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Grow your business responsibly

In this post-credit-crunch world, borrowing has almost become a dirty word, but borrowing to grow your business can still be an effective strategy.

With the headlines full of gloom, small business owners could be forgiven for lying low and taking as little risk as possible. Yet there are also good arguments for growing your business during a downturn.

Tougher economic conditions have one beneficial side effect: they tend to clear the dead wood from the market place. Marginal operators who might have scraped by when everyone was spending suddenly find themselves in trouble.

Meanwhile, well-run businesses can prosper and even grow. As billionaire investor Warren Buffett once quipped: “It’s only when the tide goes out that you learn who’s been swimming naked.”

The other big plus in a weaker economy is the big decline in interest rates. Residentially secured business loans are currently available for rates of 6% pa or less – so if you need money to expand, borrowing is more affordable than it’s been in a while.

Recently, there’s been a lot of talk about the dangers of being too highly geared, and rightly so. But that doesn’t mean we should forget the benefits of gearing. Used responsibly, a geared investment in your business has the potential to multiply your profits. Here’s a simple example to show how it works.

Case study: Getting into gear

Paul owns a laundromat and dry cleaning business in a popular beachside suburb. Surrounded by backpackers, students and rental accommodation, his business is booming – after all, people still have to wash their clothes, whatever the economic weather. Here are some high-level numbers that reveal how Paul is doing:

Paul’s investment$240,000
Sales$600,000
Netprofit$90,000
Tax$27,000
Profitafter tax$63,000
Returnon Paul’s investment26%

He’s invested $240,000 of his own money in the business, with no borrowings. On sales of $600,000, he’s making a net profit of $90,000, giving him a net profit margin of 15% ($90,000/$600,000). After 30% tax, he’s making a profit of $63,000, which gives him a return of 26% on his $240,000 investment. Not bad.

Now imagine that Paul has the chance to open a second laundromat in a nearby suburb, provided he can find the money for a new batch of washers and dryers. So he borrows another $240,000 at an interest rate of 6%. We’ll assume his new outlet is just as successful as his old one and that his sales and earnings double as a result. Here’s how the numbers stack up:

 Before borrowingAfterborrowing
Paul’sinvestment$240,000$240,000
Paul’sborrowings$0$240,000
Totalinvestment$240,000$480,000
Sales$600,000$1,200,000
Earningsbefore interest$90,000$180,000
Interestcosts (at 6% pa)$0($14,400)
Earningsafter interest$90,000$165,600
Tax$27,000$49,680
After-taxprofit$63,000$115,920
Returnon Paul’s investment26%48%

By doubling the size of his business, Paul has doubled his turnover and his net profit. Even after making repayments on his loan, that puts him well ahead. And Paul has still only got $240,000 of his own money tied up in the business, so the percentage return he’s earning on his personal investment is suddenly much greater – 48% rather than 26%.

The business tax break

But it doesn’t end there. One of the benefits of borrowing to invest in your business is that it can be very tax effective, making Paul’s strategy even more attractive.

We’ve already deducted Paul’s interest costs from his taxable income, but there are two more potential deductions to be accounted for. The first is depreciation; the second is the Federal Government’s proposed business tax break, announced as part of the recent stimulus package.

The details of the new tax break are complex, but it is intended to give small businesses with an annual turnover of up to $2m an extra 30% tax deduction for new, depreciable assets costing more than $1000 and bought before 30 June 2009 (now extended to the end of 2009). Different rules apply to larger businesses and assets bought later in the year. (At the time of writing, the measure had yet to pass through parliament, so check with your accountant for more information.)

We’ll assume that half of Paul’s borrowings are spent on depreciable assets and that he can claim depreciation at an average rate of 15% in the first year:

Depreciation(at 15% of $120,000)$18,000
Investmentallowance (30% of $120,000)$36,000
Total$54,000
Taxbenefit (30% of $54,000)$16,200

The amazing thing is, the tax benefits in the first year actually outweigh Paul’s interest costs of $14,400.

Words of warning

As this example suggests, borrowing for business growth can be a powerful strategy – but it has to be used with great caution.

Gearing multiplies your profits when you’re successful, but it also multiplies your losses if you fail, which is why highly geared businesses can collapse so rapidly when sales drop. (There have been plenty of examples of that in the media recently!) Be very confident you’re going to succeed before you sign that loan agreement.

It’s also essential to get detailed advice from your accountant or taxation adviser. Tax law is complex and everyone’s situation is different, so you need to thoroughly understand how it applies to your situation.

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Tips for effective borrowing

  • Only borrow to invest in assets that will directly generate sales.
  • Match the life of a loan to the life of the asset you’re buying, so that the asset can pay for itself out of the extra revenue it produces.
  • Ask your accountant about the new business tax break. If it applies to you, consider bringing asset purchases forward before 30 June 2009 to take advantage of it.
  • Consider options like hire purchase or operating lease arrangements. While they usually have a higher interest rate than a residentially secured loan, they can also be more flexible and tax effective.
  • Think carefully about the collateral you’ll put up for your loan. A residentially secured loan will have a lower interest rate – but you could be putting your home at risk.
  • Talk to your accountant and your business banker. They can help you understand the potential risks and benefits, and craft a strategy tailored to your business.

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