It turns out that finance is easy- as long as you remember two rules that every great financier lives by: You always want the highest rate of return that makes sense for your investments, balanced against the risk. And, you want to eliminate the highest interest rate of your debt at all times.
How do these principles play out in both business and personal finance?
In a business context, let's say we have $2 million to spend on projects inside the business. We also have $6 million worth of potential projects to choose from. How do we decide which ones to invest in? The straightforward way is to look at the potential rate of return you will get on each project measured against the potential risk of the project. Once you have those calculations, the decision is easy: you want to invest in the projects with the highest rate of return that also have the lowest risk. It is normal that higher rates of return have higher risks, so you will want to balance these two factors.
The other side of the business equation is interest rates on any debt the business holds. I've written before about the sources of capital for your business and the costs associated with them. Your first option should also be to land structured debt, where you borrow against the assets in your business, because interest rates are lower. Your next option is unstructured debt, but you'll pay higher interest rates.
In most established businesses, there is always a trade off in terms of paying down your debt and investing in projects. That's because you can typically earn a 15-20% return on money by terms of growing profits or reducing costs. If this money costs you 7%, it's a great deal. You'll make 8 to 13% more on the project than the money costs. No arbitrage is perfect. There is almost always a risk that the return won't be generated and the cost of the money is a guarantee.
One case where it can make sense to pay down the debt you have, even if you have some great projects available, is if you're close to violating the covenants you have with your bank. That's when the bank might come in and "help" you run your business or, worse, throw you in a "work out." If you risk losing that freedom of control with your business, it can be worth paying down your debt.
Another case involves the story about the entrepreneur who starts a business with a credit card and later sells the business for millions of dollars. That can be an option, especially if you can't get access to money from a bank or from friends and family. But borrowing on a credit card means paying upward of 18% interest-;which means you are betting on making a high rate of return on your business, somewhere between 25%-40% or more, to justify that expense. This is where you need to be careful. No matter what your spreadsheet might say, if you mess up, that debt is now on you and you won't have a business to help you out. If you do end up taking out money on a credit card, you may want to find a way to pay it down as quickly as you can.
This lesson also applies to your personal life. I was recently talking to a young man I mentor who is smart and well educated. He told me he had some extra money and he wanted some advice about what he should do with it. I then asked him a few questions, including whether he had any credit card debt. It turns out he had a significant amount of debt he wasn't paying off every month. I recognize that this applies to a lot of people. But if you have some extra money, you should consider using it to pay down that debt that's costing you 18% interest as opposed to trying to find an investment that might pay you 6% to 10%. We call that negative arbitrage and it is a very bad thing! After all, getting rid of that debt is the same as getting an 18% return on your money. So the advice I gave this young man was an order of attack:
1. Pay down the credit card to a $0 balance.
2. Then build a nest egg of 2-3 months of his salary to help build a cushion in case of unexpected expenses like a broken fridge or car so you don't have to go back into debt.
3. Then think about potential investments with any leftover money he might have.
The point is that you should be thinking about interest rates and finance the same way the greatest financiers do: Always invest at the highest rate of return that makes sense for your investments and eliminate the highest interest rate of your debt at all times.
You can find Jim at www.IncCEOProject.com