Personal Debt and Its Effect on Small Business

If a person has a balance on their credit card that carries over to the next month, they may have just financed a burger and fries at the industry’s highest rates.


Three boys cutting lawns


On his morning walk, an older gentleman noticed a young boy cutting a lawn. The man inquired, and the young boy, James, explained. “A friend of mine bought a new bike a few weeks ago, and I liked it so much that I talked my mom into buying me one just like it. So now I have to cut lawns to earn the money to pay her back.” The man continued his way, and he saw another young boy cutting a lawn. The young boy, David, explained that his friends are all getting new bikes, so he must cut lawns to earn enough money to buy his own bike.


The man continued walking and came upon a third young boy cutting a lawn; he inquired a third time. The third boy, Marc, said, “I’m cutting my customer’s lawn.” The man asked if he was saving up to buy a bike. Marc responded, “No, I already have a nice bike.” The man continued, “If you already have a bike, then why are you cutting lawns?” The boy said, “I cut lawns because that is what I do; I am in the lawn-cutting business.”


While it may appear that the three boys are all doing the same thing, cutting lawns, nothing could be further from the truth. James is trying to pay off debt (he owes his mother money), David is working hard to keep up with the Jones’, and Marc is building a company.


MONEY


Money is an often misunderstood commodity. With modern financial tools like E-banking, automatic withdrawal, direct deposit, and credit cards & debit cards, many people are two steps removed from ever handling cash. Add online shopping, subscription-model buying, and zero-money-down purchase models, it is easy to see how people can be dragged down into financial Hades! Everyone needs money, but many people just don’t know how money works.


It is not necessarily the things that we purchase, but the method and timing of these purchases, that will determine our future financial status. Today, wealthy Americans and poor Americans have cell phones, flat-screen TVs, internet access, and two cars. But one significant indicator of future financial status is how and when these items are purchased: first versus last.


Financially skilled people buy things last. Only after the paycheck has cleared, the money is in the bank, and the monthly allotted amount is disbursed into the savings account, does the financially skilled person consider purchasing an item that is not a normal monthly expense. And when he or she does make this purchase, it is after considering the need for the item, what other item can satisfy the same need, and the value that this item brings. Only then is the item purchased, and it will be paid for with cash.


Financially unskilled people are far more likely to make purchases first – prior to the paycheck clearing, prior to building a savings account, and prior to considering the need and value of the item, or what other items will serve the same need. These folks will make a purchase of an item without consideration of the timing of their personal financial cycle (if they are even aware of this cycle). And this item is often financed.


If two people purchase the same item, the one who pays cash will pay less, because this person has more leverage. He or she can consider many items that perform the same task and many outlets that sell these items. The one who finances the item will pay a higher price for the widget itself because he or she will be able to purchase only the item that is offered with financing, only at the outlets that offer to finance, and only on the terms available. He or she has fewer options. This buyer will also pay the finance charges every month until the item is paid off. So, the financially unskilled person has made the same purchase as the financially skilled person but has paid a higher price on more than one level.


DEBT


Like money, debt has become another misunderstood financial tool. Debt is money that is borrowed and must be paid back over time or at a later date, almost always with interest. Individuals and companies use debt to make purchases that they could not make within the confines of normal cash flow. Personal debt shows itself in the form of college loans, home mortgages, car loans, unpaid credit card balances, and other such personal loans. Start-up companies and businesses in general often carry debt in the form of SBA (Small Business Administration) loans, revolving lines of credit, working capital loans, and other forms of secured loans.


Personal debt can assist the debtor with the purchase of a home, car, or other large items that he or she otherwise could not afford. It can help with the cost of college. When used effectively, personal debt will assist the borrower in homeownership, building equity, and the purchase of big-ticket items.


Business debt can help the company owner in many ways. An SBA loan can be used to help start-ups launch their company, product, or service. Revolving lines of credit can assist the business owner with the challenges of cash flow or inventory management. Working capital loans and commercial mortgages can help the business owner with major purchases to grow the company beyond its current infrastructure restrictions.


Debt, like a finely sharpened chain saw, is an amazing tool. With the chain saw, the skilled woodsman can drop the largest tree in the forest, while an unskilled worker can use the same tool to cut off his right hand! For those who are lacking in financial literacy and discipline, debt can be a tool of destruction.


For those who are financially literate and skilled in debt management, debt is a tool that is taken out when needed, used for a specific purpose, and then neatly put away, back into the toolbox, until it is needed again. These folks have perfected the art of operating well within their means while exploring opportunities that fall a bit left or right of center. They are on a first-name basis with their banker, their accountant, and their attorney. They know this instrument called debt, they know how it works, and they play it like a vintage guitar.





Revenue through sales versus borrowed revenue


To reach profitability, a new business needs the initial infusion of capital (cash) that will allow the company to perform the daily process of business. Three common methods used to generate capital for a start-up company are borrowing money, selling equity, and bootstrapping. Borrowed money creates debt, and it must be paid back, with interest, generally in incremental monthly payments. Start-up capital can also be raised through the selling of equity in the new company, but this dilutes the founder’s ownership percentage. Bootstrapping describes a situation in which a business owner starts a company with no outside or borrowed capital, relying exclusively on his/her own cash on hand, hard work, and creativity.


In my own experience, I’ve seen the business owner who chooses the debt-free bootstrapping method will, early on, need to be more creative and likely work a bit harder. But the debt-free company that focuses on early-stage revenue through sales will more likely create high revenue streams and, without the cushion of comfort that comes with borrowed money or money raised through the sale of equity, will work harder on accounts receivables to keep the cash flow strong. And without the monthly expense of paying debt service, the bootstrapped company will keep more of the cash, thus increasing working capital, adding assets, and growing the balance sheet; just like our 12-year-old lawn cutting friend Marc.



Savings account and the credit score myth


In the business world, sales are king! When a company has excellent sales, zero debt, and disciplined ownership, the company’s bank account will reflect this. A disciplined business plan with a strong bank account will carry the start-up company a long way towards phase two of the business life. But some business owners have been taught that the credit score is more important than the savings account, and therefore create financial habits that are geared toward building credit scores instead of responsible business spending. While incurring small amounts of debt early on may build a favorable credit score, it may diminish the capacity to borrow real money down the road when the company needs it. We don’t want the tail to be wagging the dog!


Cape Cod real estate agent Barbara Corcoran agrees. “It’s important to not let debt get out of hand,” she said. “People need to realize that they should not let that credit card balance carry over to the next month. Otherwise, they are paying some of the highest interest rates allowed.”

The credit score is and should be, an overall reflection of a person’s financial picture. Responsible business ownership, attention to the expense column, and a strong bank account will result in a more-than-acceptable credit score, and this will make the small business owner a solid candidate to take on debt later in business life if needed.


Regarding business debt, Joe Fannon, CFO of RELCO, one of the largest electrical contracting firms in the Northeast, said, “Managed properly, debt can be a great financial tool. If more trucks and equipment will produce enough revenue to outweigh the cost of the debt needed to purchase those items, that could be a good use of debt. And the interest on the debt is a tax deduction.”


The savings account, while it is not designed to earn high interest, is an amazing tool that serves several purposes for the business owner. Some early-stage business owners will use the company credit card as a safety net, but the savings account is a much better cushion for the business. With a large savings account as the safety net, the company credit card becomes a company financial tool of convenience. The savings account allows the owners to ride through the highs and lows of the business cycle and the ups and downs of economic trends. The savings account also affords the business owner certain leverage when making capital improvements or making major company purchases. Joe Fannon noted, “I strongly recommend the savings account”.



Generational debt


The debt-to-income ratio (DTI) measures the percentage of a person’s (or family’s) gross income that goes toward paying recurring debts. Post-WWII estimates indicate that most families carried a DTI between 7% and 17% in 1946. By the mid-1970s, a typical DTI was 25% – 28%. The term DTI became more defined over the years to include two levels: housing costs (rent or mortgage principal, interest, taxes, and insurance) and other recurring debt (student loans, credit cards, car loans, etc.). Today, while some mortgage companies prefer a 36% DTI limit, the current standard through the Federal Housing Authority remains at 43%.


At any given time, there are three full generations on this earth, and each generation tends to deal with debt differently. My mom and dad, each born in the Great Depression of the 1930s (Depression Babies), took out one loan; it was called a mortgage. My wife and I are of the Baby Boomer persuasion; we’ve owned and flipped many properties in our early years with the help of mortgages, credit lines, and a low-interest auto loan or two. Many of today’s young folks, the Millennials, have a home mortgage, college debt, car loans, and unpaid credit balances.




Personal debt and the start-up

The personal financial needs of the owner can significantly impact a start-up company. One major barrier to entry into the world of self-employment is the personal financial situation of the would-be owner.


Incurring personal debt early in life can hinder future business ventures. We live in a world where many young graduates are saddled with six figures of college debt, car loans, and some credit card debt. Envision the 30-year-old man who has two kids and one more on the way, a college loan payment book that isn’t going away anytime soon, two car payments parked in the driveway of his rented house, and a small sum of credit card debt that just won’t seem to quit. Now imagine the 28-year-old executive working in the corporate world with no debt and a better-than-average savings account; he/she might be inclined to take advantage of a potential business opportunity that presents itself. The young corporate executive with very few encumbrances and a savings account stands a far better chance of success as the owner of a start-up company than the soon-to-be father of three. As Corcoran put it, “You need to manage debt, not let debt manage you!”



Making debt your friend


Being debt-free may allow the business owner a certain amount of creative leverage. My business partner and I own a growing home services company, American Gutter Monkeys Franchise Systems, that has remained debt-free since inception. After outgrowing our third building in just seven years, we saw the need to build a new and very large facility, one that we are never likely to outgrow, so we reached out to several local lenders. With a company resume that included commercial real estate, a modest fleet of trucks, and some solid bank accounts, the company’s balance sheet had all the right stuff, including a zero in the debit column.


Working on our behalf, our own bank not only outperformed all other lenders, but three separate divisions within that bank (Commercial Construction Loan dept, SBA Loan dept, and the traditional Equity Credit Line dept) sought to outperform one another for our business. Because our company was financially solid, we locked down the short-term equity line that we sought at just a 2.8% interest rate, with no upfront fees, zero closing costs, and no prepayment penalty.