Is There any Such Thing as Good Debt for a Small Business?

By Elaine PofeldtLifestyle and

Debt is often associated with poor planning or being in financial straits. But for a small business, there are times when it's smart to use debt as a financing option. Knowing when is the tricky part.

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We've seen the evidence of bad debt too often in the past few years. Despite the slowly expanding U.S. economy, many once-current firms fell behind on their commercial credit payments in the last quarter of 2012. According to the Experian/Moody's Analytics Small Business Credit Index, there was a 20% increase in overdue payments that were less than 60 days late.

Many late payers were borrowing to meet payroll. But even tiny firms with just one to four employees ran into trouble keeping up.

So how do you make sure that your borrowing decisions don't leave your business scrambling to pay bills -- or you personally on the hook for years to come? There's no one-size-fits-all rule, which is why so many business owners make mistakes. "It comes down to a case-by-case situation," says Ed Bayer, a senior risk management consultant at Sageworks, a Raleigh, N.C.-based company that advises banks on lending.

That said, there are some general guidelines to help you decide if it's wise for you to borrow now -- and what type of borrowing you should be doing. Asking yourself these key questions before taking a loan can help you avoid debts that are likely to become an albatross.

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What is the money for?

If you need a piece of equipment or other asset that will generate revenue, using credit can be a smart way to keep cash available for other needs, says Ellen Rohr, who runs Bare Bones Biz, a Rogersville, Mo., firm that advises small-business owners on how to improve operations. For instance, if you need a sewing machine to open a tailor shop, buying it on credit would make sense.

That strategy worked for Dan Roitman. As a new college grad in 2002, he borrowed $70,000 on credit cards to start up Stroll, a Philadelphia company that sells a language learning program called the Pimsleur Approach. He used the money to launch a successful ad campaign and then to fill the groundswell of orders that resulted from it.

"It didn't scare me," he says of the debt. That's because he knew the sales he'd booked would more than cover the credit card bills. It helped, too, that he had kept overhead to a minimum. He paid off the debt within months, and today the profitable business has grown to $80 million in annual revenues.

Whether you run a startup or an established business, using credit to purchase inventory that you can sell quickly can also help your cash flow. For instance, if you're planning to sell T-shirts at a fair two weeks from now, buying them on credit will help you keep cash on hand for other things.

There may also be purchases so big that you have no other choice but to borrow. Six-figure investments -- such as buying a franchise, purchasing a new building for your business or doing a massive renovation -- are usually bought on credit. Generally speaking, small-business loans from banks offer the best rates, says Ed Bayer, a senior risk management consultant at Sageworks, a Raleigh, N.C.-based company that advises banks on lending.

Many other expenses are not worth going into debt for. In the early stages of a business, you're probably better off delaying purchases like swish new office furniture, for example, until you're bringing in enough money to pay without borrowing -- a strategy called "bootstrapping." "It's a way most people neglect," says Rohr.

How long will you need it?

Choosing the right type of loan for your borrowing time frame is critical. Many business owners get into trouble because they use expensive short-term financing, such as credit card debt, for long-term purchases such as furnishing an entire office. Leases and bank loans are cheaper forms of long-term finance.

"It's a matching game, where you want to make sure your long-term debt is matched with your long-term assets and your short-term debt is matched with your short-term assets," says Nat Wasserstein, who has advised owners of distressed businesses at his New York crisis management firm Lindenwood Associates.

As a rule of thumb, short-term financing works for assets you'll quickly convert to cash -- such as products you'll be selling in your store next week or those T-shirts for the fair. Just be realistic about how much you can sell. "I might put $1,000 worth of T-shirts on a credit card, but not $50,000," says Rohr. "The idea of credit card debt is we want to pay it off every month."

Credit cards are also generally OK for emergency purchases such as repairs to a hurricane-damaged business. In fact, credit-card financing can be a lifesaver because it's available quickly, without the long application process that comes with bank loans.

For most larger purchases, however, you're better off looking at other financing options. Sometimes that means something other than debt -- such as leasing. One of the main advantages of leasing equipment, for instance, is that you don't have to worry about updating it. You just get a newer version when your lease expires. For that reason it's a good option for items that may become outdated relatively quickly, such as computers or other high-tech equipment.

Because it's not debt, a lease may also be easier to get. "The rates are pretty low," says Wasserstein. "They don't usually require personal guarantees."

Once you get into large purchases -- say, a new building -- you'll want to look for long-term financing such as a bank loan backed by the U.S. Small Business Administration. The rate for an SBA-guaranteed loan of up to $25,000 that is due in seven years or less must be under the base rate (currently 3.25%), plus 4.25%. That means the most you would pay on such a loan right now would be 7.5%.

Just prepare for a long and rigorous application process. The credit crisis may have thawed, but many small businesses still have trouble getting loans from big banks, says attorney Andrew Sherman, a partner at Jones Day, who advises many entrepreneurs. "You probably want to look at community banks and maybe even credit unions that are starting to lend more," he says.

What shape are your finances in?  

Your company's credit rating with agencies such as Dun & Bradstreet can give you an idea of whether your business is in the right shape to borrow. It's a good idea to look up your score before you make credit decisions.

If your score is disappointing, you may need to work on improving your balance sheet before you take a loan. Maybe you need to drum up more sales so you'll have more confidence in your ability to pay it off.

Sageworks has found that the best predictors of default on business loans are these five key metrics:

  • Low ratio of cash to assets
  • Low ratio of EBIDTA (earnings before interest, taxes, depreciation and amortization) to assets
  • Low ratio of EBIDTA to long-term debt and interest expense   
  • High level of liabilities compared to assets
  • Low profits, as defined by the ratio of net income to sales
  •    Generally, the more of these factors your business has, the higher your likelihood of default. Don't wait until you're desperate for a loan to suss out your company's financial health. "If your house is on fire, it's probably too late to buy the fire extinguisher," Bayer says. If you plan to borrow on credit cards that require a personal guarantee -- or take a loan that requires you to put your house up as collateral -- you need to take a look at your personal financial situation as well. Will you be able to pay off your debts if the business hits roadblocks? Be careful that you're not relying too heavily on borrowing to fund your business. It's important to have your own money or cash from investors to put into it. "If you're growing just with debt, you've got a real problem," says Wasserstein. "One hiccup and the whole thing falls apart." Byron Anfinson knows that lesson all too well. The former minister relied heavily on credit cards to finance his transition to a career in the Minneapolis real estate market. When he became a broker in 2005, he used his credit cards to cover many of his routine business expenses, with little cash coming in to cover them. "I didn't feel the pain as if it was my own money," he says. Three years later, reality had set in. The father of four found himself worrying about paying off the $45,000 in debt he'd racked up at 11% interest. He and his wife, a nurse, worked around the clock to pay it down in 2008. Fortunately, the couple are debt-free today and able to live off what they earn from their work. Things worked out fine for the couple, but at what cost? They sacrificed a lot of precious time with their children to pay off their debt. Given the rate of new business failures across the U.S., they're lucky they didn't lose more. See related: Used wisely, small-business cards can keep business afloat, Small-business credit card comparison chart, Financing your small business with plastic: A capital idea?