Should you borrow money to get out of debt quicker?

Just writing this out, the question doesn’t really make sense.

But in recent months, several clients have asked me this question, though from the perspective of investing in the business to increase sales. Turned around like this, it almost makes sense. And certainly, worthy of a deeper analysis.

If you are carrying a burdensome amount of debt, you’re likely thinking of ways to dig out of the hole. Increasing sales and cutting back on expenses is rightly top-of-mind. By extension, some farmers consider purchasing equipment or making other investments that can improve efficiencies (and reduce operating expenses) or increase sales. And to do this, they need to borrow more money.

This is where Farmer Ashton found himself. After benefiting from the “covid-bump” in sales, revenues flattened in 2022 and expenses started spiking with inflation. In April 2023, he took out a few operating loans to cover payroll, thinking that the summer sales bump was just around the corner. He lost a few crops due excessive rain and had to buy those in for his CSA (which just added to the losses). By the end of 2023, he acknowledged that sales hadn’t picked up the way he’d expected, and he was now buried in high-interest loans.

As he explored options for a debt consolidation loan, Ashton weighed the option of borrowing an additional $200,000 to improve the farm-stand and build-out a value-added kitchen.

“If a proper efficient farm stand and kitchen will help us get out of debt quicker, I need to assess that.”

Certainly, these investments can offer an opportunity to increase sales and improve efficiencies. But will the investment provide enough additional profits to cover the additional debt service and help pay down the initial debt down more quickly?

Let me give you an example. Let’s say Ashton borrowed the $200,000 to invest in the kitchen and improved farm stand. That’s an additional $50,000-ish in annual debt service (assuming 5-year loan at 8% interest). He would need additional profits (not revenue) of at least $50K just to “breakeven” from the annual payments. Even if the terms were extended to 7 years, it would still be close to $38,000.

We looked through his projections for 2024. His operating profit margin was projected to be 5%. Already baked into that number was his salary, so we were confident his could operate the core business profitably. We used the breakeven formula to calculate the volume of sales need to cover the debt service (recognizing that some of the expenses are fixed and others are variable): We figured out, he would need additional sales of $333,000 just to cover the debt service… and he’d need more than that to pay off the other debt more quickly. That’s a substantial jump over current sales.

It was a reminder that “increased revenue” does not translate to “increased profits.” While it can feel reasonable to increase revenue by $50,000 to cover the debt service, it doesn’t take into account that there are expenses associated with those sales.

Bottom line: if you’re thinking about borrowing money, figure out what amount of profits you need to cover the investment. I offer another example here.

Want to dig deeper?

• If you’re “in the hole” with debt, I encourage you to revisit the Rules of the Hole.
• And how do you avoid getting in the hole in the first place? Make sure you understand your costs, set your prices accordingly, create a cash flow budget that works, and refer back to it on a regular basis to make sure you’re on track.
• My suggestion to Ashton was to focus on improving efficiencies with the current infrastructure. He’s proven that it’s possible to be profitable at his scale and he needs to get back to that. Once he’s on more solid footing with a clear sense of how to operate profitably, he can then consider additional investment.