When Avoiding Debt Is the Losing Strategy

by Philip Brewer on 21 May 2012 6 comments
Photo: Wonderlane

I must have written a dozen articles about the dangers of debt, but there are circumstances where taking on debt is the winning move. Here's an analysis.

Borrowing for consumption is almost always bad. (I say "almost" only to allow for cases where you're borrowing for necessities like life-saving medical care.)

Borrowing for investment is another matter altogether. In a growing economy, refusing to use debt to grow can cost you your business.

Here's an example. (See also: Good Debt, Bad Debt)

Debt-Free Growth

Suppose you have $20,000 in capital and want to open a coffee shop. You get a lease on a storefront, buy a machine to make espresso and cappuccino, order supplies, hire a few employees, and open for business.

Let's further suppose that your business is a success. Right from the start you earn enough money to pay your rent, utilities, taxes, suppliers, employees — and have enough left over to support yourself. In fact, let's suppose you're making a little more than that.

Finally, let's suppose that you figure your town can support four, maybe five coffee shops, and that you start putting aside that little surplus you're earning with an eye toward expanding just as soon as you've saved another $20,000.

That's a reasonable-sounding strategy. But it's a losing strategy if you're up against someone who's willing to take on a little more risk.

Debt-Fueled Growth

Suppose there's another guy in town with $20,000 in capital, and that he also thinks there's room for four, maybe five coffee shops. But let's suppose this guy takes his $20,000 and goes to the bank and borrows another $80,000. Then he takes the $100,000 and opens five coffee shops.

If you're both right about the number of coffee shops the town can support, his shops may well be successes right from the start too. Like you, he can pay all his expenses. But whereas you're only taking home a little more than you need to support yourself, he's taking home five times that.

Now, granted, he's going to have to pay interest on his debt. But how much is that going to be? Right now, no more than 7% or 8% — call it $6,000 a year in interest. Even after paying his banker, he's still making a lot more than four times as much as you.

Now, this may all seem okay. I mean, he's making almost five times what you're making, but he's taking on a lot of risk, plus he's working five times as hard as you. You may figure he's earning every penny, and be pretty glad that you're not in his shoes.

Except for one thing — you both figured that there's only room for four or five coffee shops, and now there are six.

You can expect competition to get pretty fierce.

Advantage: The Debt-Fueled Guy

The problem is, the other guy can compete a lot more fiercely than you. You've got a little money to compete with — that surplus you were hoping would let you save up to open another coffee shop. You could spend that money on advertising, or you could cut prices until they ate into your profits by that much. After that, any further fall in your profits cuts directly into your standard of living.

Your competitor can cut his profits by 80% and still have enough support himself.

Your competitor has other advantages as well. He does five times as much business with his suppliers as you, so he may well be able to get bulk discounts that you can't. As a larger business that employs five times as many people, he may get extra consideration from the city council when it comes to regulations that affect the business — rules about putting tables out on the sidewalk or having live music or how the dumpsters are arranged.

The Role of Risk

Now, it's true that the other guy has taken on a lot of risk.

In particular, if you're both wrong, and the town really only has room for two coffee shops, he's probably screwed. He's got five coffee shops, and they're all losing money. Your coffee shop is losing money as well, but you don't have any debt. If you can find some way to bring a little money in — maybe getting a part-time job — you can keep your shop open for a good long while. Your competitor has no hope — he can't get a part-time job, because he's running five stores and has no spare time, plus he's got those interest payments on top of everything else.

But there's always risk in running a small business. Any of a thousand things could go wrong.

If you're a risk minimizer like me, you might be surprised to learn that one thing that could go wrong is that you're not willing to take on a bit of debt, if that's what it takes to get big enough to compete.

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Guest's picture

Like in many areas, the bigger the risk the bigger the reward is a gamble you need to think about. Those who are bold and brave enough to take a big risk will either fail hard, or be very successful- but either way they took a chance and did the best they could. A lot of this seems like it would only be plausible if you yourself were the only one to consider in the decision-making process. If one has a family, a wife and kids, the decision process may have a little more weight to it- if you are in debt alone, you only have to worry about yourself, however if you make a big risk like this and become engulfed in debt, your family could suffer as well.

Kentin Waits's picture

Great article. It might even be better to be the little guy who is totally satisfied with his single coffee shop and the modest take-home income from it. No debt, no expansion risk, decent income.

Philip Brewer's picture

I'm sure it's great to be the little guy who's happy with his lot—except when someone with a bunch of capital behind him decides to take over the space.

For example, look what happened to little bookstores when the big-box bookstores moved into town. Granted, a lot of that was Amazon and the internet totally transforming the business model, but part of it was just the inevitable consequence of the small guy trying to compete with someone who is willing to go big, and has access to cheap borrowed money.

Guest's picture
Christopher Ortega

Wrong! This mentality is EXACTLY why the country hit the last recession. The formula is simple; provide the services your customer needs and add more value than your customer. In the end, your customers will reward you with prosperity and growth.

By the way, this formula approach has worked for me personally and, as a financial consultant, for the business customers I have served.

The plan outlined in this article is basically the outline to every "get rich quick" quick business plan I have seen.

Philip Brewer's picture

So the town you live in still has little bookstores and a little hardware store and a thriving commercial downtown with clothing stores, shoe stores and the like?

You're lucky. In most of the country, those businesses have been crushed by big corporate firms that use their access to cheap credit to take over the whole space that used to be occupied by small local businesses.

All those small firms tried your strategy of providing what their customers wanted and adding value. Some did better than others, but even the ones that did so very well ended up getting crushed—because it turns out that providing the lowest price is the killer app for businesses. And it turns out that cheap credit (together with the scale that it enables) is the key to providing the lowest price.

Guest's picture

Love this article!

I have always read about wealthy individuals who take on debt in order to invest the money or use it for an incoming producing result. Instead of paying $95,000 outright for a new luxury automobile, wealthy people will make payments on the car (getting a good annual percentage rate also) and use the 80 or 90 thousand dollars they would have used on the car for investment or income producing purposes. Quite a different perspective than most low to middle class consumers might think.