For a growing SME, maintaining adequate control of its debt reduces the risk of default with creditors, suppliers, and customers, ensuring that the business operates efficiently. While some business owners are proud that they never had to borrow, this approach is not always realistic.
To achieve growth and make the jump to the international market, SMEs (small and medium-sized enterprises) need to have capital contributions. To obtain this support, they can resort, for example, to bank loans, lines of credit or financing through suppliers. But many SME owners ask, when can debt be considered excessive?
One possible answer is to carry out a careful analysis of the cash flow and the particular needs of each company. What follows are some examples of when it is convenient to take on debt, what type of debt it is useful to contract, and what are the best practices for managing it.
In which cases should it be indebted?
There are several situations in which it is worth taking on debt. For example, it may be useful to improve or protect cash flow, as well as to finance growth or expansion. As detailed in the Information Guide for SME Banking of the International Finance Corporation, “in these cases, the cost originated by the loan may be less than that of financing these actions with current income.” Among the reasons that usually merit the management of a loan are:
- Selling in the international market: when companies venture into new markets, it is common for them to have to face longer collection cycles for the products or services they offer. This may be as a result of offering more favorable terms to their clients to achieve adequate market penetration. Borrowing money can help get you through this financial lag period.
- Increase working capital: when an SME needs to increase the number of employees or rate of production of merchandise as a result of having expanded its business into new markets. Or simply to increase capacity to meet a growing demand for your product or service.
- Buy capital inputs: A company may need to finance the purchase of new equipment to enter new markets or to increase production. Generally this type of investment is made with a long-term horizon.
- Build a credit history: If a firm hasn’t taken out loans before, doing so for the first time can help them develop a good repayment history, making it easier for them to borrow in the future. A good payment history will allow you to get more financing options and better terms.
- Improve cash flow: this may be the case of an entrepreneur who has less than ten years left to pay off a long-term loan. Refinancing is a way to pay off existing debt or make prepayments on it. It consists of paying off old debts with new debts and helps improve cash flow.
Short or long term?
Not only is it important to be sure of the reasons why you are going to apply for a loan, but it is also necessary to be well informed about what type of credit is suitable. For example, taking short-term financing when long-term financing is sought can create serious financial problems, such as being forced to sell part of the business to meet payments.
In general, it is advisable to use short-term loans for short-term needs. According to the International Finance Corporation, “this will avoid the unnecessary payment of higher interest and more restrictive conditions that long-term loans tend to impose.” For example: If an SME experiences rapid and transient growth in sales, such as seasonal increases in demand, a short-term loan could help meet that seasonal situation. This makes it possible to absorb the entire demand and access additional income.
Instead, if the company expects the increase in demand to continue for an extended period of time, long-term financing options can be evaluated. For example, credit lines based on sales, accounts receivable (factoring), or merchandise inventory indicators.
In addition, there is a positive impact on the liquidity indicators of an SME. This is because current liabilities include only the debt that must be repaid within the current year and not that of later dates.
