Welcome to Thriver’s short reads about investing in SME debt and how the SME debt market works. You’ll read them faster than you finish your cup of coffee.
Borrowing by SMEs represents $400 billion in debt that is growing at 6% a year. There are 170,000 SMEs who have at least $2 million in revenue and need money to grow further.
Last time, we looked at why SME owners prefer to borrow debt rather than source equity. In simple terms, they don’t give up ownership, they retain decision-making control and debt is more readily available than equity.
The other important impact of debt is its effect on an SME’s profitability. There are a couple of elements to this. Firstly, when you have debt, you pay interest, fees and costs. Those payments are typically tax deductible. The deduction provides a partial shield against tax on earnings. In an SME, the impact of that shield is usually ‘nice to have’ rather than transformative.
The more significant impact is how debt improves an SME owner’s return on their business investment, compared to equity investment and funding everything themselves.
Let’s run through a quick example.
A business needs $100 of investment to generate $10 in profit. If the SME owner invests that $100, the return on their investment is 10% ($10/$100).
If the owner invests $80 and borrows $20 of debt, their return increases to 12.5% ($10/$80). That is a 25% increase in their return. There are few decisions a business owner can make that increase return by 25%.
If the owner invests $80 and an equity investor $20, the equity investor gets their 20% share of the profit ($2) and the owner’s return goes back to 10% ($8/$80).
That’s basic analysis but you get the picture: the business owner can use debt to massively increase the profitability of their business investment AND have $20 to invest elsewhere.
Of course, the example relies on the SME owner using debt that is appropriate for their business and cost effective such that it doesn’t eat into the $10 profit. This is Thriver’s space. We provide innovative, well-thought-out solutions with quick turnaround for funding needs of $250,000 to $1 million. We understand how the right debt solution can meaningfully impact on the owners of SMEs.
Next time, we’ll look at the importance of return of capital.