Most business owners eventually reach a point where they have to decide whether to borrow money for their company. It may be to plug temporary cash flow gaps or meet short-term working capital needs. Maybe it’s to take advantage of a growth opportunity by purchasing equipment, inventory, or raw materials, or maybe even buying another business.
So should you borrow money for your business, or shouldn’t you? There’s no simple answer. Used wisely and under the right circumstances, debt can be a valuable management and growth tool. Of course there is a cost to borrowing money, and too much debt or debt that isn’t structured properly can quickly become a noose around the neck of an unsuspecting business owner.
Uses And Structure Of Debt
A common mistake many people make when it comes to debt is how they use borrowed money and structure the debt.
One of the primary uses of debt is to finance capital items, such as a plant, equipment, fixtures, and computers. It often makes sense to finance these purchases even if you have enough cash to pay for assets outright. Financing capital items via a bank term loan saves your operating cash for the day-to-day expenses incurred in running your business.
In short you’re usually better off dedicating your operating cash to working capital expenses, such as salaries, rent, utilities, and supplies, rather than using it to pay for long-term assets. Also keep in mind that the term of the business loan should match the useful life of the asset being purchased. As in you shouldn’t finance computer equipment that has a three-year life with a five-year term loan.
There may also be times when it makes sense to borrow money to help fund daily operating expenses. A working capital loan or line of credit can help cover temporary cash flow gaps caused by a lag in accounts receivable collections. This scenario is common among manufacturers who must buy raw materials up-front but may not receive payment for finished goods until months later.
Build A Cash Flow Model
Before assuming any kind of loan, it’s wise to construct a cash flow model that will help you determine whether your business will be able to generate enough cash to service the debt. This model will show your projected monthly cash position so you can see any potential shortfalls and plan ahead for how to meet them, whether it’s by borrowing or reducing expenses.
If you believe you do need to borrow money for your business, whether for capital items or to fund working capital, start by talking to your banker. Bring your business plan and current financial statements with you, along with your cash flow model, and be prepared to explain in detail how you plan to use the money. Your banker will help you decide if a business loan is feasible and if it is, what kind of loan and structure is best for your situation.
Pull Up Your Bootstraps
There’s another kind of financing that doesn’t involve borrowing any money at all. Known as bootstrap financing, this involves looking for cash that’s already in your business that you haven’t uncovered yet.
The best place to start bootstrapping is by scrutinizing your credit and collections procedures. Are you enforcing your credit terms and aggressively pursuing past-due receivables? What about payables? If your suppliers are offering 30-day terms and you’re paying within 15 days, you’re lengthening your own cash flow cycle. Shortening your cash flow cycle by 10 or 15 days by accelerating collections and stretching out payables could eliminate the need for working capital financing altogether.
Don Sadler is a freelance writer specializing in business and finance. Reach him at firstname.lastname@example.org.