How to use debt without getting your head cut off

As a business owner, what is your position on the proper use of debt?

Here’s a quote from the legendary investor Warren Buffet quoted in a great book Seeking Wisdom, by Peter Bevelin:

“Whenever a really bright person who has a lot of money goes broke, it’s

because of leverage…It’s almost impossible to go broke without borrowed

money being in the equation.”

Most things in life and in business are not black and white. Most questions have more than one right answer. And whether you should use debt in your business is no different. It depends a great deal on how you use debt and how you assess risk when using debt/leverage.

Understand the downside

The biggest downside of using debt is you could get your head cut off!

Borrowing money always includes a promise on your part to repay the money. And you give the lender the right to take specific actions if you don’t (or can’t) hold up your end of the bargain. You basically hand the lender a big meat clever and give him the right to start chopping off limbs if you don’t do what you promised.

In return for that, you get the opportunity to grow your business faster than you otherwise would grow it. If you don’t have the cash to implement your plans then borrowing money can make it possible to implement them anyway.

Borrowing means you want to spend some money on something but you don’t have the cash to do it. That means you have to go ask a lender to loan you the money to make the purchase or investment. Many of us were taught that using leverage can be smart because you borrow money and invest it at a higher return than the interest on the debt and you get to make the difference as the owner.

But the problem is debt works great when it works – and it fails miserably when it fails.

Here’s another quote from Warren Buffet in Seeking Wisdom, by Peter Bevelin:

“If we can’t tolerate a possible consequence, remote though it may be, we

steer clear of planting its seeds.”

This is the secret

Here’s the big question you should ask yourself before you borrow money. “What are the consequences if I’m wrong?”

Say you want to buy a new piece of equipment that will help you bring in some larger customers. You want to borrow the money to do it because you don’t have enough cash to just write a check. And you don’t want to wait because you want to jump on the opportunity while it’s hot. You have to borrow $250,000 and pay it back over 5 years.

You need to think through and quantify what happens if you don’t get the new customers. If the investment turns out to be a bad decision, can you still make the payments? What implications does it have on your financial position? What impact does it have on you personally if you have a guarantee on the debt?

Remember, just because you CAN borrow money doesn’t mean you SHOULD.

The standard should be you don’t borrow the money if you can’t survive your idea or investment failing to achieve its objectives.

That’s being smart. That’s being prudent. That’s how you make sure you always keep your head attached to your body.

Philip Campbell is an accounting and financial consultant and author of the book Never Run Out of Cash: The 10 Cash Flow Rules You Can’t Afford to Ignore.