What to think when you think about debt

by Adina Luca, November 20, 2019

The whole point of a business is to make money to cover its costs, including your staff and yourself, and ideally something extra to be reinvested or given back to you, the owner(s). But that does not always happen, does it? Some years the revenues are not enough for the costs that were already spent on the assumption that the business was growing. Or collection is falling behind. Is that the time to borrow money? When is it advisable to get a loan and when should you consider cutting costs instead?

Let’s assume you have a small business that has been generating revenue over the last five years and has grown organically. Here are some things to consider when getting into debt. There are many ways of borrowing money and supplement your cash, this is just a quick review of what we have seen happening with our small business clients.

The industry you are in

If you are in production and/or retail, you need a big(ger) working capital as you rotate more money faster to buy stock to sell. You have a constant need for short-term lending. Your margins are squeezed, you are cash-starved, and seasonality plays an important role. Go have a talk with your banker about what is available. But only after a thorough profit and cash analysis, which your bank will require anyway.

If you are a professional services company, you should NOT need to borrow money for your working capital or day to day operations. There is no stock in your business and, if you need an overdraft to pay your staff and your business does not generate a healthy profit, there may be an issue elsewhere. Talk to financial analysts, like us. However, if you have an extra cash cushion and think of getting a loan for a specific purpose, read below.

What to use the money for

If you are in production and/or retail, there is a rule for controlling the associated risk: use long term borrowing tools, such as long-term loans, for permanent current assets. In other words, use the form of debt with the lowest interest rate that requires fixed payments for things that you permanently need, such as a buffer stock and money in the bank. The higher the interest rate you pay (such as when you use short term loans, credit cards or overdrafts) for the permanent current assets the higher the risk.

If you are a professional services company, you are cash positive and you are thinking of getting a loan, here is what NOT to use it for:

  • Your day to day operations (salaries, rent, delivery materials) – these costs should be covered by your revenue if your business model is sound.
  • Hiring additional salespeople with the expectation that they will bring growth. It may sound like a good investment, but in services, the sales cycle is usually long. The risk to pay interest on supporting a sales effort is high.

What you should spend it on instead: any form of ‘asset’ that can generate cash immediately, which in professional services are:

  • Getting a new license that enhances your brand and provides you access to a new market
  • Launching a new service for an existing market that you have access to.

Profit and cash analysis

Whether you are a production, retail, or professional services company, you should borrow money after a thorough analysis of the following, in this order:

  1. a) profit margins per product / service / client / project
  2. b) fixed cost budgets and EBITDA
  3. c) cashflow.

Profit catches up with cash eventually. In other words: first, make sure that your cash difficulties do not come from an internal fixable issue before you jump into debt. You should never decide to supplement your temporary lack of cash with a form of borrowing without having done a profit analysis first. If the initial problem was profit, when the interest catches up with you … you will be toast.

Disclaimer: The views and opinions expressed in this article are those of the author and do not constitute advice. We do not take responsibility if you act on it. For specific advice, please talk to us.