In many cases, the problem with debt is not the borrowing part, but the paying-back part of the deal. Yes, debt has its dark side. What you have borrowed, you must repay – plus interest. Here are the three difficult questions to answer before borrowing money for yourself or your business:
How much debt can I afford?
A very tough question, but here are some simple guidelines to help you answer it.
Plan for worst-case-scenario EBITs* twice as large as your expected interest expenses. I believe this simple heuristic – keeping your interest expenses two times lower than your lowest EBIT expectations – will keep you on safe ground.
*EBIT – Earnings Before Interest and Taxes: the annual profit of a business before interest and taxes are paid.
Are my future cash flows predictable enough?
To tell you the truth, people are not very good at prediction. This is how most people think about the future: They look at their current status and imagine it will remain unchanged for a very long time (extrapolating to infinity). Reality ordinarily turns out to be quite different, though. Cash flows can fluctuate dramatically from one period to another. Just ask yourself, “How good was my prediction for last year’s revenues?” Then be more pessimistic (more real!) about what your new, highly-leveraged project is likely to yield.
What is the worst-case scenario?
Yes, it is true that when you use debt, you can grow faster. But it works the other way around, too. If you borrow and then run into financial difficulties, those difficulties will be multiplied by the fact that you also have debt to deal with. Being in debt exposes you to the risks of uncertain future cash flows. The problem is that regardless of anything else, debt must to be paid on schedule. In most cases that’s unavoidable. This means that minor cash-flow slowdowns can badly damage your wealth. A big debt exposure is far riskier than carrying little or no debt. When you have no debt demands, you can afford idle time (temporary periods of slow or no cash flow). And in business, timing is everything.
Only after answering the questions above should you start looking for financing. I have to tell you, though, banks have been in business for quite a long time; many will try all sorts of tricks on you, hoping to increase their profits. The following are the most important clauses in a debt agreement – consider them wisely before signing!
What to consider before going into debt?
- Principal – this is the amount you will receive and eventually repay, along with all related costs. You must plan the amount you’re going to borrow thoroughly; you do not want to have to seek additional financing if the initial amount is really too small to meet your needs, or to pay more interest than necessary because you borrowed more than you actually needed. (some agreements may have such clause).
- Interest rate – this is your major cost for the loan – the amount you pay your lender in addition to the amount borrowed. Negotiate it carefully. Interest rates depend on market conditions, your trustworthiness as a borrower, your negotiating skills, and the lender’s finances too. Unethical lenders use mathematical tricks when calculating interest charges, so be very alert. If the lender tells you interest rates are based on a market-index component or a bank-determined component, beware! You may be in for a bitter surprise at some point in the otherwise-bright future.
- Bank fees and charges. Banks like to increase their ROI by charging clients all sorts of fees, like loan management fees, bank account fees, and various “client service fees.” Come on! We know such services are routine parts of the bank’s job; such fees are actually hidden interest charges.
- Payments – the most advertised part of every debt deal. In many cases, if you pay attention only to what your monthly loan payments will be, you are in danger of being misled. People who do not understand financial concepts like NPV (net present value) and IRR (internal rate of return) may experience problems in comparing financial products with different payment schedules and interest rates.
- Collateral – many debt agreements include clauses stating that if you do not make your required payments on schedule, the lender takes ownership of a portion of your assets or property. Be careful when going into debt – you don’t want to be kicked out of your home because you aren’t able to make your loan payments.
- Hidden risks – many sophisticated financial products offer so many benefits that it seems they are perfect. Well, they are not. Here is what I have observed: the more sophisticated the financial product, the more hidden risks it contains – and therefore, the less its consumers understand how to use it, and the less profitable it ultimately is. Less profitable for the consumer, that is – the banks make huge profits on these “all-in-but-nothing-out” financial instruments.
And one last bit of advice: Never finance a long-term investment with short-term borrowing. This is a one-way street to bankruptcy.