By: Ryan Lynch, CPA
Key Takeaways:
- Debt leveraging allows companies to borrow capital with the expectation of greater financial gains.
- It can be useful for various purposes such as expanding manufacturing output or responding to competition.
- Before borrowing, a thorough analysis should be conducted to determine the amount needed and how it will be paid back.
- If borrowing for non-tangible investments, such as opening a new location, lenders may require additional documentation.
- SBA-backed loans may offer lower interest rates and benefits for small and medium-sized businesses.
Understanding How Debt Leveraging Works is Key to Success
For small and medium-sized businesses, leveraging debt is an important strategy for achieving growth. “Leverage” means to borrow capital with the expectation that the financial gains will be greater than the amount borrowed.
Companies often have revolving loans from banks to help finance day-to-day operations. But debt leveraging is another type of borrowing. Say you need to buy new equipment to expand manufacturing output, or you need to finance a staff expansion to run a new location. You would expect that the increased revenues from those operations will be more than the amount borrowed, enabling you to repay the loans on time and enjoy the increased income that comes with a successful expansion.
Many owners of smaller businesses pride themselves on remaining debt-free, but leveraging debt through a bank loan – done wisely – can help a business achieve growth more quickly than bootstrapping can. This can be useful in a number of situations, such as taking advantage of a new market for your products or responding to pressure from a new competitor.
Bear in mind that borrowing to finance expansion comes with additional costs that must be worked into the budget. The lender – whether a bank or a leasing company – may want you to provide an audited or reviewed financial statement every year during the life of the loan. Those come with a cost. Additionally, beware of certain types of loans that may include a “balloon payment” at some future point, or that are based on a variable interest rate, which can increase your monthly payments on a regular basis.
Additionally, when you initiate talks with a lender, be prepared to provide the documentation about your business they will require, including tax returns, a balance sheet, accounts receivable analysis, a cash flow statement and an inventory list with valuation.
Before You Borrow
Before you borrow, put together an analysis that will help you and your lender determine how much need to borrow and how it will be paid back. Some factors to consider for a loan on new equipment might include:
- How much will the equipment cost? Will there be ongoing maintenance expenses?
- Does your cash position allow you to make a large down payment on the equipment, minimizing the amount to be borrowed? Banks often lend only 75% or 80% of the value of an equipment purchase, so a down payment will likely be necessary.
- Should you make a large down payment, or should you preserve your cash for other purposes?
- How much income will be generated by the new equipment?
- Will additional employees have to be hired to run the new equipment and/or manage the increased output it generates?
- What will be the break-even timeline?
- How long will it take to pay back the loan and what will the cost of the loan be when the interest rate and any other loan costs are factored in? And what will the interest rate be on the loan?
Leveraging Expansion
What if you are borrowing to finance growth, such as the opening of a new retail location, which does not involve any tangible collateral that a lender would want to see? Your company may need to provide the lender with an accounts receivable statement to prove future income sufficient to cover the loan payments, as well as a cash reserve to cover any risk of default. A bank lender also may want to analyze and monitor your company’s cash flow.
These measures may be particularly important in a high interest rate environment, and with larger loan amounts.
Some of the factors a borrower should consider before obtaining a loan to finance expansion include:
- What are your accounts receivable? A bank will likely look at this first.
- What are your average monthly expenses compared to average monthly revenue? Is your revenue covering your company’s spending already? The bank will require a cash flow positive status.
- How do you expect cash flow to increase with the new expansion?
- Will it cover the debt service?
- What other assets do you have and how liquid are they? Is there equipment you could sell if you had to?
- Calculate the turnover numbers – what is your average aging analysis?
- What is the value of your inventory? A bank may send in a third party to assess inventory value.
SBA Loans
You may have a comfortable long-term relationship with a bank and a preference for doing more business with that institution. However, borrowing money to finance equipment or expansion is a significant undertaking that comes with some risk. What if the revenue growth you envision doesn’t happen and you can’t pay back the loan?
It’s worthwhile to ask if your bank – or any other banks in your area – offer loans backed by the U.S. Small Business Administration (SBA). The SBA has a wide range of loan programs that benefit smaller and medium-sized businesses, and the interest rates tend to be lower than those available on the commercial market. You would still be dealing with a local bank, but the loan would be backed by the SBA.
Summary
Leveraging debt is an important tool for smaller and medium-sized businesses looking to grow their revenues through expansion. But it’s important to understand how debt leveraging works and how it may fit in with your company’s needs.
If you would like to discuss how debt leveraging can help your business grow, contact your KRD advisor.
