Many new business owners have a dysfunctional relationship with debt. Overly cautious entrepreneurs might try to avoid it altogether. This leaves them with anemic and ineffective budgets and unstable cash flow unless they can secure significant investor support. In other cases, an overconfident business owner might misuse borrowed funds or simply overcommit without a proper plan, leaving their organisation with an untenable debt load that ultimately leads to insolvency.

shutterstock 260502092 300x200 - Understanding debt is critical for small business success

To be successful, businesses need to know when and how taking on debt can benefit them, and in what cases it’s better to find other ways to come up with the capital they need. Most importantly, that means having a firm grasp of what every borrowed dollar means for your business, and making deliberate and calculated financing decisions as a result.

Large loans as startup capital

Attracting investors and funding their new business with equity isn’t a viable option for a lot of new business owners. Because of this, the majority of entrepreneurs rely on their personal savings and a business loan to provide the startup capital they need. Business loans are an excellent choice for this purpose, because they allow business owners to maintain full control of their operation, and allow them to retain all of the business’ profits. However, they can also make it more difficult for a business to become self sustaining and profitable in the first place, because that loan needs to be paid off regardless how long it takes to begin generating revenue or turning a profit.

A startup’s business plan needs to account for these costs, and you may need to attempt to scale up more quickly than a business that’s financed by equity as a result. This is by no means a deal-breaker. Rather, it underscores the need for businesses to understand and plan for the financial constraints that they’re operating under, and to innovate strategies for overcoming those challenges.

Managing cash flow interruptions

Short term financing is a set of tools that many small business owners don’t understand well, but which can provide invaluable support to a small business’ day to day operations. Supply chain finance allows you to pay suppliers early while deferring your own outgoing payments significantly, invoice financing allows you to collect outstanding client payments sooner, and stock loans allow businesses to get funding that’s secured against the purchased stock itself.

These tools aren’t about borrowing money so much as they are about rearranging the times that revenues arrive and that payments go out to concentrate your own funds over a certain time period. Done properly, it allows a business to shift its own funds around in order to cover unexpected costs, or to make a relatively large investment that would otherwise not be possible without taking on longer term debt.

Financing growth

Growing a business quickly is incredibly difficult, even when everything is going great and sales are climbing rapidly. In the past we’ve discussed how short term financing can help businesses finance growth, but that isn’t always enough.

Businesses that need to make large investments by, for example, purchasing real estate, hiring and training entire new teams of employees, working with foreign governments, or setting up new international supply lines, may need a relatively large amount of capital. The question that any business owner needs to ask themselves and their team, and that they’ll certainly need to answer for their lender, is this:

Exactly how will this pay for itself and what will this do for your business?

Debt is never just a way to cover costs. Instead, it should always be a means to a specific and gainful end. Whether you’re getting financing to scale up your business, to handle a seasonal spike in demand, or to expand into a new market, you need to have a clear roadmap in place for exactly how and when you’ll pay back any borrowed funds, and what profits and general growth you’ll be able to generate as a result of the endeavour.

It’s important that businesses understand how debt works, and what it’s for, to help them treat it as the tool that it is. Not affording it the respect and caution that it is due can quickly drive a business into insolvency. On the other hand, being overly cautious can leave a business without the financial tools it needs to survive even normal cash flow fluctuations, or to compete successfully in its markets. By taking the time to understand the role of borrowing in business, entrepreneurs give themselves the necessary tools they need to succeed.

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