From week to week, we see occasional reports that banks aren’t lending to businesses, and that businesses can’t get the money they need to grow and to create jobs. Whether that’s true remains a little murky, but frankly, I worry more about businesses borrowing too much money.
As someone who has started several businesses, I know that borrowing money for your business when you shouldn’t can be one of the biggest mistakes a company makes.
There are times when it is good to borrow money, but those times are limited. So how do you know when you truly need to borrow for your business? The answer is not always obvious.
A prerequisite for even asking when you should borrow money is being able to answer “yes” to both of the following questions: Is your business actually profitable? Can you easily service the debt?
Answering the first question is straightforward. Answering the second is, too, by calculating your debt-service ratio.
Here’s how: Assuming your business has no current debt, start with your gross income, any wages you’re taking from your business, and any other sources of income, such as rent on property. Add to those the earnings before interest, taxes and depreciation of your business. Divide the result by the total of both your existing personal debt (mortgages, car loans, etc.) and the principal and interest you would owe on the new business debt. Get your accountant to help you figure this if you need help.
This resulting “global coverage ratio,” which banks typically examine when considering a loan to a smaller business, takes into account your personal finances and those of your business. For you to safely be able to service the debt, the resulting ratio should be more than 3. If it is above 2, you’re in pretty good shape. Most banks won’t lend on ratios below 1.5 without such high interest rates that it’s probably not worth it. But that doesn’t mean 1.5 is the minimum ratio at which it’s safe for a company to borrow.
We’ve all seen what happened in the housing industry when people borrowed for houses based on two incomes, then one person in the family lost a job. Banks will lend you the money, but they can’t tell you whether you should borrow the money. The entrepreneur needs to look for a much wider cushion than the banks use when it comes to assessing your ability to service debt.
Assuming you passed the debt-service ratio test, when should you borrow money for your business?
You should borrow when you are confident that you can make more profit as a result of borrowing money. Estimate what your sales and profits are before borrowing and what they will be after you borrow. If you run a landscaping business and you want to replace an 8-year-old truck that’s a little beaten up, how will buying a new truck increase your revenue or reduce your costs? Most of the time it’s not going to.
The big problem that I see is people say, “I need capital to grow.” And actually, they need capital to keep themselves in business. Mixing up the two is super risky, because there might be some systemic problem with the business.
Sure, businesses will occasionally need short-term financing (like a line of credit) in order to get through a slow season. The risk lies in confusing borrowing to grow your company with borrowing to tide over the business. An accountant can help you run a return on investment analysis to see whether borrowing will help you make enough additional profit to justify the new debt. Otherwise, study your situation yourself. I typically evaluate any potential borrowing in the light of three possible scenarios: a conservative outlook, an optimistic outlook and something in the middle.
You can also use your banker as a source of advice. Just remember, his or her perspective is more often, “Can this guy pay this money back?” rather than “Is this a good investment for the borrower?”
If you’re trying to decide whether to borrow money for your business, there are a couple of other things you should also be doing. First, be mindful about the deductions you take on your business. Remember that banks base their lending on your tax returns, and by lowering the profit on your tax returns, you may be decreasing your ability to borrow.
Second, keep your personal credit really clean. If you have a business with less than $2 million in sales, a lot of the lending decision will be based on your personal credit. Pull your credit report every year and check for mistakes that could hurt you down the road.
Brian Hamilton is co-founder and chief executive of Sageworks, a financial information firm based in Raleigh, N.C.