The How To Guide for Leveraging Debt for Your Business
Whether you need capital to purchase inventory, pay staff or invest in facilities and infrastructure, business owners face tough decisions about the best way to close the gap between the capital they have and the capital that they need. Debt is one option to consider. But how can you effectively leverage your debt to grow your business without going underwater? Here’s a closer look at what business owners need to know when thinking about leveraging debt for business growth.
The Advantages of Taking on Debt
Business owners have multiple options when addressing cash flow issues. Financing solutions range from taking out a loan (e.g. debt) to giving an investor part of your business in exchange for funding. At first glance, business owners may wonder why debt is the right solution for their needs. Debt offers several advantages over equity deals, which may be right for your situation depending on your business and personal priorities.
Debt allows you to retain ownership of your company. In an equity deal, business owners trade a part of the company for funding. Ceding even partial ownership over your company has implications for controlling business decisions and distributing profits for as long as you’re in business. Debt is eventually repaid. Even though it may create a short-term financial obligation, there’s a time in your business’ financial picture when you’ll be debt free. In certain cases, the interest paid on loans is tax-deductible which can create a financial advantage for businesses. Finally, applying for debt financing is typically less demanding from a legal and administrative perspective than structuring an equity deal.
How Businesses Leverage Debt for Growth
Businesses take on debt for one of two reasons. The first is to fill a cash flow gap that essentially allows them to stay in business through challenging financial times. The second is using debt financing as a way to stimulate growth. Leveraging debt requires a clear plan and an understanding of what return on investment (ROI) you’re likely to generate as you invest the funds.
Debt is often based on factors such as the owner’s equity and the perceived value of the company. In exchange for financing, business owners pay back the debt over time. Payments encompass both the principal – that is, the amount that the owner took out the loan for – and interest. Interest is essential to determining whether leveraging debt will be profitable. The amount of return that you’re generating based on how you’re investing funds needs to exceed the interest that you’re paying in order to make sense. One way to think about this is a business term called EBITDA: earnings before interest, takes, depreciation and amortization. Essentially, when you take revenues minus expenses, will you turn a profit when taking a loan’s interest and fees into account?
To determine this, ask the following questions:
- How much money are you considering borrowing?
- What’s the interest rate?
- How do you plan to spend the funds?
- Does your planned investment have a return on investment (ROI) that can be captured in a direct economic sense?
- Does the timeline for the planned ROI match up with the repayment obligations?
Leveraging Debt: Two Case Studies
Let’s take a look at two case studies of how companies might leverage debt. In the first example, consider the case of an online business that needs to buy inventory to meet demand for the following season. A $100,000 loan at a 10 percent interest rate paid back over one year would be equal to $10,000 in interest. If the profits on that $100,000 are $30,000, then leveraging debt created opportunities for meaningful growth.
In a second case study, if a business takes out a $100,000 loan at a 10 percent interest rate and uses that for facilities that don’t impact the bottom line, they could end up losing from the deal. That’s why having absolute clarity on how those funds are being spent is so important.
Debt can be a useful tool for helping companies grow. Leveraging your company requires a clear plan, a realistic understanding of the finances and a commitment to following through. Without these things, debt can not only hinder your growth but put your company at risk.