Piling up debt could kill your business

Borrowing appears to be the most colloquial form of seeking finance irrespective of the source – banks and other independent lenders or family and friends.

The UK government debt has risen to a record £1.004 trillion, from £883 billion 12 months ago. This debt figure represents 64.2% of UK GDP. In addition, the debt figure was attained after government borrowing fell by 2.2 billion in December 2011 to £13.7 billion.

Borrowing money to make money is a suitable way of operating in this increasingly difficult economic climate. This explains why credit companies and financial institutions lend depending on your ability to repay debt rather than the state of your cash inflows.

Debt and Capital could strike a good balance

 Most large companies, governments and to a large extent SMEs have huge amounts of debt backed by a progressive capital balance. This should leave them with active working capital to get going in the short-run. Despite the disappointing UK net debt figure, GDP rose by 0.9% for the year 2011.

In countries with high inflation such as the UK (current UK inflation rate stands at 4.2%), traditional bank borrowing may also be inflation-indexed which eliminates the extra facility costs incurred. Businesses also use debt in many ways to leverage the investment made in their assets, “leveraging” the return on their equity.

It is possible for some organisations to enter into alternative types of borrowing and repayment arrangements which may not result in bankruptcy. For instance, businesses can sometimes convert debt that they owe into equity in themselves. Also, businesses can use invoice finance to improve their cash flow. This demonstrates how cost minimisation could be rewarded with a long-term return on investment.

Businesses may leverage their equity by borrowing money. The more they borrow, the less equity capital they need – any profits or losses are shared among a smaller base and are proportionately larger as a result.

 Excess Borrowing could cause you to have a double-think

Excesses in debt accumulation have been blamed for exacerbating economic problems as evidenced by the recent credit crunch. This excess of debt, accumulated due to exaggerated optimism or a lack of foresight, accompanied asset bubbles on the stock markets.

Many businesses have undergone bankruptcy, not because they were unprofitable, but because they suffered from a shortage of working capital – sometimes due to a cash flow crisis . In working capital we mean adequate cash flow to cover payroll (even if it’s just you), operating costs, make supplier payments or to reduce existing debt

This leverage, the proportion of debt to equity, is considered important in determining the risk of an investment; the more debt-per-equity, the riskier the investment. For both businesses and individuals, this increased risk can lead to poor results, as the cost of servicing the debt can grow beyond their ability to repay the debt due to either external events (income loss) or internal difficulties (poor management of resources).

In an economy with high interest rates (and inflation rates), debt will be more costly to a business when compared to flexible dividends on equity investment. It may be easier for a struggling business to be financed through equity investment as it may be possible to avoid paying a dividend if times are hard.

Acquiring debt could a shrewd choice if you are 100% sure that the funds could be repaid on every maturity date. You can prevent this economic dilemma by properly allocating your resources and effectively managing your risks.

Our aim is to find the most suitable financing solution that could fuel growth into your business. Call us on 01451 832533.

About the Author

Mark Jefferson is a seasoned commercial finance professional with over 25 years’ experience in financial services, much of that spent providing funding to SMEs. Mark has worked with many other firms in a similar situation to yours. Call Mark on 01451 832533 and you can also follow him on Google+

Share this post: