It is a tool that every business can utilize to start a business, operate and expand a business. Many businesses do not understand how to use this tool to their benefit. All they know is that they need money to do what they want to do. Your first question should be? How am I going to finance this?
Let’s start with short term vs. long term debt: short term is paid back immediately or within a year; long term is paid back longer than a year: usually term loans. Debt can be secured or unsecured; unsecured is preferable; some types of security liens can be receivables, inventory, equipment, etc.
Bank business lines of credit usually require that the line be paid down at least once a year. That is a good thing. The line can be secured or unsecured; a probable requirement is the owners guarantee for payment. Banks have also been known to call the line; that means they don’t think the business is in a good place, and they want their money. If a line is not paid down and the owner chooses to just pay interest, the cost of whatever they used it for skyrockets.
Since short term is paid back within a year, it should be used to pay for current assets such as inventory, smooth out the business cycle, etc. With the availability of credit card debt, a business can find itself carrying debt (paying high interest rates) used to buy inventory that should be long gone for years.
When should long term debt be used? Many businesses try to finance what should be long term initiatives through operating revenue. Not a good idea. Why because they need operating revenue for payroll, rent, short term debt, etc. Buying a piece of equipment can be a long term endeavor, leasehold improvements, expanding the business such as adding locations. Analyzing the life of what the business is buying will help determine whether it should be short term or long term. A single computer is probably no longer considered to have a long life and would be considered for short term debt; however, replacing a multitude of computers should be considered a long term purchase. Financing a buildout and/or adding a location (in my opinion) should not be financed short term.
To me the beauty of a term loan is your paying interest and principle; there is an end in sight for the debt. Credit card debt is just a vicious cycle when used improperly.
Margaret L Crosby, EA of Pace Consultng Beverly MA Advanced Certified QuickBooks ProAdvisor can assist you in solving your business issues. Certified in QuickBooks Point of Sale software call 781-738-1669 or go to www.paceltd.com for your free report.
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