Early in the life of your home-based business, financing its growth primarily will happen through the reinvestment of profits into operations. Only after building sufficient cash flow and an excellent reputation will you be able to approach the bank for traditional loans. That is, of course, if you even want to. Many successful companies of all sizes have stayed in business for years without borrowing a single dime. Debt can be an incredible burden.
According to a December 2006 American Express survey, almost half of small-business owners planned to use reinvested profits to grow their business. The next highest answer, at 20 percent, was borrowing funds from a traditional bank. So who is right? That depends on how good you are at reinvesting the funds. What type of return can you expect on your investment in the business? What could you earn with those same funds in the stock market or in a real estate investment?
The Standard and Poor's 500's average annual return between 1980 and 2005 was 10.2 percent, while home prices in New York and San Francisco (two of the country's biggest increases) over the same period were up almost 7 percent. Over an even longer period, the annual returns of both stocks and real estate drop by two or three percentage points. Let's assume you can earn 7 percent annually investing in stocks. On a $20,000 investment, that'll produce $1,400 in pretax income. What could your business return be on that same investment? It depends on the margins. Being conservative, we'll say profits before tax are 5 percent of sales. To earn an equal $1,400, the business must generate $28,000 in new revenue. The question becomes can the business spend $20,000 to produce $28,000 in additional sales? In most cases, the answer should be yes.
However, another option is to use debt instead of reinvesting the profits. The typical bank loan, with collateral, might be 7 or 8 percent. To cover interest payments, again assuming a 5 percent pretax margin, you would need to produce at least $56,000 in sales to justify adding $20,000 in debt. It's common for publicly traded companies on the S&P 500 to leverage their debt to more than 100 percent of shareholder equity. In fact, 133 of the 500 companies in the index do just that, with seven loading up debt more than 10 times shareholder equity.
It's probably not wise to leverage your home-based business to this extent, but it certainly illustrates that debt is an acceptable form of corporate financing today. A compromise may be to reinvest some of the profits in the business and put the rest into other assets like stocks and real estate. Diversification is always a sensible idea.