When Debt Is Good10th May 2017
“What are these three loans for?”
“Oh, we needed them to tide us over. Money just wasn’t coming in fast enough. No big deal.”
I was taking a first look at the accounts of a new client. Their balance sheet wasn’t in great shape, but at first glance there wasn’t anything too disastrous either. Then I noticed the three loans, which had been taken out roughly once a year for the past three years.
It was an immediate alarm bell – and should have been for the client, as well, alerting them that there was a serious problem with their finances. But it wasn’t.
As we looked closer at their books, we saw that even though they were bringing in a lot of new clients, they had severe cash flow issues. They just weren’t getting paid fast enough to cover their expenses.
Each time, when they thought they were going to run out of money, they used a loan as a stopgap measure, allowing them to continue functioning smoothly for another few months. Then the old cash flow issues reasserted themselves and they took out a new loan.
It was a vicious cycle which they had no intention of getting out of, because the loans created the illusion that all was well. In reality, not only were the underlying financial issues still there, but they were burdening themselves with piles of debt.
Recently I’ve been talking about one of the hidden dangers of fast growth, which is that it is very expensive. One way to overcome that is to shorten your cash cycle, as I explained last week.
But sometimes that’s just not enough. There may come a point where you need to finance your growth in other ways, by borrowing money. This could either come from a bank, or (the more modern way of doing things….) peer-to-peer lenders or some other type of loan.This is not inherently a bad thing. Every engine needs oil.
But there is a big difference between borrowing to grow faster, and borrowing to stop yourself going under.
If you are performing well and are profitable, and want to borrow to give your company the tools that set it up for future success – for example, paying for essential new equipment or larger premises that allow you to process more orders, or putting the right staff in place – that’s great.
The loan will actively build your business, and the money you’re generating can be used to pay off the debt.
But that can never happen if you're borrowing to try and cover a loss, or cope with financial problems such as cash flow. That’s a sticking plaster solution which can only get you into more trouble, as in the case I told you about earlier.
I do understand why companies take on debt for the wrong reasons.
When you are growing fast and things feel like they’re moving in the right direction, it’s so tempting to believe that you just need a little bit of cash to help out, and that everything will sort itself out in a few months’ time. Sometimes business owners are so confident in the future of their business that they are even willing to prop it up with a personal loan, which is easier to get.
It could be called an optimistic approach – but it’s misguided. In a few months’ time, chances are that all those recurrent, underlying financial challenges will still be there.The only real solution is to put in place proper financial planning and management.
That’s what we did for the client I mentioned before. With good cash flow management, they could stop using borrowed cash to plug gaps, and instead use it to improve their position, and even start paying off their debts.
I compared debt to oil before, but it’s like fire too. Used carelessly it becomes destructive and uncontrollable, but used wisely it can be an extremely useful tool.
If you need to borrow (for wise reasons!) we can help you find competitive funding. But equally, if you think you need a loan “just to tide you over”, we can help you with that too. Just get in touch and let’s talk about how we can get your finances in order – so you never need loans for the wrong reasons again.