Dealing With Small Business Debt
March 22, 2016
Cash flow and debt often go together when discussing small business. When additional equity resources are scarce and a business needs cash flow to support operations, invest in new sales and marketing initiatives, or acquire additional fixed assets, there is little alternative other than debt financing. Debt financing, however, can be a detriment to business growth if not handled correctly.
Sources of Debt Financing
Although debt financing in the broadest of terms is simply borrowing money (creating debt), there are many sources to choose from depending on various factors of a business...profit or loss, cash flow, collateral, length of time in business, personal credit rating of owner, invested equity, etc.
Debt financing might be from friends and family, commercial banks, alternative or non-traditional sources, credit cards, or vendor financing. The debt can also be short-term, seasonal, single purpose, installment, master notes or working lines of credit, or long-term. Regardless of the source or reason, small businesses can help themselves by understanding the process and what can be done to obtain an advantage in the debt market.
All lenders want small business owners to have "skin in the game." They don't want to lend money to a business when the owner has little at risk. If times get tough, which can certainly happen, lenders want to make sure business owners are not going to "turn and run." A key to prevention is when owners have sufficient invested capital of their own to lose if the business fails.
The ratio of debt financing and equity capital is referred to as a debt to equity ratio. This is the relationship between borrowed money and invested money. It shows the amount of protection that owners provide to creditors. Improving the debt to equity in a business...lowering debt and/or increasing equity will make it easier to obtain financing at more favorable terms and interest rates. Lenders don't want to loan funds to businesses that are highly leveraged.
Sufficient Cash Flow and Collateral
Although creditors seek businesses that can cash flow debt servicing, they still need collateral for extra protection. Lenders don't want to be in a position of liquidating assets. However, if a business cannot make principal and interest payments on time, sufficient collateral can help offset a bad debt.
Collateral might be business or personal assets with sufficient equity. Typical collateral assets are business fixtures, furniture, equipment, inventory, and receivables and personal home, autos, cash, stock, bonds, and other investments. The more collateral a small business can offer, the greater the chances of obtaining a loan. Before seeking debt financing, small business owners should understand the cash flow of the their business by preparing a cash flow budget...a forecasted monthly amount of cash inflows and outflows along with a list of collateral available to secure a loan.
It's exciting to have a great idea but if the idea cannot be transformed into a viable business, no creditor will want to participate in lending regardless of projected income statements or collateral. Lenders want to feel confident that a business is going to be successful, so the debt can be repaid. One important success factor for any small business is experience of the owner not only in the technical aspects of the business but overall management experience. Having sufficient business experience can help secure a loan. It is easier for lenders to loan money to proven leaders.
The credit history of both the business and owner plays an important role in a lender deciding whether to loan money or not. Business owners should plan in advance for the day when they might need to borrow money for business purposes. This means making sure that all debt is paid on time. There's no reversing late payments, judgments, or bankruptcies. Planning today for tomorrow's debt by maintaining an excellent credit history is a good practice.
Even though a small business might need debt financing, this does not mean that terms cannot still be negotiated. Payments of due dates, maturities, and interest rates vary from lender to lender. It is wise to shop around and negotiate but before favorable negotiations can take place, it is wise to consider the above points. Debt financing can help or hinder a small business, so owners must prepare in advance for the day when additional financing is needed.