For many small business owners, debt is a four-letter word and something to be avoided. But is that always the smartest way to view it? No, says Charles Green, executive director of the Small Business Finance Institute, an Atlanta-based non-profit that provides financial education to entrepreneurs. Business writer Susan Caminiti recently spoke with Green about the smartest ways SBOs can use debt, how it can help to facilitate growth, and when it’s not a good idea.
SC: Let’s start with the big picture: Is it getting easier for small business owners to get debt financing?
CG: I would cautiously say yes, not because of the environment, but because of all the choices that are out there. I’m actually writing a book that will look at different financing sources for small businesses, including the private equity money that is now available through different technology platforms. In the past, private equity rarely connected to a small business unless that business had the potential to scale up and go public. Now you can get a $5,000 working capital loan through a technology site such as IOU Central.
SC: Why then do you believe that so many small business owners have such a negative view of debt?
CG: It’s a value judgment and I don’t criticize it. A lot of people want to build a business from the floor up and they don’t like the idea of being indebted and therefore obligated to a third party for anything. And so they are very cautious about using any kind of leverage to extend their business opportunities or to step out and grow. My father was the same way. He was a child of the Depression and very cautious about money. He used to lose sleep over a $92-a-month house payment.
SC: What are some of the reasons why a small business owner should consider taking on debt?
CG: If there is an opportunity to expand the business, financing basically allows you to move forward in a more timely or bigger manner without having to wait for accumulated profits. If you have customers lining up to buy your goods or services and you need financing to provide the labor or the raw materials, then that’s a good reason for taking on debt. The challenging part is measuring what that growth really is and not letting it overwhelm you.
SC: In what regard?
CG: Growth can put a company out of business as fast as insufficient sales can. If you have a manufacturing company, for example, that has to order raw materials, you typically have to pay for those materials shortly after they arrive at the plant. Then there are labor costs in the form of workers who have to be paid every week to convert those raw materials into product. Now once those products are complete, you may not get paid until 30 days to 60 days after those goods are delivered to the customer. That gap—the time between what you have to pay your vendors and when you actually get paid—has to be managed correctly or a business will run into trouble.
SC: Is that where debt financing can help?
CG: Yes. If a business can cover say, 25 percent of costs from the cash they have in the company and they can obtain a line of credit that can handle the other 75 percent, that’s a pretty good ratio. Then once the payment is received from the customer, the business pays down the line of credit.
CG: A small business owner would want to have that conversation with their banker. But the banker is also going to want to see that the owner is going to hold some of those profits in the business and reinvest them rather than just rely on the bank to put up the additional money.
That simply means that the owners are not taking money out of the business when they see that there’s been a significant increase in sales. Too often you’ll see an owner run out and buy a new car or lake home with that extra money rather than let the cash accumulate in the business.
SC: When is it not a good idea for a business to use debt?
CG: If a company owns a piece of real estate or some other asset and the owner starts borrowing against that for general purposes, that’s not a good idea. If the owner loans the money to himself, it serves no economic purpose for the business.
SC: If a business is in good financial shape, should it consider a line of credit just in case?
CG: I would say so. It’s a contingency against any number of factors that might come up that have nothing to do internally with the business. It could be that a weather event shuts your company down or the business is a victim of financial fraud. Think of it the way you think of an insurance policy. When you’re in that position you don’t want to go hat in hand to get capital to survive. You want the resources to get up and move on and have the financing issue behind you. The best time to ask for money is when you don’t need it.
CG: I think the more important thing is for you to understand what your business can handle in terms of paying it back. If I have a net profit of $100,000 a year, I don’t think I can get a line of credit for $100,000. It will probably be something smaller than that. But then again, I shouldn’t need much more than that. Start the conversation with your banker and simply ask how they would approach a loan for a business like yours.
This interview has been edited and condensed for clarity.
Disclaimer: The opinions expressed are solely those of the author and interviewee. Since the details of your situation are unique, you should always seek the services of a financial planner, CPA, or other qualified professional.