Using Debt Capital to Finance Business Growth

debtsDebt capital can be the best way to finance operations in your business venture but it can also turn out to be the biggest mistake you will ever make in your life.

It is simple. Debt is money you do not own that you can use to grow and expand you business then pay back the lender with some interest on top.

The best way to employ debt is when you are very sure that the returns from investing the debt in your business will be higher than the cost of acquiring that debt. Say you get a loan worth $1000 at 21% interest rate. It is a good loan for you as long as the returns you anticipate to get from investing it in your business are more than the 21% with a significant margin say 5% or more. This makes your total required rate of return about 26% and above before getting the loan.

Anything contrary to the above simple principle of funding growth for your enterprise using debt is both outrageous and suicidal!

However, as much as debt is a good way to gain from leverage, it is also a bad omen when it forms a big proportion of your capital employed. The more debt you accumulate, the less likely you are to repay the whole of it when it falls due, thus increasing the riskiness of your business. This is as a result of a potential bankruptcy in-case the cash-flows from the business can not meet its financial obligations if creditors and lenders were to want their money back at a given point in time.

It therefore follows that it is a came of wits and logic when you want to make the decision of employing debt capital into your business. The core principle of higher required rate of returns than the cost of debt not withstanding, there is a rule of thumb that must be adhered to all times before getting a loan:

NEVER use short-term debt to finance long-term capital investments; and never use long-term debt to finance short-term financial needs!

The rule of thumb above can never be overemphasized. I will however expound on it further in our next article on debt financing.

Cheers!

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