Should I borrow to fund my business growth?

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.

Every serious business owner should always be using debt to … (a) be ready for moments of poor cash flow; and … (b) maximize their ability to grow and build wealth.

So, YES, debt is a vital part of a small business strategy. To decide how it fits into your own strategy, ask these questions:

• “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.”
• “If I grow too fast, will cash flow be a problem?”
• “Do I have a real growth plan that requires additional cash?”
• “Do I know what my internal rate of return is for growth capital?”

The first couple questions tackle the personal and emotional issues around debt. 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. If that’s you, it’s unlikely that I’ll be able to change your mind.

The last 3 questions are strategic and financial. Not all growing companies require cash, but most will.  And investing additional cash into growth is only smart if you have a solid plan — one that returns more than the cost of debt (the interest you’ll pay).

Why You Need Debt

In nearly every business, growth is 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” (or, more precisely, “Return on Invested Capital“)– 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 Invested Capital is the ratio of Net Profit divided by Total Cash tied up in the business (think of the result as a percentage). And if that percentage is higher than the interest rate the bank charges you to borrow the cash, then you might have a winning strategy — borrow at a low interest rate, and invest at a higher rate. By the way, most stable companies return AT LEAST 50% ROIC … and many exceptional companies can return 150%!  Compared with today’s interest rates of 8% to 10%, it’s easy to see why borrowing growth capital makes sense.

Growth vs. Stability

Any 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 paying back the debt consumes cash (from profits), and when a contraction occurs — say you lose a big customer or your product becomes obsolete — the debt still has to be repaid.
It is exactly analogous to taking out a mortgage on the house you live in. If you were averse to debt and tried to pay for your home only with cash, you’d live in a very small home (or none at all!).  Likewise, a business that is always debt-free will always be smaller, and grow more slowly.

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 profitable growth,
David Worrell
FuseCFO