For many people, debt is a dirty word – but when used wisely, it can be a valuable tool in the savvy business owner’s arsenal.
Despite the negative connotations sometimes associated with debt, it is a key part of financing for both households and businesses alike. Certainly, Australians are no strangers to debt – three out of four households have some form of debt, and almost one in three people owes three times their annual income.
Much like a person who uses debt to buy a house, debt can provide businesses with the funds they need to expand their operations by stocking up on inventory and equipment, hiring new employees, purchasing real estate and so on.
Depending on what you do with it, debt can be a friend or a foe. Here are five reasons why you should consider using debt for your business – and three pitfalls to look out for.
Five reasons why you should consider debt for your business
1. Debt is currently very cheap
Essentially, debt finance is money provided by an external lender – such as a bank, building society, credit union or private lender – that has to be paid back with interest. That interest rate is, in effect, the cost of borrowing the money.
Interest rates in Australia are historically low at the moment. The cash rate, as determined by the Reserve Bank of Australia (RBA), has stood at 0.10 percent since late 2020. This is the lowest it’s ever been. The cash rate is the rate charged on loans between financial institutions, which has a significant impact on the interest rate you’d pay on a loan for your business, although the exact rate a lender is willing to offer you will depend on your circumstances.
Low interest rates are bad news for savers, because it means your money is earning little interest while it sits in your bank account. But it’s great news for borrowers, because it makes debt more affordable than ever – as long as the cash rate remains low.
2. Debt allows for flexibility in cash management
Access to capital can be a significant barrier for small businesses – capital can come as either debt or equity (see below).
There are many different types of debt, but broadly speaking they fall into one of two categories.
- Term Debt. Think of this like a fixed term mortgage on your house – it is generally for a longer period of time and for a fixed dollar amount.
- Cash Management Facilities. Think of these more like your credit card – there is an upper limit to how much you can borrow, but you won’t borrow it all all the time, and you will regularly be paying it back (although not necessarily every month as you should your credit card).
Working capital facilities, overdraft facilities, business credit cards or even invoice financing are all forms of Cash Management Facilities and provide businesses with the funds they need to cover any gaps in their day to day operational needs.
Working capital or overdraft facilities allow you access to a set amount without needing to apply for a loan and wait for the cash injection. These facilities are particularly handy in managing cashflow. However, these types of facilities generally carry slightly higher interest rates than term debt and may be comprised of establishment fees as well as line fees which are charged regardless of whether or not you use the facility.
Term debt is commonly used to finance the purchase of business assets or to decrease the amount of cash the owners have invested in the business.
3. Debt reduces your reliance on equity finance
Debt finance helps to reduce the use of equity finance. Sources of equity finance include money and assets contributed by you (the owner), private investors (such as family and friends and ‘angel investors’), investment managers (such as venture capital or private equity firms), and, in the case of a public offering, the stock market.
Private investors and investment managers can provide your business with the capital you need to grow, as well as the benefit of their expertise and advice, but they’ll usually require a share in your business’ profits in return.
If you want to maintain complete control over your business, and you don’t want to dilute your ownership or have to deal with other shareholders, debt is your only real option., Bbecause debt it doesn’t require a change to your ownership structure – your relationship with your lender ends when you repay the loan in full.
Consider, too, that equity financing is a greater risk to the investor than debt financing is to the lender, because payment of the debt is required by law, regardless of the company’s profits. For this reason, the equity investor will demand higher returns than the lender, which means that capital – the cash a business is sourcing – can typically be obtained at a lower cost through debt financing than equity.
4. The interest on your business loan is tax deductible
An oft-overlooked aspect of debt financing is that it can give you an advantage at tax time.
You won’t be able to deduct the loan principal (i.e. the repayments of the initial loan), but you will be able to claim the interest you pay on business loans as an expense and tax deduction.
Of course, you should always check what you’ll be able to claim with a tax professional or financial advisor who’s familiar with the specifics of your business. However, this is generally true of virtually any type of business loan, as long as you keep adequate records of the interest payments you’ve made to your lender, so you can prove it if the ATO comes calling, and as long as you use the entire loan for business purposes. The interest on loans used for personal purposes isn’t tax deductible.
This is another reason why debt is typically a cheaper way of obtaining capital than equity – because you can deduct the interest paid on your business loan from your company’s taxable income. So if your business’s tax rate is 25 percent and you pay $100 in interest, the net cost of that debt is actually only $75, as it effectively ‘saves’ you $25 in taxes – something that isn’t true of dividends you pay to other equity investors.
5. Debt enables you to increase your return
By using some debt, you can increase the return on your investment. For example, if the total return on assets of a business for the year is 10 percent, and the assets are entirely funded with your equity, then your return is… 10 percent. No more, no less.
But let’s say the assets are 50 percent funded by debt. Take interest out of the equation, and that’s now a 20 percent return – the same income when you have only invested half the amount. This creates a multiplier effect.
Of course, in reality, you can’t take interest out of the equation, but even if you have to pay interest of five percent, then your return after paying for the debt is still 15 percent on the amount you contributed. The more favourable the interest rate, the higher the return for your business.
You should be aware, however, that just as debt can increase your return, it also adds to your risk. If the overall return is less than what the bank demands, you may end up owing more than you can pay, and defaulting on your loan. Not only will this leave a black mark on your credit report, but if it’s a secured loan – more on that in a moment – your assets could be repossessed by your lender, in order to make up the remainder of the loan.
Three potential pitfalls to look out for
1. Rising interest rates
Yes, debt is currently very cheap – but it won’t stay that way forever.
Exactly when the RBA will raise the cash rate, and by how much, has been a matter of much debate. However, many economic commentators are currently expecting the first of a series of rate increases in June 2022 and some have suggested that the May RBA board meeting should be considered ‘live’.
In much the same way that a low cash rate has meant low interest rates for borrowers, the cash rate going up will increase the general cost of debt.
Considering interest rates are at record lows, this isn’t exactly unexpected, and it isn’t necessarily a significant issue. The risk will be your preparedness to deal with an increase in interest rates – if you leave yourself with no wiggle room for rates to rise, you may find yourself unable to pay back your debts.
Of course, you can lock in your interest rate for a time, but this can cost more upfront, as lenders expect a higher fixed rate if they expect rates to go up.
2. You may be blindsided by a downturn in your business or the economy
Sure, that loan you’re taking out might seem repayable today, based on the current economic climate and your projections for your business – but what happens if your business doesn’t perform like you’re expecting, or there’s a sudden downturn in the economy?
This could leave you in a position where the debt you owe is greater than the value of your business or your business assets. That’s already a tough situation to be in, but it can be compounded by the fact that your lender will likely have covenants in place that may be breached when this happens – and you may find yourself having to pay the debt back when you are least able to do so.
Of course, those are the worst-case scenarios, but you should always have a plan for dealing with increased interest rates, which may include repaying part or all of the loan if needed.
3. You may be required to put your assets at risk
When lenders offer finance to businesses, they tend to require collateral to secure it. Collateral is the right to an asset the lender can take from you and sell for cash if you’re unable to pay back your loan – just like your mortgage is secured by your house.
The amount of collateral you need to put up is usually related to your credit history and the size of the loan. For a business, collateral can include buildings, equipment and inventory. If you have to personally guarantee the loan, you may have to put your own assets – such as your family’s home – at risk.
This ups the stakes significantly for business owners, as we discussed in a recent article, and can make debt financing simply too much of a risk to be a viable funding option for some businesses.
How PieLAB uses debt
“Everything in moderation,” goes the proverb, and that’s certainly been our approach to debt at PieLAB.
PieLAB is a financial investor in SMEs that likes to partner with founders and CEOs. Unlike most private equity firms, we’re not looking to simply grow your business and then sell it – instead, we prefer to buy a significant stake in a business, and then grow and hold it for the long term.
We like to use a modest level of debt in the businesses we invest in. This allows the capital we contribute to go further and be used to make more investments, and for the multiplier effect on returns discussed above to be achieved. The type and amount of debt we use in a business depends on the consistency of the revenue and expenses of the business; whether there is a seasonal nature to the cashflows; and a variety of other attributes. We like to work with the owners to get the right mix for each business.
But it’s not something we do lightly. We closely monitor debt on an ongoing basis, tracking debt-to-profit metrics and ensuring the company’s ability to pay the interest bill on time, every time.
If circumstances change – if, for instance, interest rates increase substantially – then we can readjust the use of debt and put more equity into a business.
Like most businesses, we’ve found that a well-considered use of debt can give you the edge – and as long as it’s used wisely, it can be what enables your business to go the extra mile, reduce the amount of cash you need to invest or get that extra bit of return out of the money you have invested.
To learn more about how PieLAB can help your business grow, contact the team today.