The talk in Washington this week is all about how to deal with the United States debt ceiling crisis and whether Congress should again raise how much the federal government can borrow to prevent it from defaulting on its obligations. While no small businesses is looking to borrow $14 trillion, it can plan how much debt to incur.
Businesses should only borrow for two reasons:
1. Capital expenditures
Companies need to buy equipment, invest in technology, or buy a building. Banks love this form of debt because the borrowing is tied to a specific asset.
2. Short term cash flow
If a business has sales peaks and valleys, short term lines of credit are perfect for the short fall. In these cases, banks want the line of credit paid down every year to zero to ensure it is not a permanent term loan.
Many owners make the mistake of borrowing to fund losses and when profitability never comes, their business is in trouble. Not every business needs to have debt. Manage cash flow so the business does not need to borrow. Most cash necessary to grow business can come from profit and the proper management of accounts receivables, accounts payable and inventory levels.
If a business does need to borrow, financial statements, not sales forecasts will tell how much a business can afford. This is done by:
1. Reading the balance sheet
The quick ratio (current assets divided by current liabilities) will show the company's ability to pay its short term obligations. In most industries, this should be greater than one.
2. Studying the cash flow statement
This is the most forgotten financial statement and the one that never lies. This will tell the owner whether they have enough cash flow to pay pack their debt and at what rate.
3. Checking the borrowing base
For most bank loans, it is 75 percent of current receivables and 25 percent of the value of current inventory. Again, this is a crude method that banks use to insure that if they have to liquidate a business, can they cover their loan.
Banks are not the only place to borrow cash short term for small businesses. Creative owners use other sources such as:
1. Vendor credit
When Tony Hsieh, CEO of Zappos was trying to grown his business fast in a difficult market and needed more capital, he turned to his vendors and got better terms. He was able to increase the cash in his business, by increasing accounts payables.
2. Accounts receivable financing
This can take the form of selling the companies receivables for less than face value for immediate cash (factoring) or auctioning them off on a receivables exchange.
3. Family and friends
With interest rates at record lows, family and friends may be willing to take a higher risk for a higher short term return. Be careful with this type of debt. Being unable to repay the loan will affect the business owners relationship with their family or friend.
How do you determine how much you should borrow? Have you ever borrowed too much?