‘How much must I borrow to start a business?’
Question: I have been working for a good number of years and have come to realize that most of my retirement will have to be funded by me and not my employer or the government. As a consequence, I am now planning on setting up my own business that I hope will be the source of my retirement income. I know that I should not set up a business upon retirement as doing so may already be too late. I also agree that I should start small but think big. But because I don’t exactly have overflowing cash, I think I would need to borrow money. Up to how much of the needed start-up capital do you think I should borrow? Is it also wise to get a loan against my house and use the proceeds as the initial capital for my business?—Retirement-conscious employee
Answer: A great many of the training participants at ourEnRich©training runs have the same aspiration—to run their own business. And perhaps an equal number of them have the same dilemma—how to fund the business given limited resources.
While there is always the option of getting equity partners, the idea does not readily fly with entrepreneur wannabes who want the business all to themselves. After all, they are trying to migrate from a situation of being employees to being owners, with no one else to answer to but themselves. The other option then is to borrow.
There is a financial ratio called equity multiplier that is fairly simple to compute. It is computed as Total Assets ÷ Total (Stockholders’) Equity. It is a measure of how much a company is using debt to finance asset holdings. Now before you get lost or doze off, consider the following:
Total Assets = P1,000,000
Total Equity = P500,000
If we were to compute for the equity multiplier for the above data, the answer would be P1,000,000 ÷ P500,000 or 2 times. This means that the company is able to use debt to “double” the power of its own equity to hold on to assets worth P1,000,000. And since the basic formula for a balance sheet is Assets = Debt + Equity, the more debt you use, given a constant level of assets, the less equity will be needed. And the less equity is used, the larger will be the equity multiplier.
To demonstrate this, assume Total Assets at P1,000,000, but this time around, Total Equity stands at P200,000. The equity multiplier comes to 5 times (i.e., P1,000,000 200,000).
In fact, if you had used only debt for financing assets, your equity multiplier would be “undefined” as you would be dividing your Total Assets by zero.
Debt is a great way to increase your business’ growth. But there is potential risk in using debt.
If you were to finance your business with debt, that means part of your cash flow will have to go to paying interest on the debt and repaying the loan principal. Further, while interest expense is reflected in the income statement, it is booked as non-operating expense. This means that part of your net operating profit has to be shared with creditors. And that doesn’t even count the principal you have to repay. In effect, it is like you took on partners. The only difference is that, this time, they demand a fixed return on their money.
Now let’s push it again to the extreme. If you finance your business entirely with debt, you could end up working for your creditors if most of your cash flow goes to just paying interest and repaying the loan principal. Is not this contrary to your original goal of being your own boss?
The exact mix of financing between debt and equity will have to depend on a lot of things including the nature of the business, the cost of debt as well as the cost of equity. Do not follow any rule of thumb as this might get you into trouble.
But if there is anything that you should do, particularly with starting up a business, it is to start using more of your own money. This way, you can allow more of the earnings to be reinvested in the business to make it grow all the more. Debt is good. But debt can mean financial death to those who abuse it.
As to using your house as collateral for the loan, be very careful. This is your home you are talking about. If your business goes belly up, the prospect of you losing your home shoots up. While you cannot be 100 percent sure that your business will fly, you must at least put into place ways to minimize the risk. I will tackle some of the ways to do so in another article.
In the meantime, if you want to know more about effective cash, debt, risk and wealth (CD-RW) management, come and attend the EnRich©CD-RW personal finance training now scheduled for October 18. You may also want to ask your employer to integrate personal finance training into your company’s employee benefits. Invite your company’s employee relations manager to attend the EnRich©CD-RW personal finance training as well. There are limited free seats allocated for HR practitioners. Visit www.personalfinance.ph, e-mail email@example.com or call (632) 216-1541/(632) 359-3094 for more details.
(Efren Ll. Cruz is a registered financial planner of RFP Philippines, personal finance coach, seasoned investment adviser and bestselling author. Questions about the article may be sent by SMS to 0917-505-0709 or e-mailed to firstname.lastname@example.org. To learn more about the RFP program, visit www.rfp.ph or e-mail email@example.com.)