Business Credit: The Difference Between Efficiency and Headaches
Business credit can be the difference between a smoothly-run operation and a waking nightmare. Contrary to the naysayers, credit is, in fact, a powerful tool necessary for the proper operations of most small and medium-sized businesses. It allows for the prompt payment of bills and expenses, helps deal with emergent and unexpected situations, and generally makes one’s financial life significantly easier.
Of course, there are situations where it is unwise to utilize business credit. We’ll talk about those situations a little bit later when we distinguish between the responsible and irresponsible use of credit. But for now, read on to discover the many uses of business credit and how it can make your life as a business owner easier!
A Quick Business Credit Primer
What exactly is business credit? Well, for our purposes, it’s any quick and easy source of lending that a business can utilize for operational reasons. Types of business credit include revolving credit lines, a credit card, and overdraft accounts. (Although, due to interest or fee costs, revolving credit lines are by far the most ideal solution.)
We’re not including a business loan in this analysis because it’s not typically used in operations. As discussed in a recent article, a business loan is better suited for large capital expenditures in which the rate of return on the purchased capital is greater than the interest rate on the loan. They’re not ideal for frequent, smaller expenses or unexpected emergencies
The Only Alternative to Business Credit: Cash
Some of us have been raised on the notion that credit and debt, in general, is a bad thing. While this is true about some forms of debt in certain situations, it’s not the case with intelligently used credit. We can see this when we look at the consequences of using the only alternative to business credit: cash.
Cash reserves can be a wonderful thing. They hedge against risk and emergencies and provide the ability to pay the bills and acquire new resources at any time.
But there’s one big problem with holding large amounts of cash: opportunity cost. Opportunity cost, you’ll remember from 12th-grade economics class, is the cost of a missed opportunity and the loss of the benefits that could have resulted from that opportunity. In this case, the opportunity cost of businesses holding onto cash is the profit you could have made by putting that cash to use, whether with a passive investment or a business opportunity.
If you could make a 20% return by buying new equipment then the opportunity cost of holding onto that money becomes prohibitive over time.
The Only Alternative to Cash: Business Credit
You might be saying to yourself, “If holding cash carries such significant opportunity cost, I might as well put all my cash to use and rely on business credit to fund my operations and business expenses.” This would, arguably, be just as misguided.
Failing to hold any cash reserves at all leaves you exposed to unexpected financial events that might require significant expenditures. If you don’t have any cash, you can’t make those payments. This exposure creates a great deal of risk for both the business and the business owner. Too much exposure to risk creates situations in which a single unfortunate circumstance can lead to a crippling of the business or, even worse, bankruptcy.
A Happy Medium
The best way forward is to strike a balance. Carry some business credit and hold some cash. The exact amounts of each depend on the risk tolerance and personal circumstances. But the correct balance can be the best and most responsible use of both cash and business credit.
Responsible use of business credit can increase a business’s exposure to new opportunities, allow for greater financial flexibility, and simultaneously protect against unexpected contingencies.
Avoiding Irresponsible Business Credit Use
Even if you have a perfect balance of credit and cash on hand, it is still possible to fall prey to bad habits in the use of credit. It’s best to avoid these, lest your finances get out of hand. Once that happens, it becomes very difficult to recover.
Buying things you don’t need
When using credit, some businesses are prone to buying things and hiring people they do not need. Brand-new equipment, extra employees, and fresh consultants that don’t justify their price tags are not an appropriate way to use a credit line or business credit card.
Spending money you don’t have
When using credit, it’s important to have a realistic plan for paying back the amount borrowed relatively promptly. Borrowing without a repayment plan is a recipe for disaster. When a business owner finds themself in a position where they are forced to borrow against a business credit line or use a credit card to meet everyday expenses, are unable to promptly pay back those funds, and have no plan for the future to make up the shortfall, they’re in trouble. This can lead to bad credit, difficult repayment terms, and dings to your credit report.
The responsible use of business lines of credit involves a careful balancing act. Taking a cash advance from credit lines or a business credit card should be balanced against cash reserves so that emergencies are adequately prepared for but opportunity costs do not rise too high. The use of such credit involves balancing the immediate need for funds with a future plan to pay back that money.
While there is no definite sweet spot, each business owner should take a look at their own circumstances to discover how much of a credit limit they need to make the best of their resources without taking on too much risk.
Do you run a small business? Would you like to adjust or rebalance your ratio of credit to cash or learn about other business financing options? Apply for a no-obligation, 2-minute line of credit offer, send us an email or give us a call at Financing Solutions. Our business lines of credit involve no setup or maintenance fees and usually don’t require any personal guarantees or collateral.