How Should Entrepreneurs Manage Their Debt?
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Starting your own business requires a lot of capital upfront which implies raising capital either in the form of Debt or Equity. An Entrepreneur would have saved a certain portion of his capital to invest in the business, but that might not be enough. He would be needing additional funding to run and grow his business and meet the day to day needs. A start-up usually takes about 3-5 years to generate profits. Hence, debt is a huge component during that time. Unlike the salaried, an entrepreneur does not have a regular monthly cash flow and is bound to encounter ups and downs in their cash flow. During this time, it is important to manage your money effectively and cut down on unnecessary expenses, while growing the business.
Before taking on any debt, an entrepreneur should keep the following key points in mind –
Know the Sources of Financing Available – Choose the Best Option
Large businesses with an investment-grade rating and stable cash flows will get favourable debt terms. Whereas, a small business set up might not. The sources of funding available to business owners are:
Family or Friends
One of the best sources of funding that a small-scale entrepreneur or someone who is just starting can opt for is through family or friends. This is the easiest and fastest source and usually requires no documentation and collateral.
Debt – Banks and Financial Institutions
This involves Secured Loans that are backed by an asset (house, car etc) and includes, Business Loan or Equipment Loan, Overdrafts against Fixed Deposits, Loan against Property and Investments etc. Another type of loan is unsecured loans which are usually riskier and carry a higher rate of interest and includes, Personal Loan and Credit Cards.
Also, at an early stage, one may lack access to debt instruments, bank loans or capital markets. In this case, one may pitch their ideas to Venture Capitalists, that provide funding to start-up companies and small businesses that have long-term growth potential. They also open doors to raising further capital. In such a scenario, the Venture Capital investor would get an equity stake in the company.
One should raise capital from the source that best suits their business and would minimize the cost.
Set a Budget
Analyse your budget. Start planning on where you would be spending your money and get an idea on your variable and fixed costs that you would be incurring. The aim is to reduce unnecessary costs and identify areas that are not necessary for business daily operations and cut it down. Keep a track on the cash flow you are generating. According to that, decide on the debt and equity funding that you would be requiring and restrict your borrowings to the extent needed. Do not overstretch your budget!
Keep in mind the Cost of Debt
With Debt, comes interest payments. It is very important to understand your actual cost of borrowing and make sure you can afford that debt. You must make timely interest payments. Any default could have a bad impact on your credibility and could have disastrous consequences. Use debt wisely by utilizing low-interest loans (Family, friends, overdrafts from FD’s, Mutual funds and properties ) These usually come at a lower rate of interest than personal loans and credit cards. Personal loans should be the last resort to fund personal and business needs. Also, make sure your return on equity is more than the cost of debt. Otherwise, you will be incurring a loss. You must aim to minimize the cost of debt while maximising growth.
Prioritize Your Debt Payments
Maintain a list of all debt payments that need to be made. Segregate the large payments and debt that has the highest rate of interest, make sure you pay them off first.
Create Liquid Assets
In case of any contingency, it becomes difficult to service debt payments. Hence, you must ensure that you have enough liquid assets to meet any contingency. Running up huge liabilities without enough liquid assets is not a good idea.
For an entrepreneur, debt is unavoidable and can be a useful tool to help start and grow your business, if managed well. Use debt to create assets to boost your income and grow your business rather than taking debt for things that will not add any value. If you fail to make payments on time, the result could be disastrous and could lead to legal proceedings, bankruptcy etc.