Does it make sense to incur debt?
For an SME in expansion, ensuring adequate control of debt reduces the risk of default with respect to creditors, suppliers and clients, and secures efficient business operations. Although some business owners feel proud of the fact that they have never taken out any loans, this is not always a realistic approach.
In order to achieve growth and make the jump to international markets, SMEs (small and medium enterprises) need capital contributions. This funding can be made available through bank loans, credit lines or funding providers. But many SME owners ask themselves, when is a debt considered excessive?
A possible answer can be given by carefully analyzing the cash flow and the particular needs of each business. Below you will find some examples of when it is convenient to incur debt, what type of debt is advisable, and best practices for managing debt.
When does it make sense to incur debt?
There are several situations where it makes sense to incur debt. For example, it may be advisable to improve or protect cash flow or to finance the company’s growth or expansion. According to the IFC Banking Knowledge Guide, “in these cases, the cost originated by the loan can be less than having to finance these actions with current revenue.” The reasons that typically require requesting loans include:
- Selling in international markets: when companies gain a foothold in new markets it is not unlikely for them to face lengthier collection cycles for the products or services they manage to place. This may be the result of offering more favorable terms to clients in order to properly penetrate the market. Taking out loans can help overcome this period of financial maladjustment.
- Increasing working capital: when an SME needs to increase the number of employees or its rate of production as a result of having expanded the business towards new markets or simply to increase the capacity to satisfy the growing demand of its product or service.
- Purchasing capital goods: a company may need to finance the purchase of new equipment in order to enter new markets or to increase production. Generally this is a long-term investment.
- Building credit history: if a company has not previously taken out any loans, doing so for the first time can help to create a good credit history, which will help future funding. A good credit history enables more financing options and better terms.
- Improving cash flow: for example, the case of a businessman with less than ten years to cancel a long-term loan. Refinancing is a way to repay the outstanding debt or to make debt prepayments. It consists of paying old debts with new ones and helps improve cash flow.
Short or Long-Term?
Not only is it important to be sure of the reasons for taking out a loan but it is equally necessary to be informed on which type of credit is adequate. For example, obtaining short-term financing when long- term is needed can cause serious financial problems, such as having to sell part of the business to meet payments.
It is generally advisable to use short-term loans for short-term needs. According to the International Finance Corporation, “this will avoid unnecessary payment of higher interest and more restrictive conditions usually imposed by long-term loans.” For example, if an SME experiences temporary rapid sales growth, such as a seasonal increase in demand, a short-term loan can help satisfy this seasonal situation. This helps to absorb the total demand and to obtain additional income.
If in contrast a company waits for the increase in demand to continue for an extended time, long-term financing options should be considered. For example, credit lines based on sales, accounts receivable (factoring) or inventory indicators.
This also generates a positive impact on the liquidity indicators of an SME. This is because current liabilities only include debt that must be returned within the current year and not at a later date.
Proper capital planning helps predict funding needs and serves as a very valuable tool for determining how much financial support is needed and when. Additionally, it allows more time to explore all possible financing sources and to negotiate under more favorable conditions.
Before requesting any financing it is key for each company to plan its capital needs ahead of time. According to the publication “SMEs in Latin America and the Caribbean: A strategic business for banks in the region” by the Inter-American Investment Corporation it is advisable not to assume debt in the middle of a crisis. Frequently in these cases, unforeseen loss of suppliers’ credit, the impossibility of paying salaries or other emergencies may occur compelling to rapidly take out loans under the most unfavorable conditions.
According to information published on the website Emprende PYME, “capital planning consists of a complete review of the balance sheet to help analyze cash flow, assets and liabilities.” Additionally, it is advisable to prepare a pro-forma financial statement, which is a projected balance sheet for the next 1 to 3 years.
It is also important to prepare an itemized budget including: sales, production (to obtain the cost), direct salaries, indirect expenses and administration costs.
List of Priorities
When interest rates are low and money is cheap, a businessman might be tempted to take out loans to purchase equipment or to make other capital good purchases. If this is the case, the SME must be sure that this decision is based on real needs. The Inter-American Investment Corporation affirms that “the possibility of a hike in interest rates should not be a valid reason to spend money in things that one does not really need.”
For example, if the company needs to increase its production capacity through additional equipment. However, purchasing equipment because it may be more expensive to do so tomorrow is not sufficient justification. This may lead to purchasing a machine that is not really needed (surplus in production capacity) and debts that will have to be paid in the future.