Debt financing in business

Peter Done: Managing Director and Founder

October 06 2015

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According to recent survey by Sage, 60% of UK business owners have at some point used their personal savings or re-mortgaged their homes to drive their company forward. As for the other side of the picture, according to the SME Finance Monitor, nearly half of small businesses are considered “permanent non-borrowers” (PNBs). That means they haven’t applied for debt in the past five years and have no plans to do so in the future. So who’s right? In many ways, both points of view have validity. Borrowing can have many advantages for businesses. Some companies are in high-growth industries with capital intensive opportunities, while others are in more moderate growth environments where having excess capital brings little, if any advantage. Whilst you shouldn’t borrow for its own sake, there may be very good reasons why an injection of cash is just what you need to grow your business in a way you wouldn’t be able to otherwise. So ascertain the level of debt that is both necessary and appropriate for your industry and your business model and borrow accordingly. Debt financing can also be advantageous for tax reasons as interest is tax deductible. Also it doesn’t dilute the ownership of your business, unlike raising capital through equity finance, which can also make it very attractive to entrepreneurs who want to retain control of their destiny. And you can improve your business’s credit rating if you make your repayments in a timely and regular manner. So debt is not necessarily a bad thing but is inherently more risky than equity. The main reason is cash flow. As an SME you may find yourself with large loan payments or interest charges at precisely the time you need funding for start-up costs, new equipment or that essential new hire. If you don’t make payments on time, your credit rating will inevitably be decimated. And of course you run the risk of bankruptcy if you don’t make your repayments. It’s not just SMEs, though, that are vulnerable to getting it wrong on debt. Look at the example of Glencore, the global powerhouse commodities trader, which has spent the last few weeks “teetering on the edge” to quote the business pages and is now facing a fire sale of its assets to remain afloat. The reason for this catastrophic collapse is the rising cost of financing a $29.5 billion debt burden. Put simply, with shrinking earnings due to declining commodity prices alongside eye-wateringly heavy debts, something had to give. One potential scenario is that Glencore will have to direct all its earnings towards debt repayment. The company is quickly running out of options. Essentially Glencore didn’t factor in the “what if?” scenario – if the market turned, if the backdrop changed, if the worst happened, would they still be able to service the debt levels they had built up? They believed they’d developed a robust business model that would work when the market went up but would protect them if it turned against them. As ever, if something seemed too good to be true, then it probably was - as they are now learning to their (and their shareholders’) cost. So the message is – be very careful. Cautiously managed, prudent and considered borrowing can be a good thing – it can help the business accelerate and develop at the right time and it can help maintain a well-rounded balance sheet. But always, always factor in the “what if?” scenario and never take on more debt than you can repay, even if the market turns against you.

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