The FINANCIAL — A new business is like a baby: during and after birth, you are only concerned with its survival. However, after you are pretty sure that your new baby will survive, you start to focus on making sure that your baby gets enough food, education, and care, so that he becomes a healthy and successful adult.
The same goes for businesses: after survival comes growth.
Imagine the following scenario. You started a new ice cream business a few months ago, and spent all your money buying equipment and inventory. Sales are skyrocketing, and you do not have enough cash in the bank to buy all the inventory that you need to satisfy the demand for ice cream that you are facing. This is a dilemma that many businesses face: sales are growing, and the business is profitable, but the company does not generate enough cash to expand as fast as you would like it to expand.
When you’re facing this dilemma, there are two possible options: you can grow, but at a slower pace than you would like, using the cash that the business generates; or you can try to find money outside the company, so you can grow faster, and capture a larger market share.
In the case of any small company, selling part of your company (in the form of equity) is always hard. Unlike large companies that are tradable on the stock market, small companies are usually held by one individual or a small group of people. Selling part of your company will also mean that you have to split the profits with someone else.
A logical alternative for small- and medium-sized companies is debt investment, or in other words, taking out a loan. Loans are attractive because you don’t have to give up ownership, and debt is usually cheaper than equity. Because in the capital structure of a company, debt stands above equity, equity holders are the first ones to take losses, which means that debt is less risky than equity. This makes investors (usually banks or microfinance institutions (MFIs) in the case of small- and medium-sized enterprises (SMEs) more likely to invest in debt than in equity.
Even if you have enough money to fund your business, it may still be an attractive proposition to use debt instead of putting in your own money. Consider this simple numerical example. Imagine that for every two lari that you put into your business, you generate three lari. This is a 50% return.
Now imagine that you put in one lari of your own money, and you take out a loan for the other lari. The cost of this loan is 20% (20 tetri). Now your amount at the end is 2.8 lari, because you have to pay 20 tetris to service the debt. However, because you only put one lari of your own money, the return on that money (“return on equity”) is 1.8 lari, or 180%! Thus, by using debt instead of your own money, you can increase the returns that you generate.
Loans can serve a variety of purposes. Business can use loans to buy fixed assets (such as real estate), or to finance current assets (such as inventory). You will get lower rates from your bank if you have collateral, which is something that the bank can take from you if you don’t pay back your loan. Common types of collateral are real estate, other fixed assets such as equipment, or even cash. If you don’t have collateral, banks may be hesitant to give you a loan, because if you don’t pay back, they will lose all their money.
Interest payments, unlike payments to equity holders, are also tax-deductible. Interest comes out of your company’s pre-tax income, while dividends to equity holders come from your post-tax income. This means that interest payments can reduce your pre-tax income, which will reduce your tax liability.
Take your ice cream business for example. If your profit is 100 lari, and you want to pay out 50 lari to your equity holders, your total tax liability is still 100 lari. However, if you need to make a 50 lari interest payment, this will reduce your tax liability by 50 lari, and reduce your corporate income tax by 7.5 lari – in the case of Georgia where the corporate income tax is 15%
When you take out a loan, you have to convince the bank or other lending organization that you are going to pay back the loan. You can do this by showing that you generate enough cash to cover the loan payments. While having good projections definitely helps, banks are most likely to look at your past financial statements and credit history to see how you will be able to cover the loan. Be well-prepared when you talk to any credit officer at a bank, and make sure that you are familiar with your own numbers, and that you can answer most questions that they will ask you.
There are different types of loans, and when you talk to a bank, know what kind of loan you are looking for. While explaining all possible loan types is beyond the scope of this article, it is important to understand the difference between amortized and non-amortized loans. When you take out an amortized loan, you pay back the principal over the term of the loan, while with a non-amortized loan, you only pay interest during the term of the loan, and pay back the principal (the amount you initially borrowed) at the end of the loan. You can also take out a credit line, which gives you the right, but not the obligation, to borrow up to a certain amount.
Whatever you decide to do, ensure that the cash flows of the business match the repayment schedule. For example, in the case of an ice cream business, it might not make much sense to take out an amortized loan, because during the winter you won’t have the cash flow to make regular principal payments.
Also carefully read the contract that your lending institution gives you, as discussed in my last article. You would be surprised to hear how many people do not read the contracts that they sign, and face unpleasant surprises afterwards.
Loans can be a powerful instrument for business, but are poorly understood by many business owners. If you try to learn more about debt and how it works, this will not only help you make better business decisions, but it will also better prepare you for conversations with banks and other possible funders. Many people still believe that the only way to grow their business is to put in more of their own money, or use cash flow from the business. Now you know better: you can use debt to grow your business faster.
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