Think Twice About Debt

Christmas has just passed and soon people will begin to see the consequences of their gift giving. Some of course have been very disciplined by either paying with cash or at least knowing they had the funds set aside to pay their credit card bill in total. Those who cannot pay their bill in total when it arrives have likely used debt in the wrong way. The only reason I say “likely” is because there can be exceptions, but don’t be so ready to think you are the exception. This issue is not limited to individuals and families, but also applies to businesses.

Debt Use Wrongly

Suppose your business has the opportunity to purchase inventory to last you six months and that the price is 20% less than normal as long as you purchase this quantity. Well, that could be a good thing, but if you are going to have accounts payable that takes you six months to pay, maybe not. Accounts payable is really just short-term debt. As you know, the terms for most invoices in accounts payable are generally net 30 days or slightly more, but generally no more than 60 days. Stretching your payments out much beyond the vendors’ terms can end up costing you the ability to make critical purchases. This is an example of debt used wrongly. Another classic example of debt used in the wrong way is when a company never pays off a line of credit that was intended to help with fluctuating cash demands, such as those caused by seasonality. I had a client that got in a bind by doing just that. Although not as frequent, some businesses purchase equipment with a short-term loan that should have been structured as a long-term debt. This also could be a way a line of credit is used improperly.

Debt Used Correctly

Before I go too far, let me first say that, if possible, attempt to finance from the normal cash flow of your business. If you do have to borrow here are a few guidelines:

  • Before you decide to go into debt, make sure you really need what you want to purchase. Don’t be like the people who misuse credit cards
  • Only use short-term debt for expenditures that will be utilized quickly (like using the line of credit to fund payroll shortfalls resulting from seasonality
  • Use long-term debt to purchase assets like machinery and vehicles that have a life of several years. That way you are paying the debt over the time you actually use the equipment

Debt is one of those things that can be very helpful, but I have seen too many times when it was used for the wrong purposes and it became a drag on these businesses.

One last thing to remember: Proverbs 22:7 “The rich rules over the poor, and the borrower becomes the lender’s slave.”

If you want to know more, contact AimCFO – Contact

As always, your comments are welcomed.

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