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Debt 101: How Debt Can Help or Hurt Your Business

October 8, 2015     |     Posted by:     |     Category: Blog, Turnaround finance

Is your business afraid of debt? For many people, the word “debt” doesn’t sound all that appealing. Many of us associate debt with risk and poor financial health, often with good reasons.

While debt may be a bad thing for consumers and households, debt can often be a good thing for businesses. When used right, debt can have a huge range of benefits for a growing business with an effective plan for the future.

Of course, taking on debt is a risky proposition, and businesses that don’t have the right combination of financial strength and good planning can quickly run into big problems as a result of their debt.

Are you considering using debt to help your business grow? Read on to learn more about how debt can help your business when used properly, or lead to big financial issues when used the wrong way.

Debt lets your business avoid giving equity to investors

There are several ways to grow your business. You can fund growth using the cash flow of your business – revenue that comes in as a result of product sales or service delivery.

You can also fund growth by raising cash from investors. Finally, you can fund your business’s growth by borrowing money from a bank, giving your business access to cash at a specific interest rate.

Both of the first options have significant disadvantages. Funding growth using your business’s cash flow can be a slow process, whereas funding growth using venture capital or outside investment can dilute your equity in your own company.

Debt, however, lets you grow your business without having to worry about giving up control or ownership. Since banks don’t require any equity in your business to provide a loan, your shareholders experience all of the benefits of its growth.

By using debt, your company can speed up its growth

Does your company have an effective plan for growing its revenues? Growing your business is an exciting process, but it can be impossible to achieve steady, scalable growth without a large amount of cash.

By using debt, your company can access the cash it needs to buy new equipment or hire new employees and fund its growth. You can open new branches, expand your marketing efforts and push your business towards achieving its new targets.

This is particularly important for businesses that benefit from economies of scale to deliver their products or services at a competitive cost. Debt can make it far easier for your company to reach the scale it requires to become more profitable.

Debt lets your business avoid serious cash flow issues

Does your business have cash flow issues? Many businesses are profitable, earning more money than they spend on a monthly or quarterly basis, but rarely have cash on hand to fund growth due to slow cash flow.

If your business constantly has to wait for several months to be paid by customers, you may be able to use debt to fill in the long gaps between delivering products or services and receiving payments.

Cash flow is the key to any successful business. Without cash, your business can’t fuel its continual growth, making it impossible to achieve milestones or get ahead relative to your competitors.

With a line of credit, your business has access to the cash it needs when cash flow from sales is slow. This makes it easier to pay employees, purchase supplies and continue trading when incoming cash is slow or unpredictable.

When overused, debt can hurt your business’s finances

Debt has significant benefits, but it also has serious downsides. Many businesses, as well as many individuals, misuse debt, becoming overleveraged as a result of taking on too much debt at once.

We’ve all heard horror stories about profitable businesses growing too quickly and subsequently failing. These failure stories are often the result of businesses using an excessive amount of debt to fund their growth and expansion.

Loans aren’t free. When your business borrows money from a bank, it doesn’t just need to pay back the loan principal – its debt service needs to pay for the principal and the loan’s interest.

When interest rates are low, borrowing a reasonable amount of cash to fund your business’s growth can be a good idea. However, borrowing too much – particularly when interest rates are high – can hurt your business’s financial position.

If your company is a risky investment, debt is expensive

The riskier your business is, the more you’ll need to spend to borrow money to fund its growth. Lenders dislike risk, and few banks will be willing to loan money to your business if its business model isn’t proven and predictable.

This can be challenging for business owners and entrepreneurs, as risky ideas often have the potential for the highest returns. When you borrow money to fund a risky business idea, you’ll need to be prepared to pay for it.

In order to reduce their risk, many banks require small business owners to provide a personal guarantee for business loans. This could put your personal assets at risk if the business fails to grow at a rate that lets it service its debts.

Risk is always a part of business, and minimizing risk is an important part of being a responsible entrepreneur. If your business model is risky, taking on debt could be a challenging and expensive process that isn’t always worth it.

Debt can affect your ability to seize new opportunities

While debt provides your business with cash in the short term, it can have a severe impact on its long-term cash flow. This is because a specific amount of your monthly or quarterly cash flow will need to be set aside for debt service.

The old saying that “cash is king” isn’t untrue, and when a large percentage of your business’s cash is being spent servicing its debt, it becomes harder to capitalise on new opportunities for growth and development.

When a business has too much debt, it’s referred to as being over leveraged. If its core business suffers and revenue declines, servicing its debt can become a tough process, pushing the company closer to insolvency.

Should your business borrow money?

Borrowing money can be a great way to fuel your business’s growth, but it needs to be done carefully to avoid becoming over leveraged. Can your business afford to use debt to speed up its rate of growth, or should you use equity or cash flow to grow?

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