efficient, help increase production, and reach more customers. The business might need different equipment to offer new products or services.
- Hire staff: It may take several months for employees to complete training and reach full productivity, and the business may want to take on debt to help cover expenses during that period.
- Create or update marketing materials: A business could leverage a website, brochure, social media campaign, or other types of advertising and marketing, tracking ROI of these initiatives.
- ·Expand to a new location or business line: Perhaps the business has outgrown its space or customers are clamoring for something fresh. A loan could help finance a move to a larger building, an additional location, or new products or services.
Leveraging Debt: Two Case Studies
Let’s take a look at two case studies of how companies might use business debt.
First, an online business needs to buy inventory to meet demand for the following season. A $100,000 inventory loan at a 10% interest rate paid back after one year could accrue $10,000 in interest. If the profits on that $100,000 are $30,000, then leveraging debt might create an opportunity for growth.
Second, if a business takes out a $100,000 loan at a 10% interest rate and uses it for facilities that don’t generate additional revenue, it could end up losing money overall. Unless the business needs to maintain or repair the facilities to stay operational, taking on the debt might not make sense.
The Advantages of Taking on Debt
Business owners have multiple options for addressing cash flow issues. A company might leverage credit to get financing in the form of a loan or business line of credit. A loan provides a lump sum upfront, whereas a business owner can take multiple draws (or loans) from their line of credit up to their predetermined credit limit.
An enterprise might also look for equity investors who will take part of their business in exchange for funding. But debt could offer a better fit, depending on business and personal priorities.
- Debt allows for the retention of ownership: In an equity deal, business owners trade a part of their company for funding. Ceding partial ownership has implications for making decisions and distributing profits.
- Debt is eventually repaid: Although financing creates a short-term obligation, a business could pay off the debt over time and become debt free.
- Debt may be less stressful: From a legal and administrative perspective, applying for debt financing may be less demanding than structuring an equity deal.
Exploring Financing Options for Leveraging Debt
Debt can be a useful tool for helping companies grow. Leveraging debt requires a clear plan, a realistic understanding of a business’s finances, and a commitment to following through. But without these, debt could hinder growth and put a company at risk.
The type of financing could also be important. When considering how to leverage debt, exploring business funding options could help identify financing that works best for a business. The material made available for you on this website is for informational purposes only and is not intended to provide legal, tax or financial advice. If you have questions, please consult your own professional legal, tax and financial advisors.
The material made available for you on this website is for informational purposes only and is not intended to provide legal, tax or financial advice. If you have questions, please consult your own professional legal, tax and financial advisors.
