At the recent APEC–FIND Conference on “Strengthening Credit Infrastructure,” a panel of modestly successful entrepreneurs were asked about their attitude toward borrowing from formal financial institutions. Not surprisingly, majority of the speakers expressed their fear of borrowing, especially after citing horror stories of friends and acquaintances about being trapped by debt. Because debt is a legal obligation, many entrepreneurs fear that it would be counterproductive, it would eat up into their earnings, leading to unnecessary anxiety for the debtor, and could accelerate company failure. There was also the impression that banks would not give SMEs good deals, anyway, and that loans are offered more to those who don’t need them, rather than to those who would benefit most from the borrowed money.
The observations are not without basis and are reinforced by the proliferation of self-help books advocating a debt-free scenario. After all, there abound anecdotal stories about unscrupulous moneylenders offering “easy credit” to unsuspecting borrowers who end up paying high interest, leading to a spiral of further debt to pay initial debt. The end result is a disaster.
As a practitioner advocating better access to finance by SMEs in the country, this mindset of fear definitely deserves review and must be overcome. For one, those who are not inclined to borrow should definitely not be forced or even induced into a borrowing arrangement unless they are fully sold on the benefits of debt. This is where the small business community must be educated on the pros and cons of getting into debt. Debt is precisely called financial leverage for a reason. By analogy, a lever is a rigid bar for pivoting about a point allowing mechanical advantage or power to move a bigger object. In like manner, good debt allows the investor to use the borrowed funds to gain higher returns on its original capital or equity.
Borrowing money for business must be a well-considered decision, weighed against the basic earning power of the enterprise. The first order of the decision is to ensure that the return on asset (prior to financing) will more than offset the cost of borrowing. The firm’s basic earning power is normally a function of the profit margin and the efficiency of asset utilization, or turnover. In other words, the entrepreneur must be able to use borrowed funds to generate enough profits to more than cover the cost of borrowing. The successful businessman must be able to compute the difference between how much it cost to get into debt and the additional income from the project financed by debt.
Businesses normally have to understand their cash conversion cycle model because it takes time to convert resource inputs into cash flows. Before a single sale is made, the company will invest in something like inventory, machinery, equipment in order to produce some products or services. And when the sale is made, oftentimes there is need to sell on credit. The cash conversion cycle reflects the length of time for a company to purchase inventory, collect receivable and pay its bills. Borrowing can help settle some of the pending costs before collection. Typically, suppliers need to be paid before the company collects. There is pressure on cash flows and if the company aims to grow at a faster rate it should study whether all working capital can be financed from the owner’s investments and how much, if any, can be borrowed.
In fact, many businesses sometimes overly rely on supplier’s credit when in fact this could be costly. Suppliers often will offer discounts for early payment, but a correct computation of the cost of not taking the discount can be an eye-opener. In many instances, it will save the business a lot by taking advantage of the discount and seeking lower costing bank debts instead.
In another setting, the business may consider it unnecessary to borrow money when there are inflows from the business. But if such re-flows are needed for other business needs, such as an improved process change or an opportunity to explore new markets or customers, then it may make sense not to tie up internal cash and, instead, find an external fund. After all, new funds may be needed for market expansion, product development, process reengineering and other interventions meant to improve performance levels.
In looking at alternative fund sources, especially when investigating the cost of debt versus the cost of equity, not many are aware that, in fact, debt could represent the cheapest cost of capital. Debt costs are usually capped while equity costs are unlimited by the earnings of the firm. Outside equity sources are also expensive from the control viewpoint. A budding entrepreneur once talked about joining a business plan competition where the reward appeared to be a very generous P500,000. However, while it was a venture investment, it also represented 20 percent equity into the business. From the valuation perspective, the winner should study whether the reward was worth 20 percent of all the future earnings of the firm.
For the tax-paying firm, debt is also a tax shield as interests are deductible expenses, whereas dividend payments are not. Classical finance texts actually consider this tax shield benefit as one of the primary advantages of borrowing. There is also the signalling effect as external debt serves as a bonding mechanism for managers to convey their good intentions to outside shareholders. Of course, too much debt reaching critical levels in turn opens up the firm to costs of financial distress.
There is good debt and bad debt. The astute entrepreneur must not borrow just because of the need for new funds. Debt must be kept at prudential levels where financial risks are manageable, the firm’s future flexibility is maintained and the costs and benefits are carefully weighed.
Benel D. Lagua is executive vice president at the Development Bank of the Philippines. He is an active FINEX member and a long time advocate of risk-based lending for SMEs. The views expressed herein are his own and does not necessarily reflect the opinion of his office as well as FINEX.