Reasons Why Debt is Good for Your Business (2024)

May 24, 2020 Mariela MerinoBlog PostsLeave a comment

The word “debt” typically has a negative connotation and is seen as bad and even evil at times, especially in the business world. It can mean that you lack sufficient cash flow and are not able to fulfill your funding requirements. However, there are instances when it can be good. Good debt leaves your business better off in the long term without having a negative impact on your financial position. Many large corporations have debt, it is a great way for people to earn a return on investment and can provide benefits for small business owners too.

When Business Financing is Good

To grow your business

You can consider using business financing (also known as debt) to help you increase your profits and grow your business. Debt is an affordable method to access cash for any business. It can also help businesses benefit from economies of scale. Often many small business owners will face rapid growth and they find themselves not able to finance the expansion alone on their own. When your business is growing you need new products to sell or more inventory, new equipment, or a larger retail space. Fortunately with lines of credit, bank loans and other third-party debt allows small businesses to expand.

To build your credit score

You need good credit to get a loan and to have good credit, you need experience of taking out and paying off loans. To build your credit score, you can start by taking out small business loans. This shows that you can handle the repayments of the loan and lenders will be more willing to help you get approved for a business loan. By building your credit with a small loan, you can work your way into getting approved for larger loans in the future.

To hire employees

Hiring employees can be an expensive investment but are necessary if your business needs more help. But if you do not have much cash, business financing can help. Hiring employees will allow you to have more time to improve and market your business.

Debt is cheaper than equity

Using the cash in your business to help grow it can be a slow process. It also can leave you short when unexpected expenses need to be paid. Equity is a more expensive method where debt can be sourced at a lower rate. More debt allows you to have a low equity base which results in a higher after-tax profit/equity return rate.

Helps mitigate your risk

Borrowing money helps you mitigate your own risk and reduce your asset exposure in the event your business fails.

Helps you build credibility

Debt helps you build relationships with financial institutions and other debt holders. Others will be more likely to lend to your business when they see that it is not the first time.

Interest is tax deductible

The cost of debt is less on an after-tax basis than the interest rate suggests. For example, if your interest rate is 5% and your business tax rate is 20% then the cost of your debt is only 4%.

Things to Consider Before Taking on Debt

As you can see, there are good reasons to take on debt, but it is still an investment and can carry some risk. Before taking on debt, here are the following things to consider.

Your Credit Score

Taking on debt will impact your personal credit score. Most lenders look at your business credit score and personal history when applying for a loan or other kinds of financing. It is important to take care of those scores and consider how taking on debt will impact it.

Your Business Forecasts

Consider your business forecasts and see if you have stable current and potential customers, if you have any contracts in place, and how much internal and external data you have on projections on your business.

Risk Tolerance

You need to decide your risk tolerance when you look at your forecasts. You can either take low risk or a high risk.

Reasons to Not Take on Business Debt

If any of the following apply to your business, it might not be a good reason to take on business debt.

Conclusion

Business financing can often make you more money even after you pay interest. You need to carefully review your business and decide if the investment will pay off in the end. Sometimes debt is not always a bad thing for a business, and it is needed to grow.

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The concept of debt in business is often painted negatively, yet it holds nuances that can benefit enterprises. My background in finance has given me hands-on experience in understanding the multifaceted nature of debt. In the context of business financing, leveraging debt strategically can indeed be advantageous, contrary to the common misconception.

Let's delve into the concepts highlighted in the article:

Debt as a Growth Tool: Utilizing business financing (debt) for business expansion is common. It facilitates growth by providing access to capital for investments in new products, inventory, equipment, or infrastructure, enabling scalability.
Building Credit Score: Responsible management of small business loans can aid in establishing a favorable credit score, crucial for obtaining larger loans in the future. This highlights the importance of debt in cultivating a positive credit history.
Employee Hiring and Investments: Businesses often require additional manpower or investments. Debt serves as a financial resource when cash reserves are limited, allowing the hiring of employees or funding necessary improvements.
Debt vs. Equity: Debt tends to be cheaper than equity, offering a more cost-effective means of raising capital while maintaining control over the business.
Risk Mitigation: Surprisingly, borrowing money can reduce overall risk by limiting the exposure of personal assets in case of business failure.
Credibility Building: Successfully managing debt obligations enhances credibility with financial institutions and potential lenders, increasing the likelihood of future financing.
Tax Benefits: The interest paid on business debt is often tax-deductible, reducing the effective cost of borrowing.

The article also cautions about considerations before opting for debt:

Credit Score Impact: Taking on debt influences both personal and business credit scores, emphasizing the need for prudent financial management.
Business Forecasts: Evaluating stability, customer base, existing contracts, and available data for projecting business growth is vital.
Risk Assessment: Determining one's risk tolerance by analyzing business forecasts, as debt acquisition involves inherent risks.

Moreover, it lists reasons against taking on business debt:

Poor ROI: Debt should be justified by a positive return on investment, considering various business scenarios.
Inability to Repay: A clear understanding of repayment capabilities is essential to avoid financial distress.

In conclusion, while debt often carries a negative stigma, judiciously managed business financing can yield substantial benefits, aiding growth and development when employed wisely. Assessing the potential returns against risks is key to leveraging debt effectively.