The wise use of debt can propel a small business to new heights. Yes, I know you’ve heard the stories about people losing their houses and filing bankruptcy because of the debts they’ve acquired. Those are examples of unwise debt use. Don’t follow their path and don’t be afraid. Cautious, yes. Afraid, no.
When used properly, debt can help a business weather downturns and instability. Debt can be the fuel for your business engine. If every entrepreneur had to wait until his business was profitable before starting it, no businesses would ever be started. Debt can provide the cash injection needed to propel growth.
Debt is different than equity financing because there is an expectation that the money owing will be repaid no matter what. This is the main reason for taking a cautious approach. Make sure that your situation is appropriate for using debt. If you don’t have sufficient collateral, don’t have a strong personal credit score or need a large amount of money, equity funding may be a better answer. Perform considerable self reflection. If your personality is not one that can handle the pressure of making monthly payments then debt is not for you. Thoroughly analyze your business plan. If a reasonable person cannot believe that you can produce enough revenue to cover your debt service and provide a fair return on investment then don’t take on debt until you have reworked your strategy.
Let’s continue the discussion by listing the types of debt most commonly available to small businesses:
- · Vendor payment terms
- · Credit cards
- · Loan from yourself, friend or family
- · Leases
- · Bank loan
- · Line of credit
Each type has its unique characteristics and may be more appropriate to use in certain circumstances. Remember, whenever you take on any type of debt you incur a legal obligation to repay the loan. Debt, therefore, should never be entered into without careful thought. Now let’s review each type of debt in detail and determine the best use of each.
Vendor Payment Terms
Every business must purchase goods and services. Many vendors allow their customers to make purchases on account. In other words, you can buy today but not pay until some time in the future. Vendors don’t charge interest for this privilege unless payment is late. They offer payments terms to encourage their customers to buy more and more often. Mindful recommends obtaining payment terms from as many vendors as possible for the longest possible payment period. When you have payment terms you are using your vendor’s money, interest free, to fund your business.
Credit terms are especially important to those who sell products or whose sales cycle is more than a few days. Unless you’re lucky enough to sell something extraordinarily popular your product will likely sit on the shelf for a little while. Without credit terms you will have to fund inventory purchases yourself. This can be tricky for small businesses that often are on the edge when it comes to cash flow. With credit terms, you have time to sell the inventory before you have to pay for it. Cash generated by sales are then used to pay for inventory purchases.
The optimal credit term is 2% 10, Net 30. Simply this means that if you pay your bill in 10 days you receive a 2% discount. If you can’t pay or don’t want to pay in 10 days, then you have 30 days to remit payment but you don’t’ get a discount. If you have sufficient cash flow, why not pay in 10 days if you can get a discount? Vendors offer varied terms based upon their credit strategy and upon the industry standard. The key word is “Negotiate”. You’ll be surprised what you can get just by asking.
Credit Cards
I’m sure you’re familiar with credit cards because you probably have at least one. Credit cards are relatively easy to get and are accepted by most businesses. That’s why they’re so widely used. The problem with credit cards is that once you’re deeply in debt, it is extremely difficult to get out. Credit card companies are notorious for charging usurious interest rates (24%+) and for piling on fees for late payment, exceeding your credit limit and for making a payment on account by phone. These can quickly add hundreds or thousands of dollars to your balance.
Mindful believes credit cards are best suited in two situations. The first is when you are able to pay off your balance in full each month. A credit card with good terms is equivalent to receiving net 30 day credit terms from a vendor. Instead of the vendor funding your purchase, the credit card company does. Use your card to pay for purchases from vendors who don’t offer payment terms and to extend the credit terms of those who do. Sometimes you may need a little more time to pay a bill.
The second is as a last resort to fund business operations. Sometimes your business will go through a slow patch or you need extra money to fund an effort to grow sales. Pay for these with a credit card only if you have no source of low interest debt such as a line of credit. Compared to a line of credit or a loan from a family member, credit card interest rates are 2 to 4 times higher.
Loans From Yourself, Friends and Family
Your most reliable and forgiving source of funding is from yourself, friends and family. If you have a nest egg saved up, what better way to invest it than to put it into your business? Money you put into the business technically may be a loan, but in reality it is an investment. This investment is different from stocks and bonds because you have a large amount of control over the outcome. Friends and family have an emotional bond with you. They want you to succeed and many are willing to help you financially.
Whether its you, your best friend or your mom who loans you money, it is very important to handle the transaction professionally and at arms length. Sign a written promissory note containing specific repayment terms. The interest rate should be a market rate. Treat this debt with the same respect you would a bank loan. If you don’t, you risk ruining your business and your personal relationships.
Stay tuned for October's issue of Mindful Musings where we will discuss leases, bank loans and lines of credit. In the mean time if you have any questions about this article or applying debt concepts to your business please send us an email at Info@MindfulBusinessInc.com or by clicking the "Ask An Accountant" button on our website: www.MindfulBusinessInc.com.
