Many business owners avoid using debt to raise additional capital. When managed properly, however, business debt can be an effective tool to finance business growth, and successful companies often use both equity and debt to raise capital. In this article, we will discuss five reasons why business debt should not always be viewed as negative, and provide an example to illustrate the concepts.
#1 Using debt to fund company growth
A firm’s cash balance is typically used to fund day-to-day operations, including payroll, inventory purchases, and marketing costs. Most businesses cannot use cash on hand to finance growth, which means that they must raise capital. Debt provides a way for businesses to secure the capital they need to launch new products or services. Without debt, many businesses would not be able to achieve their growth goals.
#2 Interest costs may be tax deductible
Interest costs incurred on business debt is an expense, and interest expense is often tax-deductible. If a business can deduct interest expense on the tax return, the actual cost of borrowing is lower, and the savings can be reinvested into operations.
#3 Improving business credit score
A business can improve its business credit score by taking on debt and making all interest and principal payments on time. A good credit score can make it easier for businesses to secure additional financing in the future, with better interest rates and terms. This can be especially valuable for small businesses, which may have limited access to capital.
#4 Better cash flow management
Some businesses experience fluctuations in their cash flow, which can make it challenging to pay bills and cover expenses. By using debt strategically, businesses can smooth out their cash flow and avoid running into cash flow problems.
For example, a business may take out a short-term loan to cover payroll during a slow season and repay the loan once cash flow picks up again. As discussed above, borrowing and repaying loans on time builds the business credit score.
#5 Taking advantage of opportunities
To outperform competitors, owners can take advantage of business opportunities, and these situations often require additional capital. For example, a retailer may have the chance to purchase inventory at a discounted price, but the dollar amount of the order is much larger than normal. The owner needs to act quickly to secure the deal.
By using debt to finance the inventory purchase, the retailer can take advantage of the opportunity, pay a lower price for each inventory item, and generate a higher profit when goods are sold.
Working through an example
Assume James is the founder of Alpine Lakes, a beverage company that produces a line of sparkling water products. Alpine generates $15 million in annual revenue through both DTC and traditional retail distribution.
The Alpine Lakes management team has just completed a strategic plan to expand retail sales to the West Coast. Alpine needs capital to lease and staff a warehouse in California, and to lease trucks to make deliveries to retailers. The marketing department needs a budget to build retailer awareness on the West Coast, and to update the website.
The strategic plan will require $3 million in capital, and James discusses financing options with Alpine’s CFO. Alpine generates a 50% gross margin on sales and positive net income, but the firm does not have nearly enough excess cash to finance the West Coast expansion.
Consistent profits over the last seven years have increased the cash balance over time. Alpine also maintains a relatively large cash balance, so that the firm can operate if retail customers pay later than expected. Effective cash flow management requires James to use the large cash balance for current operations, and not for the strategic plan.
Alpine’s CPA firm, which prepares the company’s tax returns, confirms that the interest expense on a $3 million loan is tax deductible. The company can borrow at a 6 percent interest rate, generating $180,000 in interest expense in year one of the loan. Alpine will pay a smaller tax liability if the firm has a loan outstanding.
Alpine Lakes has used a $150,000 line of credit for years, and the firm has reliably paid down the credit line when cash is collected. Because the firm carries a large cash balance, the credit line is not used frequently. If Alpine repays principal and interest on time over the life of the loan, the company will improve its business credit score.
When the business needs more capital, it can borrow at a more attractive interest rate. Management expects rapid consolidation in the industry, and Alpine’s team would like access to capital to potentially buy competitors down the road. A better credit score will make it easier to raise capital.
As businesses grow over time, the decisions made to raise capital may change. Companies that start by using capital invested by the founders need other financing options to scale.
When used strategically, debt can help businesses grow, build credit, manage cash flow, and take advantage of opportunities. However, it is important for businesses to borrow responsibly, make payments on time, and have a plan to repay their debt. By doing so, businesses can leverage debt to reach their goals and achieve long-term success.
Business owners also need effective tools to make informed business decisions. To learn more about how Brightflow AI can help your business, visit Brightflow.ai. Once you create an account, you can request your free business credit score in our app.