The old saying of ‘Cash is King’ is true, you always want to ensure you have enough of it (and you need quite a bit when starting a new business). It’s one of the critical decisions entrepreneurs face – whether to use available cash reserves or resort to borrowing.
Both options have their advantages and disadvantages and exploring them will help you make an informed decision.
The first thing to mention is that if you borrow for the business (or for an investment property) then the interest is tax deductible.
Secondly, and probably most critically, is to understand your “cost of capital”. The cost of capital measures the cost that a business incurs to finance its operations. It measures the cost of borrowing money from creditors or raising it from investors through equity financing. Once you determine how much capital is required, you’ll then get a clearer picture of which path to take.
Let’s look at the merits of cash first. Utilising cash provides a sense of financial freedom, and it allows businesses to operate without the burden of debt, while offering flexibility in decision making and reduce the risk associated with repayment obligations.
What’s more, is that using cash means you’ll avoid interest payments, which can affect your cost of capital. Not paying interest will result in significant savings and increased profitability (and who doesn’t want that?)
Having available cash also means that you’ll be able to make some quick financial decisions without having to bother with the processes of borrowing. If there is a time-sensitive opportunity, then cash can take full advantage of it.
A cushion of cash also means there is security in times of economic uncertainty. Making sure you have substantial cash reserves acts as a safety net and acts a buffer from any rough financial situations that arise.
While we’ve spruiked the benefits of cash being king, let’s play devil’s advocate for a minute and look at the drawbacks of cash.
Firstly, there is the notion of missed opportunities, meaning by not leveraging external capital, you may forego projects or expansions that could lead to growth. Also, relying solely on cash might limit liquidity, especially in the case of unexpected expenses or a sudden need for capital.
Now we shall look at borrowing as an avenue. Using other people’s money means you can undertake larger projects or investments without depleting your own cash reserves. It also provides a safety net. Another benefit to borrowing is that it can build a positive credit history for you which will help facilitate more favourable loan terms down the track.
If this is the route that you’ll most likely choose, one must be aware of several factors: the first one is interest payments. Borrowing usually amounts to high-interest rates or unfavourable terms – once you are locked in, they can put a strain on you’re the financial health of your business.
Also repaying borrowed funds requires a consistent cash flow. Before taking on such a large amount, you’ll need to crunch the numbers to work out if you can meet the repayment obligations. Which leads to warning against excessive borrowing. As tempting as it is to secure a large amount, the risk of overleveraging can mean you may struggle to meet the financial commitments.
The decision between using cash and borrowing is not one-size-fits-all; it depends on the unique circumstances and goals of each business. Striking the right balance between cash and borrowing involves careful consideration of factors such as current financial health, growth objectives, and risk tolerance. Whether you choose to rely on cash or external financing, taking the strategic approach is the key to long-term success.