5 things you need to know when taking on debt
(MoneyWatch) Unless you have been on a walk-about in New Guinea, hibernating in a cave for the last century, or visiting us from another planet, you know that debt fuels just about everything in our world, from helicopters to housing, countries to cosmetics, derivatives to designer jeans. The list can be almost as big as, well, the U.S. national debt.
Whether it's to start a startup, give a leg up to the next level of growth, or survive business setbacks or cycles, debt plays a key role in most companies. Managing the process of borrowing, and the money, is just as critical as the ability to borrow it.
Here are five tips to help you get debt-smart:
1. Borrow for opportunity, not operations. Debt can be either a transfusion or a tourniquet. A transfusion jump-starts growth, whereas a tourniquet stops the bleeding but eventually kills the organ. Opportunities to increase profits, add assets, or improve your business are all great reasons to use debt; covering for bad management or an unsustainable business model is not. Don't take out a loan, run up credit cards and credit lines, or hit your family up for money without first defining the benefits and weighing the risks.
2. Care about the cost. Credit cards and vendor financing programs are oh so convenient and, more often then not, oh so expensive. For example, Ann thought she too busy building her business to bother with getting a bank loan. Instead, she used her credit cards. Soon, her business was paying nearly $8,000 each month in interest payments, averaging 18 percent per card.
She got a term loan from her local bank and was able to cut the interest rate by more than 10 percent. That went right to her bottom line, adding nearly $6,000 of profit each month. The lesson: Credit cards can be terrific cash-flow tools, but also be huge profit drains. Do you want an easy way to increase your profits? Keep your credit card balances to a minimum or, better yet, pay them off monthly.
Sometimes credit costs can be sneaky. Bob was paying 21 percent interest and didn't have a clue. The vendor sent him a statement each month showing the minimum payment required, which he happily paid. That is until the balance grew to $25,000, and only then did he learn that they were charging 21 percent.
3. Look beyond the cost to the consequences. Getting a visit from the local loan shark might be preferable to having the IRS empty your bank account the day before payroll because you "borrowed" from your payroll withholding account.
Even the strongest companies can sometimes run into cash-flow shortages and have to make tough decisions on whom to pay when. If you don't pay your suppliers when you agreed to, you are essentially borrowing money from them. By recognizing this, you can better manage your borrowing. Be strategic and proactive in your communication. Remember, that we communicate is as important as what we communicate.
If not, you could end up throwing the baby out with the bath water, like our friend Chuck did. His company was falling deeper and deeper into debt. His bookkeeper decided that he could pay off all the other vendors if he did not pay their largest one. Months went by and all was quiet. Then one day, it wasn't a loan shark, but a process-server who came knocking on his door. Chuck now works for the vendor. We hate when that happens!
4.Too little, too much, or just right. A few years ago, a rock climber in Phoenix needed rescuing when he tried to rappel a 400-foot rock face with a 250-foot rope. Determining your cash needs is the equivalent of choosing your rope. Are you going to leave yourself dangling 150 feet in mid-air?
Almost as precarious as borrowing too little is borrowing too much. Not only does it add unnecessary costs, it usually gets spent needlessly. Make a rock-solid business plan before you seek capital and, more importantly, have qualified people in place to execute that plan.
5. Plan the pay-back. If you borrow from a bank or another traditional lender, the repayment terms are clearly spelled out. Do the same if you borrow from your payables, friends, or family. Agree on when you will pay the money back, how much you'll pay, and how you will pay.
Families and friendships have been destroyed because of money lent and not paid back. Don't let what happened to Stuart's family happen to you. He borrowed heavily from both his parents and brothers. When they asked when he would re-pay them, his response was always "as soon as I can."
He never paid anyone back a dime. The loving, fun relationship he had with his family was never the same again. Although his intentions were good, without a disciplined scheduled plan, it never happened.
Whenever and whoever you borrow money from, write out your repayment plan. If it is not in writing, it is not worth the paper it's written on.
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