Business Debt – A Catch-22 Situation for Businesses

Getting a loan for your personal or commercial purpose is very easy now, thanks to the liberal lending policy as well as the use of technology in the loan processing techniques. Loans are now more accessible, provided in quick time and there are multiple sources that you can avail. Given such a situation where talking on a debt is so alluring, whether or not you should take on and run your business in debt is the question.

You may wonder about the productiveness and how far it will leverage your business. Well, this is not an easy decision to make and you will need to know much more than the basics and consider much more than your business needs.

The basics

Most people refer to debt in many different ways. However, debt is considered as leverage more commonly. This is because debt usually increases the Return On Equity or ROE when specific level of earning is considered.

Typically, there are only two ways in which you can capitalize a business. One is debt and the other way is through equity. However, both of these are inversely proportional meaning, the more debt your company has, the less equity is needed by it. Moreover, the ROE will be higher in such cases.

However, this does not mean that you will take on more debt for your business. More debt can often be bad news and have a lot of negative effects on your business overall both in the short and especially in the long term. This is due to several reasons as under:

  • Debt requires regular repayment on time
  • It will come with interest and the rate of it can be varied depending on the type, tenure and amount of loan taken and
  • Failing in paying the debt back in a timely manner may force your company to file for bankruptcy.

Taking on debt means taking on responsibility failing which will allow your creditors to force the company to liquidate the assets in order to collect the amount owed in full or as much as possible. This means early shutdown of your business.

On the other hand, companies that do not have any debt do not have this risk to face because there are no:

  • Required monthly payments
  • No collection calls and
  • No threat of bankruptcy.

To sum up, debt increases the risk of the company especially when it is not managed properly.

Much to the contradiction of the above facts, there are a few people who support companies that have debts. They are of the opinion that every company should have some kind and amount of debt or another.

Exploring beyond the basics

Ideally, it is all about maximizing risk adjusted rate of return. Therefore, carrying some debt can be good under specific conditions. These are if:

  • Taking on debt means that the equity investors will have to put or leave less money into your business
  • The equity investors have more money to invest in other things and find other ways to do so
  • The capital of the equity investors yields a higher return that the cost of the debt and
  • The increased risk of taking on debt by the business is manageable and does not offset the increased ROE.

However, even if you follow the above helpful guidelines while considering taking on a business loan, this will certainly not allow you to precisely calculate the appropriate amount of debt to take on. For this you will have to use a series of formulae available but ideally to calculate the optimal amount of loan you will need to exercise something more to it.

Your calculation should involve estimates and assumptions that you think would render the optimal results and serve your purpose imprecise at best. Moreover, you will also need to make a few precise decisions, some sound judgment, know the consequences and resources to arrange for payments, read the debt settlement reviews and that of other options to repay your debt, and much more.

Deducing the loan amount is not an exact science and no matter how much math you do, it all depends on the type of your business, the needs and good judgment.

Common mistakes

No matter how immaculate you are in business operation and management, when it comes to debt management everyone seems to make a few common mistakes.

Few business owners think that it is better for a company to return capital to its shareholders by taking on debt as long as the company has the resource to repay its debt on time. Few other believe that allowing the shareholders to retain their investment is much better way even in the event of a significant downturn in their business. You should follow these two guidelines while considering taking on a debt:

  • Typically, it is not a good idea to take on debt for your short term needs on a long-term basis. This is because long-term financing will lineup with your long-term initiatives and business goals.
  • Moreover, it is also required to hold other financing tools such as a line of credit for your working capital needs such as financing of inventory and receivables on a short-term basis.

The best way to look at it is to line up leverage with the type of assets you want to acquire. This will ensure that the debt service period matches with the time period in which you expect to receive the desired returns from that particular asset.

If you overlook this, you will be obligated to make the debt service payments before you receive the benefits from the machinery purchased or from an acquisition, provided things do not turn out to be as expected.

There is another significant reason to consider leverage or debt financing. It is the fact that the cost of debt is much lower than the cost of equity. You should take on debt under such situations and properly balance leverage and equity so that you can increase the business profits overall as well as the return on equity.

Daniel Ng

Daniel Ng is a freelance writer who has been writing for various blogs. He has previously covered an extensive range of topics in her posts, including business debt consolidation, Finance, E-commerce and start-ups.

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