If you’ve ever been at the helm of a Laser or raced on a catamaran you know that you have to be prepared to adjust your sails the moment the wind shifts. The same logic applies whether you are managing your portfolio or investing in your business. Well, don’t look now, but the winds have shifted considerably over the past year – particularly when it comes to financing your business.
As interest rates climbed over the last two years, taking on debt to finance growth or operations was a challenge. Depending on the kind of loan required and the institution you were borrowing from, annual interest rates climbed well above 10% – a far cry from the ultra-low rates you would have received between 2008 and 2022.
As rates have started falling, though, business owners have more financing options again, whether it’s for acquisitions, buying new equipment or expanding their footprint. But while today’s rate environment offers an opportune time for business owners to finance their growth, finding the best way to finance that growth is critical.
“When you are going into any type of facility or debt or financing arrangement, you want to make sure you are not going to strain the business,” says John Paniccia, Vice President and Head of Business Advisory and Succession Planning at BMO Private Wealth.
Here’s what you need to know about financing with debt.
Understand why you’re borrowing
While many entrepreneurs are wary of using debt to grow a company – they’re often concerned about what might happen if they can’t pay back their loans – corporate finance theory suggests that every business should have a certain level of debt, says Paniccia. “The right choice depends on factors like the business size, the stage of the business, the creditworthiness of the business and the specific needs for expansion,” he explains, adding that leverage can help optimize the return on total invested capital. Leverage (using debt) can potentially increase the return on invested capital if the company can generate higher returns on its investments than the cost of debt.Business owners can also access equity by taking on a strategic partner or venture capital funding – and that can make sense in certain situations, such as if the owner needs special expertise to help it grow – but debt is almost always cheaper than equity, notes Paniccia. That’s for two reasons: “Debt is the cheaper alternative because interest payments are tax-deductible and the rates of return that lenders expect are a lot lower than what an equity investor would expect,” he explains.
Know what lenders want
Typically, the best interest rates come from large financial institutions rather than private lenders. They also have clear processes in place to evaluate both the likelihood of default, based on a business’s cash flows, and better understand the consequences of default, especially when using assets – either personal or linked to the business – as collateral, says Paniccia. That can lead to more favourable terms.
What you borrow, though, should match the specific needs of your project or organization, says Paniccia. For instance, short-term financing might be used to cover working capital needs, while long-term financing can be more appropriate to fund capital expenditures that will produce a return years down the road. It is important to use debt wisely and be strategic on how you use debt to fund expansions, notes Paniccia. “Focus on projects that will provide a return on investment and contribute to sustainable growth,” he explains.
Pick your spots
Borrowing comes with risks of course – if the economy tanks and sales dry up then you may have trouble paying back the loan. So it’s important to think about whether now is the right time to take out a loan.
From Paniccia’s perspective, deciding when to borrow comes down to your company’s current financial health, growth plan and tolerance for risk. You’ll want to be in a position where you think you can use the funds to help move the business forward. In tougher economic times, like the world has been in over the last couple of years, carefully consider how you expect your target market to behave in the short term and long term. After all, they’re experiencing the same economic complications as you.
Before approaching lenders, have a solid business plan with projections that help you determine how much you can borrow without jeopardizing your company’s future. The time to look for financing would be when you’re reinvesting profits into the business to fuel growth, but it’s not enough to really accelerate that growth. “Focus on planning long-term, monitoring cash flow and return on investment with a business plan that demonstrates a clear path to growth and profitability,” says Paniccia.
Minimize the risks
When borrowing, it’s essential to not be overly aggressive and to have a clear vision and plan, with guidelines in place to ensure that a loan has a positive effect on cash flows. Be realistic and make sound estimates based on reliable data, advises Paniccia.
Other key ingredients are a sustainable, achievable anticipated return on investment, a system in place to monitor cash flows and covenants, a budget that comfortably incorporates debt payments and adequate cash reserves to overcome any obstacles that may come along.
If you do have a higher-interest-rate loan right now, you might consider talking to your business advisor to adjust your financing strategy. For instance, you may be able to recapitalize, switching to lower-interest debt from higher-interest debt.
In some cases, there may also be times when you want to “take some chips off the table and diversify,” says Paniccia, by investing borrowed money in other markets, such as the equity markets. Investing borrowed money could be an attractive option in situations where the business operations are able to finance the debt and there is an opportunity to earn a return that is higher than the interest rate on the debt, while at the same time allowing for diversification outside of the business.
At the end of the day debt is just another expense on the income statement that can be used to drive future growth and revenues. “We work with our clients to ensure their success,” Paniccia says. “A lower interest rate provides opportunity making it more affordable to borrow and provide the necessary capital to grow your business without burdening your cash flow with higher interest costs.”
