Let’s just go ahead and say it: debt gets a bad rap. Between taxing student loans and hefty mortgages, it makes sense why many business owners are averse to taking on debt.
However, as the adage goes, “it takes money to make money.”
And unless you happen to have an extra $100K sitting around, it’ll be nearly impossible to capitalize on a growth opportunity without obtaining additional funds
Debt financing provides business owners with the opportunity to invest in new equipment, additional employees, and pretty much any other operational necessity that arises.
That being said, it’s crucial to have a firm grasp on how your initial investment will improve your bottom line.
Conducting an ROI analysis of the growth opportunity can help you decide if taking on debt is the right move.
ROI for debt
In determining whether taking on debt makes sense, business owners should look beyond just the cost of capital and consider the ROI (return on investment).
ROI is a measure of the gain accrued from a specific investment, relative to its cost. ROI helps you determine the value a growth opportunity adds to your business. It’s calculated as:
(Gain from Investment - Cost of Investment) / Cost of Investment
If you borrow $50,000 for an expense that will generate growth or revenue, the investment will have a positive return on investment. If you borrow $50,000 for an expense that will not generate revenue—such as for repainting your office walls—you will have a negative return on investment.
You’ll also need to be sure to factor in the APR, which is the total interest payable on the loan, on a yearly basis, averaged over the duration of the loan. This is inclusive of fees and service charges.
Some business owners may become concerned that this rate appears too high. However, a higher APR doesn’t always mean debt is the wrong decision, as long as you understand how your business will generate additional funds with the loan.
Remember: Before you begin calculating the ROI for a prospective growth venture, be clear on what your hurdle rate is. This represents the minimum rate of return you’re willing to accept for a particular investment.
Peter’s Pizza Shop
Evaluating ROI is crucial, particularly when you’re operating on a limited business budget. Using ROI as a guide can help you pinpoint those opportunities that offer the highest potential return, based on the amount you’re able to invest.
Take, for example, Peter owns a pizza shop that does not currently deliver and is limited to customers who can come into the restaurant. Several customers have asked Peter about delivery options, but he is hesitant about borrowing money to buy a delivery truck and a driver. Peter qualifies for a $50,000 loan at 15 percent APR for five years but feels that the APR is too high. The true cost of the loan over five years would be approximately $71,370 ($21,370 in interest). Would it make sense for Peter to take out the loan?
In this example, Peter would be paying $21,370 in interest over five years. The cost of debt per year would be slightly above $4,000, not including tax deductions for interest payments. Peter does a bit of research and estimates that he can generate about $12,500 in net profit per year by adding a delivery component.
Not only does this investment cover the cost of borrowing capital, but a delivery truck and driver would contribute to significant financial gain for Peter.
Additionally, if Peter doesn’t take out the loan, he may lose customers who want to order delivery and find an alternative pizza purveyor. With his loan, not only would Peter be able to provide delivery for his existing customers, but he would potentially be growing his business by attracting new customers previously out of his reach. These are just a few of the “intangible” benefits Peter would obtain from his investment.
The bigger picture
In making any business decision, it is important to not look at the cost of debt without taking into consideration other factors.
Just because a business loan may have a higher APR, the opportunity cost of not investing in the company’s future may be greater.
When looking at ROI, business owners can make decisions more strategically by evaluating potential growth rather than only looking at costs one-dimensionally.
Samantha Novick is the Social Media Manager at Bond Street, a company focused on transforming small business lending through technology, data, and design. Bond Street offers term loans of up to $1 million, with interest rates starting at 6 percent.