As business owners are faced with spending money on their businesses, I find that there isn’t a good enough grasp of the difference between outlaying cash or even incurring debt for an expense versus outlaying cash or incurring debt for an investment.
Spending to make a return on your money
Not all debt is bad debt. Borrowing money to cover investments makes sense, if the potential return is great enough to justify the risk and the cost of capital. Borrowing to cover expenses is just plain costly.
Let me give you a personal-life example. Let’s say you use debt (i.e your credit card) to buy a new wardrobe. This is an expense. The wardrobe decreases in value over time and if you borrow money to purchase it, it will end up costing you more than the purchase price.
However, if you use debt to pay for an investment- your house, your education, etc.- you are borrowing money (hopefully) because you expect the return you get from your investment to be higher than the cost of your borrowing, even with the interest-at least that’s how you should approach it. (Note: I know a bunch of you will argue with me about the value of a college education, so you should approach it with the return on investment mindset. Mine paid off.) The key factor is having a reasonable expectation of earning a return on your outlay of capital over time.
The same principle goes for business spending. If you borrow money to invest in part of your business that directly helps it grow, then if the business grows at a rate higher than the value of the money you borrow (during a given time period), it is a good investment. If you are borrowing money to pay for expenses of your business that don’t produce a return (like fixed overhead costs such as rent), then it just costs you more money.
The time value of money
Then there is the gray area, for example, borrowing to fund inventory costs. Inventory can produce a return if it is sold within a timely fashion. But eventually, the cost of the debt increases your cost for the inventory, and as time goes by, your return is less. If you hold onto inventory too long, then you may actually lose money. It can, in some cases, be better to sell your inventory at a discount quickly than to hold onto it for years hoping to recoup your actual investment.
Let’s look at an example of how debt affects the cost of your inventory:
You buy $600 worth of product to sell at a markup that you hope gets you $1000. But you find that the inventory is a bit of a dud and it’s not moving. What do you do?
Let’s say you borrowed that $600 at a 10% annual interest rate. If you don’t sell that inventory in a year, it will cost you, with interest, $660. If the interest compounds, at the end of year two it costs you $726 and almost $800 after year three. So, while you want to ideally get the best return you can, you will be better off selling it for $700 after one year (still making a small profit) vs. $725 after two years (just barely breaking even) or $750 after three years (losing money). The cost of the capital and the effect on your return needs to be figured into your thinking on investing and spending.
The opportunity cost of an investment
If you allocate capital to an investment, you are making a choice. If your money is tied up in a particular investment, you can’t make another investment with it. This is called the “opportunity cost”. Let’s use the above example again and say that you borrowed the $600 at a 10% annual interest rate and it takes you two years. You sell the inventory for $800 at the end of year two. The $600 cost you $726 with the interest, and you sold it for $800, so you made a $74 profit off of your $600 investment.
What if you invested instead in inventory that you could sell for $650 after 3 months, and were able to do this again and again every three months? Three months interest at 10% costs you $15, so you make a $35 profit every 3 months. That means at the end of just the first year (even if the profits didn’t compound), you would have $140 in profits (in just one year- $280 in two years) from this investment, instead of the inventory that you could sell for $800, but took you two years and only garnered you $74. That’s a big opportunity cost. You need to put your capital to work in the investments that have the biggest aggregate pay-off, taking into account the value of your investment over time.
So, what can you take away from this?
– While we all have expenses in our business, focus as much as possible on spending where there is an investment and return to be made;
-Remember the time value of money; if you are borrowing to make a return, there are additional costs to consider over time; and
-There is always an opportunity cost to an investment. If you spend your money on one investment, you may have to forgo another one with a higher return.
Hopefully this will help inform your spending decisions for your business so that you can make better choices and get the most possible out of your business.