Personal v. Business - Understanding Credit Usage

I’m going to make an assumption about my reading audience here, but just in case, please answer the following question:

-?????????Do you personally live within your financial means?

If yes, then you will appreciate this discussion, and I won’t have to spend much time going over personal finances. However, if you answered no, then you will need to start from the beginning and understand the flaws in using credit beyond your means of repayment. Come back when you’re ready!

Now, moving on to our subject.??????????

As a business banker, I have the joy of working with entrepreneurs who are looking to grow their young businesses. They have survived the initial 18-month hurdle, are profitable, and see a path for growth. For many of these Small Business Owners, they adhere to a strict personal budget to run their lives. They are adverse to debt, rarely use their credit cards, live within their means, and put money away into savings.

Great, this is what I like to see. I live my life like this, and strongly encourage this mindset when it comes to personal finances.

But, this isn’t the best way for them to approach their business finances. In fact, properly using credit can be a huge driver for business growth. This is something they struggle with at times, for various reasons.

I want to share with you the same lessons and examples I share with them. First, we will dissect the difference between individual and business cash flows, and secondly we will dive into the business operating cycle to get a better understanding of where credit can properly be used to drive continued growth.

The Personal Side

In this section, I am talking about every single American who earns a paycheck, and then uses that paycheck to pay for services for which they do not anticipate to see any financial return. This group includes hourly associates, sales reps, and even business owners. When I talk about personal finances, I am talking about living expenses that you do not make a profit from, and which the use of credit to pay for these expenses would not help in producing more income.

For this example, let’s look at a 9:00 – 5:00 worker making $60,000 per year after taxes, or $5,000 per month. Let’s say they spend $3,500 on all their monthly expenses (rent, utilities, insurance, etc.), and then they also spend $1,000 every month with their credit card (going out to eat, gifts, shopping, etc.).

They use the remaining $500 dollars from their paycheck to pay towards their credit card monthly statement.

Everything is good, for a couple months at least. Then, the obvious happens. Not only do they eventually max out their credit limit, but the $500 payment only covers the interest on the card, resulting in no progress ever being made toward paying down the balance.

Hopefully this isn’t an exact description of you the reader, but it’s an easy example that works great to illustrate my point.

Bottom line, credit and debt used to cover your expenses above your income level will ultimately lead to financial chaos.

Now, there are techniques and methods for the successful use of credit in personal finances, but those techniques will never enable you to spend more than you make month after month. So, stick with my mantra, try to avoid credit usage when it comes to personal finances and funding your monthly budget!

The Business Side

**Spoiler alert, I’m about to say credit usage can be very helpful for a growing business**

Credit is a great tool to help Businesses grow. So where does the difference come from?

It all stems from the basic concept of a business – use money to improve an object or service, then sell that new product for more money to make a profit.

That one sentence is at the core of every business, and it is where the credit usage conversation originates.

In my business example, let’s explore a company that buys trees to make plywood boards. Our company opens and the owner takes out a loan of $50,000 to make a purchase of $50,000 worth of raw cut trees. Then, they spend another $10,000 turning those trees into sheets of plywood. Once all the plywood is made, they are then able to sell it all to a Home Improvement store for $100,000. At the end of the day, they made $40,000! That is a great success for them, and they want to do their operating cycle again. The owner is happy, and vows to never use credit again to purchase raw materials.

And this is where the credit conversation really makes sense. Let’s say they take their $40,000 profit and fully invest it back into buying more raw material. They purchase $40,000 worth of raw cut trees, spend $8,000 turning those tress into sheets of plywood, and then they sell them all for $80,000. They have made a profit of $72,000. Run this scenario again and they will be sitting at $129,600 profit!

Not bad at all. But what if they had continued to use credit along with their profits to continue their growth?

Let’s go back to when they had just sold their first load of plywood and made $40,000 in profit. Now, they take out another $50,000 loan and are able to purchase $90,000 worth of raw cut trees. Run this scenario twice (just like the previous version), and the company will have made $241,600 in profit!

By properly using credit, this timber company was able to make $112,000 more in the same number of operating cycles than they made by just reinvesting their own profits back into their raw materials.

The Difference

Again, the real difference comes down to the basic fundamentals of individual finances and business finances.

Individual = spending money with no anticipation of seeing a return; Business = spending money to improve an item or service to then selling it for more money.

Credit only helps to boost growth in a business application. Credit used in personal finances to cover monthly expenses will ultimately lead to more money being spent with no increase in incoming cash flows.

*Note, there are many examples of credit being properly used for personal reasons, auto loans and mortgages are great examples. Use these types of credit loans to make larger purchases when you don’t have the excess money to pay in cash (then adjust your monthly budget to account for the recurring monthly debt payments).

If you are a business owner, or young entrepreneur, I hope this conversation sparked some ideas and helped improve the way you view business finances.

• Credit can fuel growth
• Fast growth can create a borrowing need
• Even profitable companies can fail if the operating and cash cycles aren't managed properly

Again, this was a very basic example used to simply illustrate the benefits of using credit in business application. Every business is different, and it is possible to bite off more than you can chew financially. Talk with a trusted resource before making any financial decisions. Be smart with your money, and learn to use credit to fuel your continued growth.