A very successful business owner and mentor of mine used to say, “The path of least resistance is what makes men and rivers crooked.” In your business, the path of least resistance is using a credit card or some other form of borrowing. Before you know it, the amount of debt has piled up, the interest you pay on the debt is significant, sometimes 18-24 percent, and you begin to question whether borrowing the money was a good idea or not.
So, how much debt is enough and how much is too much? What form should the debt take: short term or long term? What’s the cost of the debt relative to all the options? Here are five things you need to know before you borrow and create leverage, or debt, in your business.
- Growth always requires cash. Strictly from a cost perspective, you want to use the cheapest forms of debt, which is accounts payable. Typically, this is free money because the cost is built in to the price of the product or service. Unfortunately, businesses don’t give brownie points for paying early. So, take full amount of terms that are given. If possible, try to stretch the terms a little without jeopardizing your credit rating with that vendor.
- You may choose to finance your growth internally or with equity. Many business owners feel that their cost of equity is free. However, that’s not the case. There’s a somewhat complex calculation for cost of equity. Let’s just say that the cost of equity is almost always more expensive than debt financing.
- If you’ve maxed out your terms with your vendors, the cheapest form of debt is a bank line of credit. However, before you approach a bank, be sure you’re bank ready, meaning you produce timely and accurate financial statements and bankable, meaning you’re profitable, managing your AR well, you’re relatively liquid and have modest leverage. Most banks begin to get uncomfortable when leverage is higher than 3-4 to 1 (total debt/total net worth).
- Once you hit 4 to 1 leverage or higher, there’s a shift from being a balance sheet or cash flow lender (bank) to a collateral lender (AR). Many asset-based lenders are willing to extend up to 80-90 percent of your eligible accounts receivable depending on the lender. However, get ready for a monthly service charge of 1 to 1.5 percent or 12-18 percent annualized and a rate of Prime plus 3. So, a total cost of borrowing could be as high as 24 percent.
- Private sources of debt or equity are probably the most expensive source of financing with interest rates of 18 percent and warrants. Warrants are sometimes called equity kickers that give the lender a minority stake in the business and can easily push up the total cost of capital to 30-50 percent depending on the deal.
Many business owners do understand that leverage does magnify profits, but forget that it also magnifies losses. If you managed a business through the last downturn you understand that borrowing money to fund losses is like pouring gas on a fire. When you borrow to fund losses, you’ve mortgaged your future. So borrowing a little money can help grow your business, but should be used in moderation. Once you hit the 4-1 debt to equity mark, the lending arrangements become different and the cost of capital goes way up. You want to match the loan to the use of the funds. A line of credit is a short term loan and should be used to finance accounts receivable. Equipment is a long term purchase and should be financed with a long term loan, like a term loan.