“But, isn’t it a really bad idea to go into debt for your business?”
Sound familiar? It’s a line every entrepreneur has heard at one point or another from a well-meaning friend, a nosy relative, or maybe even a perfect stranger. And it’s enough to make even the most confident business owner weary of their own financing choices.
Well-meaning friends and family don’t mean to undermine your business plans. They really are trying to help. After the 2007 financial crisis and subsequent big bank bailout, a lot of folks became weary of our banking system and of debt in general. Those who were affected by the recession in a big way have a “never again” mentality, which pervades into every conversation of their daily lives.
The truth is, these folks are not entirely wrong. There are a lot of bad uses of small business financing—uses that aren’t likely to generate an increase in revenue and that leave businesses at risk of failure. At the same time, there are still a lot of great investments made possible by financing. And some of the most successful modern companies could not have gotten off the ground without some type of debt.
So how do you know whether you’re using your loan for a good investment? Well, that’s a determination only you and your financial advisor can make for your particular business—but to get you started, here are some scenarios that are considered good uses of small business financing.
1. Expanding to a New Location
If your business has grown to the degree that you feel the walls closing in on your current location, you may be ready for an expansion. But even businesses for whom expanding to a new location is a smart financial decision are unlikely to have the necessary cash on hand to make such a move without some sort of financing.
Before you take out a loan for expansion, there are some important questions to consider. Is your current location running at a profit? Can your business run successfully without your constant presence? You can’t be two places at once, so if your customers insist on doing business only with you, adding a second location can quickly strain and even compromise both of your storefronts.
It’s important to do the necessary market research to objectively confirm your belief in the potential of a second location. We are your new target markets? How strong is your existing demand? What kind of marketing efforts will you need in order to grow your customer base? The answers to these questions will help you decide whether taking out a loan to open a new location will have a positive impact on your long-term profitability.
2. Purchasing Equipment that Generates Revenue
For businesses in the manufacturing or food service industries, equipment financing is a necessary investment for starting and expanding operations. And this equipment has a direct impact on revenue: a tailor can’t repair clothing without a sewing machine. A restaurant can’t operate without kitchen equipment.
That’s why, especially if you’re taking advantage of a good deal, purchasing equipment is considered one of the best possible investments of borrowed funds. It has a measurable return on investment and presumably a long term impact on the vitality of your business. You want to make sure that your business can afford the loan and confirm that you’re buying good quality equipment—but otherwise, this use of funding is almost a no-brainer.
3. Purchasing Inventory
Cost of inventory is among the highest expenditures that many businesses make, and sometimes businesses don’t have the cash on hand to take advantage of a great deal. That’s why—if you have the opportunity to purchase inventory at a discount—this can be a great investment of borrowed funds.
There’s a couple of points you’ll want to consider before investing borrowed funds into purchasing inventory. Are you getting a good enough discount to offset the interest on the loan? Is there any expiration on the inventory, and if so will you be able to use it within that time frame?
4. Marketing With a Known Expectation of Result
No matter how strong your product is, your business model will inevitably fail if your target market can’t find you. That’s why marketing is considered an acceptable if not recommended use of borrowed funds. But setting a marketing budget—especially one that relies on debt—can be tricky. It’s often a significant expenditure for businesses with a less than certain rate of return.
For your existing business, many experts recommend a budget of 5 to 7% of your annual projected sales. If you have a new business, however, you will need to devote a larger portion of your budget to marketing in order to establish recognition among your target audience. A study from the business school at Iowa State University found that between 20 and 30% of total operating budget was an appropriate allocation of marketing funds for startups in their first two years.
However you decide to set your budget, you’ll need to factor into your marketing plan a method of measuring the return on your spend. Marketing can certainly be a worthwhile investment of borrowed funds, but only if you can track how the campaign is increasing your revenue.
5. Making Needed Decorative Improvements
Particularly for older restaurants and retail businesses, well planned decorative improvements—such as remodeling your dining room or storefront—can be a positive investment that yields a return in more business. Like marketing investments, taking on debt for a storefront facelift can be tricky because it’s hard to estimate what kind of return you’ll see.
Experts say a well done remodel can bring in a 5 to 10% growth in sales. It’s enough to get customers attention, but likely not enough to turn around a failing business. And if you’re facing an issue of size and meeting customer demand, be sure to consider whether expanding to a new location would be a better long-term investment before you go ahead with the project.
Keep in mind, decorative improvements are really only a good investment for retail establishments or businesses who do the majority of their client-facing work in office. If the nature of your business is such that customers almost never see your office, decorative improvements are highly unlikely to impact your revenue and thus are probably not a good reason to go into debt.
6. Covering a Gap Before You’re Paid By Clients
For businesses that are cyclical or seasonal in nature, cash flow can be a real problem. When there’s more money going out than coming in, or the delay in outstanding receivables is impacting your cash on hand, a short term loan can get you through until cash flow levels out.
But remember, this type of debt is meant for a gap in expected payment, not hopeful sales. It’s not recommended to take on a total loan amount (meaning principal plus interest) for any more than 90% of accounts receivables or 70% of projected sales. That way if you have difficulty collecting or if your seasonal sales don’t meet projections, you leave a cushion to keep from losing more money than you can afford.
No matter what, you’re likely to lose some amount of profit due to interest on the loan, so using debt for this purpose is only a good investment if it’s absolutely necessary to keep your business running. Be sure to review your policies and look for ways to improve your accounts receivables ratio so that your need for this type of loan doesn’t become a common theme.
No matter what the particular use, there’s no such thing as a good debt investment if you’re taking on a loan you can’t afford. To determine whether you can afford to pay back your loan, use the cost benefit equation:
This commonly accepted equation is a great measure of the affordability of your small business loan. Essentially, the equation states that your typical end of month cash on hand needs to be 1.5 times greater than the monthly payment on your loan. If this isn’t the case, you may need to reconsider whether debt financing is the right choice at this particular point for your business.
Remember, no matter what your cousin’s uncle says—only you know for sure whether debt financing is a good investment for your business. Do your research, be objective, and make the business choice that is best for your financial future.
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About Meredith Wood
Meredith Wood is the Editor-in-Chief at Fundera, an online marketplace for small business loans that matches business owners with the best funding providers for their business. Prior to Fundera, Meredith was the CCO at Funding Gates. Meredith is a resident Finance Advisor on American Express OPEN Forum and an avid business writer. Her advice consistently appears on such sites as Yahoo!, Fox Business, Amex OPEN, AllBusiness, and many more. Meredith is also the Senior Financial and B2B Correspondent for AlleyWire.
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