Did you know that not all debt is the same? Although there are many loan and financing options in the marketplace, knowing when and where to use certain types of debt will determine your overall success in life.
Debt can be broken down into many categories, but on the whole there are two main types of debt – long term debt and short term debt. We all recognise that a home loan is a form of long term debt, while our credit cards represent short term debt. Just like you wouldn’t use a home loan buy groceries nor a credit card to purchase a house, the same logic applies to debt used for business and wealth creation.
Before we look at the differences between the debts (and how to best utilise them), we need to understand that we all have our own ability to service our debt. What does this mean? It means that, depending on our incomes and expenses, there is a limit to the amount of debt we can service, irrespective of the size of security offered for the debt. So, for those debts requiring some form of security, you can only borrow so much – it’s not unlimited. This is key in understanding when and how to utilise debts.
Long term debt typically takes the form of a loan, be it for property, equipment, or other large investments. Long term debt is often secured, meaning that there is a limit to the amount of debt that you can access. Because we each have a limited supply of long term debt, it needs to be applied to a long term strategy, such as investing in income producing property, large capital purchases (for example our own home), or other investment that will either appreciate in value over time or provide a constant income stream for its lifetime. By utilising long term debt for these purposes, you will maximise your return on your borrowing capacity.
Short term debt can be secured or unsecured – an overdraft is a form of short term debt that consumes security (which may impact on your long term debt borrowing capacity), while invoice financing is a form of short term debt that does not impact your borrowing capacity. Short term debt is often more expensive than long term debt, but it does have a very useful purpose in wealth creation. Because short term debt is used “as and when needed”, it is best used to finance short term cash flow gaps in business – for example wages payments, tax debts, materials costs, etc. These costs do not add long term return to your business and often your business has the profitability to pay for these expenses but you need to manage cash flows to be able to pay these debts on time.
So how do you know which form of debt you should be using? If your aim is to maximise your long term wealth, then you need to be applying long term debt to long term investments and short term debt to short term cash flow gaps. Consuming security and/or debt serviceability for short term cash flow gaps is very poor business finance – anyone advising you to trade your long term wealth for short term cash flow management isn’t providing good advice.
Invoice financing is a quick and easy form of short term business finance, perfectly suited to manage cash flow gaps. Often a business’s debtor book is its largest asset, so using your debtors to manage business cash flows is properly structured business finance. But, be warned, the invoice financing industry is unregulated, so it’s very much a case of “buyer beware” – in 95% of cases it is not the cost of a facility that is most important, what is most important is to have complete control of the facility, to be able to use it as and when you need to. When it comes to providing an industry leading facility and service, Capitalise Business Finance is an industry leader – just ask our clients! We recently score over +77% Net Promoter Score, validating our claim that our finance facilities and service levels are unrivalled.