Where to use Debt

Some would say debt is the greatest invention as an adjunct to capitalism and the free market system since money was invented. Many would agree with that statement, but having too much of debt could be bad for you.  Use it wisely and it will serve you well. Abuse it and you could become its master.

Business people go into debt to purchase a business, it’s very common and in most cases it’s the correct action to take if you don’t have your own funds readily available.

Say you borrow $500,000 to buy a business over fifteen years. The Financials show it is currently returning a net profit before interest and any loan repayments of $165,000   a year. Doing the sums without interest payments, it will take about three years to repay the debt. But interest will be involved and that repayment schedule will more likely be over five years. You likely need drawings or a salary for yourself, so the debt repayment schedule could be up to say six or seven years even though according to your bank schedule it will go as far as fifteen years.

Let’s assume you buy a business with growth potential  (a reasonable ambition), and the net profit at the end of the second year has grown by 15%. I would suggest you continue with your own repayment schedule and have the loan paid off in five to seven years. I would always advise using the extra net profit to go towards paying down the loan. It is in your best interest to get rid of the loan as soon as possible. Try to make the business self-funding. That means the business will grow only as fast as it returns better results; it’s an organic growth. No growth means no need for more capital injection.

If you were to borrow another $100,000 you could buy another machine and increase sales. You may have the customers waiting. What is the risk? The risk is like an alcoholic having another drink.  You have two options. Wait until you have the capital to buy the new machine outright or borrow and buy it now. The trouble with the borrowing now option is, it is too easy. You will continue to be tempted by the bank and others to keep borrowing for more expansion. And before you know it, you have a medium size business with large borrowings, and potential trouble.

Royal Doulton and Waterford Wedgewood went into administration after being in business for over 150 years. Their problem was too much debt. Why would a company that old ever need to borrow?  It goes for Kodak. Technology changed, and all they had to do was dip into their reserves and re-invent themselves. They had billions of dollars worth of patents. But when it came to the crunch they had to sell the patents just to pay off the billions in debt.

What I am saying here is you should start a reserve the day you start the business. Whether you call it a sinking fund, buffer, reserve, insurance, it’s all the same. One day your business may be enormous and when you get there you should be there with no debt and a large reserve fund.

  1. Pay off the loan in your time frame. (5-7 years)
  2. Pay yourself a salary/drawings.
  3. Put half of the growth in net profit into expansion and the other half in a your reserve fund. This will be your insurance in the future against disaster.

You may have borrowed the loan against your house and you don’t want to put your house at risk any longer than necessary.

Keep putting 50% of your net profit into your reserve fund. Don’t touch it until you sell the business. By doing this, not the bank or anyone, will ever have the power to tell you how to run your business.

July 1, 2011

Leave a Reply

Your email address will not be published.

4 + 2 =