I own a small business. We do well in excess of $100, 000 a year. I have never borrowed a cent from a bank or any one else from that matter. When I bought the business, I used personal savings. The business was profitable from day one and that was over 20 years ago.
My bank, Wells Fargo, is constantly asking me if I need to borrow any money. We sometimes need to buy new equipment and we are always buying supplies, but everything goes on a credit card that is always paid off in full with the profits we make that month.
I’ve heard how farmers borrow money for seed for the spring planting. After the harvest, the crops are sold and the bank is paid back in the fall. But the cycle starts again come spring. Can’t a farmer somehow get ahead of this cycle? Just think if the farmer had enough of his own money to buy the spring seed! No more borrowing. No more interest payments.
It seems that most businesses are like this. They borrow money for inventory or raw materials and when the products are sold, the bank gets paid back. Can’t they ever get ahead? It seems that this is some kind of business model that companies mindlessly follow. Do businesses even try to get ahead or do they try to expand if they have a little profit left over at the end of the year?
Using your farmer example, let’s say he uses all his cash to get set up and buy his first year’s seed. Fine.
But a farmer has no cash flow until he has a crop to sell. So now he’s spent all his money and has no money until his crop comes in. He has to live on credit for the next six months. Then the crop comes in and he pays all his bills. Of course, that takes all his cash, so he has to borrow to buy seed for next year.
Or suppose it’s a clothing store. You have to buy clothes so you have something to sell. But you don’t get the cash until the clothes actually sell. So you buy the clothes on credit.
You say you pay for your new equipment and supplies at the end of the month. But you’re still buying on credit, if only for a few days. Wouldn’t it make more sense to wait until next month and buy your equipment and supplies then? Of course not, because you need it now.
The fact is, relatively few businesses have a year-round consistent cash flow that allows them to pay for the stuff they need next month using only the money they made this month.
not an MBA but also a small business owner. The answer is leveraging and the obsession with growth.
It seems to me that in our current society a successful profitable business that makes the same profit (adjusted for inflation) every year is actually looked on as a failure, or at best as mediocre. Businesses have to aim for continuous growth to be regarded as “hot companies” and that takes leveraging, which requires debt.
If you’ve got a profitable niche and you’re happy with your yearly profits you don’t need to grow and you don’t need debt but very very few business owners think that way.
Actually, the only reason I use a credit card is because my Shell Mastercard pays me in gas credit 5% on all my gas purchases and 1% on all others. Over the years, they have given me well over $1000 in free gas. They hate me!
From an “mba” perspective, or better put corporate finance perspective, large corporations making financing decisions have a different mindset than a small business. Remember from Business 101 that businesses can engage in financing activities - bringing in cash to be spent on investing activities - things like new product lines and new factories. There’s also operating activities like spending cash on raw materials or bringing in cash from the sale of finished goods. Now forget about operating activities for the rest of this post.
A major component of a corporation’s financing decisions is minimizing its cost of capital. That is, the return it has to pay to the provider of capital in exchange for using it. If you borrow money from the bank, the interest rate you pay on it is your cost of debt. If you’re a publicly traded company you can compute a market cost of equity for your business reasonably easily. The corporation’s goal is to minimize its cost of capital - overall - so that it can obtain more money for investing activities at a lower cost.
So why would a corporation use debt? Primarily two reasons. 1) Debt is tax deductible which makes it relatively cheaper than equity. The actual (after tax) cost of debt for a company is the nominal cost of debt multiplied by one minus its tax rate.
Credit holders are superior to equity holders in the event of default. So as everyone knows, if you own stock in a company and your friend owns a bond issued by the company and the company becomes insolvent, your friend gets repaid before you do. So it’s only proper that the company pay a higher return to equity holders for taking on the higher risk.
Incidentally, the reason corporations don’t borrow for all their needs is that the more debt they carry relative to their equity the greater risk of default. This is (especially) true of a public corporation whose bonds are rated by a rating company and also of any other company. When the default risk is seen as more likely, not only does the cost of debt rise, but the cost of equity rises in kind. So there’s a theoretical balance between using debt with its lower cost of capital and using too much and raising your overall cost of capital for the firm. Something I’ve always found fascinating but no ‘actual’ businessperson I’ve met has found similarly interesting is that in extraordinarily leveraged companies, the cost of debt is as high or higher than the cost of equity in peer companies with less levered capital structures, because the debt holders effectively are equity holders. If there’s $50 in debt for every $1 in equity, you really can’t say that the equity holders are subordinate to the debt holders in any financially meaningful way.
The goal is to allocate your funding sources so that the overall cost of capital is minimized. So to finally answer you question - why doesnt all this apply well to small businesses? Because, even if your small business is incorporated, there's no real difference between you, the business, and the equity. A large corporation really doesnt care if it’s paying stockholders or bondholders a return in exchange for funding - it just wants to minimize what it pays. No rational small business owner would think that way. Nobody is going to say “Well sure I’m paying a huge amount of interest on this massive line of credit from the bank, but it’s cheaper than the rate of return I’d be looking for for myself!”
The more money a business has, the more weight it can swing around. It may be able to buy more inventory at lower cost, open new branches, invest in marketing, etc. So, businesses borrow to have the maximum amount of money for such activities, as coremelt said.
Also, no one likes saving. Why should the farmer have a $20k fund for seed buying, when he can buy himself a bunch of shit and just buy the seed on credit. You might think that’s flawed thinking, but he’ll think the same about your perspective. Free money. Hey!
The first reason is growth. A small business like yours stays small because its model is not growth-oriented. Borrowing creates leverage to grow while preserving cash for day to day operations.
The second reason is a mindset to use Other People’s money. Consider the difference:
If I owe you $100,000 I have a big problem.
If I owe you $100,000,000, you have a big problem.
Borrowing OP money transfers (or at least, distributes) risk.
My boyfriend’s video production business is suffering from the growth thing. When it was just him, he never needed to borrow a dime. But he got enough business to hire employees, which he did, because that’s the only way to move up to the kind of clients he wanted. Except those employees need to be paid, and you need the employees before the money comes in (and there still hasn’t been the kind of growth he needs to pay them all.) Especially since video production is a lot like farming - you get paid months after you get the client, but you’re working all that time. So he’s really getting into a lot of debt now and it’s crushing him. Making him damned hard to live with, too.
Remember, too, that if he then has a good year, so do all his neighbors and the prices crumple and he makes no more money than in an ok year.
Businesses borrow because it’s a good idea: if you can borrow at 5% and gets a 5.1% rate of return at no risk, you should do it. Now, there’s never no risk, so you have to decide how much potential profit justifies a given risk level, but the idea is sound–do you think it’s weird that people borrow to buy a house? It’s the same idea.
People also borrow because you have to strike when the iron is hot: if you have a new, original idea for a company, you can be pretty sure that so do another half dozen people. If you wait 2 years to save up the capital, it’s too late, they have the market share and the experience and you are the latecomer.
Maybe all of you are answering the question the way Mangosteen wanted and I’m the one who missed his point but technically what you and most other posts in this thread are saying is that businesses finance things because it’s a good idea, not that they borrow because it’s a good idea. The purpose of fund raising for a business is to use that money to expand and invest whether it was raised by borrowing or through equity.
Again, maybe I’m adding more nuance than Mangosteen was looking for but to answer the question “Why debt?” with “To invest it” is missing the point. That’s the point of financing whether it’s debt or equity financing. “To invest it” is the answer to “why raise capital?”. The answer to “Why debt?” is “because in our best judgment it was cheaper than equity”.
I don’t have an MBA, but I have owned a successful small business in the past, and I run one now. Both with a bit over a million dollars in sales annually.
Both companies had a credit line that was used on a regular basis. When you do the work, but don’t get paid for 30, 45 or 60 days, the credit line is there to smooth things out. It’s how we pay for things like supplies or wages while we wait to get paid.
The credit line gets drawn on and paid on continually.