Business owners often ask me whether or not they should borrow money to fund growth.
It’s an earnest question, but when you understand the bigger picture, there’s really no decision to make.To me it is straight-forward: every serious business owner should always be using debt to maximize their ability to grow and build wealth.So, YES, I believe you should always consider using debt to fund growth. But that’s not the whole story. Perhaps better questions to ask would be:
- “Am I trying to build a larger, more profitable and more sustainable company?”
- “Do I believe in myself and my business enough to take on debt.”In this sense, using debt is really an emotional issue and not a financial one. There are business owners who simply will never want to be beholden to a bank; either they can’t stomach the personal risk, or they believe that their company is not fundamentally sound enough to repay the loan in the long-term.I understand that, and its not wrong. But from a purely financial basis, a healthy, growing company should always have some debt.Why You Need DebtKeep in mind that there are only two kinds of money: debt and equity. Together, they may up the “Capital Stack” of a business — the list of sources of funding used to operate the business day to day. Equity is “money at risk” because if the business tanks, you’ll likely loose it all. Debt, on the other hand, is not your money to begin with, so it is not really “at risk”.The next thing to know is that growth will always be limited by the availability of capital. In fact, there’s a mathematical formula for this (Called the “Affordable Growth Rate”). If you try to grow faster than your ability to find or create new capital, you’ll create a potentially devastating cash flow problem.Debt is called “Leverage” because it can help you grow faster and increase your returns on the money you have already invested in the business (equity).Since you already have some investment in the business, you should be thinking in terms of “Return on Equity” — how much profit is generated from the risk capital you invested. (And how much more return can you get without putting more money at risk?)Your Return on Equity is the ratio of Net Profit divided by Total Equity (think of the result as a percentage). And if that percentage is the same or lower than the return you can get in the stock market, or any other safe investment, then you should not be putting more of your own money at risk in your own business. Instead, you need… yes… Leverage.If that seems confusing, think of it this way: If you have to invest $1 million of your own money to make $100,000, you may decide that you have better things to do with your cash. But if you can borrow the $1 million instead, then the extra $100,000 profit becomes found money.
Growth vs. StabilityAny business that grows only organically — by re-investing profits — will grow slower than one that uses debt. But it may also survive the tough times better than a company that has large debts. This is because debt consumes cash, and when a contraction occurs — say you lose a big customer or your product becomes obsolete — the debt still has to be repaid. If an all-cash business can react quickly, it may have a small advantage in tough times.It is exactly analogous to taking out a mortgage on the house you live in. You can either live in a small home with no debt, or borrow enough to buy the larger more luxurious home. If your income drops, and you stop paying your mortgage, there will be consequences. But if you want to live debt-free, you will always live in a smaller home. And if you spend ALL your cash on the house, you may actually have troubles buying a car or a lawnmower! Likewise, a business that is always debt-free will always be smaller, and always have trouble finding funding for other opportunities — even highly profitable opportunities, like expanding their product line, or getting into foreign markets.When to Say “When”Of course, at some point, debt could overwhelm your ability to make payments from cash flow. Knowing when to say “no” requires a different calculation called the Debt Service Coverage (DSC). A company’s DSC is equal to Total Debt Payments divided by EBITDA. Banks will always require a ratio of 1.25 or better for DSC, so you should pay attention to that as well.
I’m all for a reasonable amount of debt in a company. It doesn’t scare me in the least. But taking on debt should not be entered into lightly. To learn more, take a look at my last post on this topic: 9 Lies We Tell Ourselves About Loans.
Dedicated to your growth,
Managing Partner, FUSE Financial Services
Banks and VC are in many ways, the least important sources of capital for a growing business. They are two ends of a spectrum that is rife with hundreds of alternatives. When you find the funding source that fits you best, you’ll sit down with someone who understands your vision of the future, and who is willing to invest in your dream…And you won’t hear even the slightest snicker as they write a check to you. That’s the goal; Find the right people, at the right time, with the right amount of capital – and sell them on your dream. It is always an arduous task. But I hope you’ll find that this e-book can help.