A debt brings significant cash flow in the present in return for an obligation to pay it back in the future with interest. Many small business owners have a misconception that debt is bad, as defaulting on debt can have dire consequences. While living a debt-free life can be liberating, a well-managed debt and financial structure has benefits your business may be missing out on. As a small business owner, you can use debt to grow your business, reduce taxes, and generate wealth. You need to understand how debt works and make it work for you. This article will discuss instances where debt can be your friend and how to manage it.
Why and When Small Business Owners Use Debt?
A business needs funding to grow. As a business owner, you have put in your money to get where you are. Now the business has started churning money and is bringing working cash flow. But you may need external funding for a major order, equipment, or land. The first choice of external funding is debt because it is cheaper than equity.
In debt, your maturity and interest rate is pre-determined. You know your capital cost and income above that is business profit. In equity, you give a share of the profit if the person holds the equity. Hence, it is recommended to take the debt route to acquire income-producing assets like equipment or property. And when the venture is risky with no guarantee of the likely outcome, take the equity route.
When you take debt, you prepare all necessary documents, including financial statements, business plans, and projections. Financial institutions scrutinize your documents to see the potential of the business to generate income before approving a loan. It gives you and your suppliers confidence that your business can attract funding. Debt also brings financial discipline into business as you make regular payments.
There are various types of debt like bank loans, overdrafts, credit cards, and third-party loans. Each debt has a different interest rate, tenure, collateral, and tax treatment. If you understand the working of debt and plan your debt structure and repayments well, the debt can pay for itself. Here’s how.
How Can Small Business Owners Create Wealth Using Debt?
Debt gives you cash flow today. If you use this cash flow to build wealth by acquiring an investment property that can generate income through rent, the rental income can pay partly for the debt. Moreover, interest on such loans is tax deductible. You enjoy tax benefits and rental income while creating an asset under your business.
If you choose your debt wisely, it can create business opportunities and wealth. Avoid using debt for recreational activities or other non-income-generating activities. And even if you use a business credit card, repay the entire amount to avoid falling into the debt spiral. Such debt carries high interest and has no tax advantage.
Tips to Plan Debt Repayments
The CRA allows you to deduct interest payments on certain types of business loans. When planning your debt repayments, categorize your debt based on the interest rate and tax advantage and prioritize the repayments in the following order:
- Make it a priority to repay the high-interest debt that is not tax-deductible, like credit cards and personal loans. You may pay way more than what you get.
- The second priority should be low-interest debt that is not tax-deductible, like secured loans and mortgages on the principal home where you stay. Even though they carry low interest rates, you are better off paying this debt as there is no tax benefit.
- Once you have repaid the debt with no tax benefits, you may consider repaying tax-deductible high-interest loans, like loans to purchase investments or student loans from the government. A tax deduction can bring significant savings if you fall under a higher tax bracket.
- The best forms of debt are low-interest loans that are tax-deductible, like mortgages for investment properties or business loans. So if your business tax rate is 20% and your loan interest is 5%, the tax deduction reduces your loan interest rate to 4% (20% of 5% = 4%).
A Common Mistake Small Business Owners Make When Repaying Debt
The above order of debt repayment priority will bring significant interest and tax savings. But there is another angle to debt repayments. The above order includes both business and personal loans. A common mistake business owners make is withdrawing a significant amount from business to repay a tax-deductible personal loan.
For instance, John annually withdraws $99,000 from his business, which puts him in the 20.5% tax bracket. This year he withdrew an additional $60,000 to repay his tax-deductible student loan. The CRA will add this $60,000 to John’s personal income, putting him under the 29% tax bracket. As he repaid his student loan, he can no longer deduct the interest from his taxable income. But there could be a situation where John would be better off paying his student loan.
Your debt strategies change as per the situation. A well-qualified CFO can plan financing strategies considering the cost of capital, tax benefits, and ease of funding best suited for your business requirements.
Contact Edelkoort Smethurst CPAs LLP in Burlington for Professional CFO Services
A skilled CFO can help you plan your finance and debt structure in the most tax-efficient manner. At Edelkoort Smethurst CPAs LLP, our expert consultants and CFOs can provide services to support your funding and optimization requirements. To learn more about how the professional team at Edelkoort Smethurst CPAs LLP can assist you with CFO services, contact us online or by telephone at 905-517-2297.