After discussing the good and points of debt generally, here are some specific points about when to use debt financing and how to assess the risk.
If you have financial skills, create a cash flow model on a spreadsheet and calculate the impact of the additional expense of making the loan payments.
This will force you to look closely at your expenses and revenues. And estimate the likelihood of being able to pay off the loan. If you don’t know how to calculate this yourself, then bring in a financial advisor. Not all CPAs know how to do this accurately though they may claim otherwise. They may not even know that they don’t know. Do they consider tax implications (including depreciation), the timing of payouts (time value of money), and know how to develop a proper discount rate? And so on. So be careful who is your advisor.
The lender will require payments on the loan almost immediately after you receive the money. This means you will need cash to begin making payments right away. Even a successful business may be short of cash when times are good. Sometimes customers are slow to pay or a piece of machinery needs repair – immediately. Those unforeseen problems can affect your ability to pay. So have a cushion.
When you are thinking of taking out a loan for your business consider:
Are your customers reliable and paying on time? Having customers that always pay on time is critical to cash flow. And therefore, your ability to repay debt. Pay attention to your customer’s payment habits and maybe provide incentives to get them to pay early. Make sure your payment terms are similar to your competitors and what is common in your industry.
How long will it take for the reason/project for which you are taking out the loan to provide a return? Is the money being used for short or long-term projects? If you’re investing in fixed costs such as a new piece of equipment, then you probably won’t see any cash returns soon. But if you need the money to invest in variable costs such as materials for your products or costs associated with a new client, the debt investment should have a positive cash inflow more quickly.
The overuse of debt can be dangerous in the early stages of a business. The company will probably be losing money at the beginning. Your profits will be low so the tax advantages of debt will be very small if there is any at all. As the business grows and becomes profitable debt becomes a better alternative. Cash flow will be more predictable, the tax advantages more meaningful, and so on. Most importantly, the risk of debt in forcing bankruptcy declines the longer the business operates.
Bottom line: think carefully before taking on debt. There are always unintended consequences. Be aware of these risks and plan for them.
