To Borrow or Not to Borrow? That is the Question.
on August 16, 2016 No comments
Recent economic events and the passage of health care reform have added an unprecedented uncertainty in the life of a private practice owner. Higher costs and lower reimbursements are the order of the day and this environment forces the clinic owner to manage his financial affairs more efficiently than ever before.
Every business owner is faced with the challenge of profitability. And to be profitable, many private practice owners look to the use of debt to expand and cover the expenses of their practice, not to mention personal lifestyle choices. In fact, borrowing money may be necessary to purchase certain assets because we may not have the cash available for the acquisition.
But when should we maintain debt versus accelerating the payoff of these assets?
The fundamental principle in borrowing money is that the interest and other costs of obtaining the loan are less than the value that is created by borrowing the money. This is simple and easy to understand, but doesn’t always happen.
For example, if a practice owner has borrowed money, then that money was used to purchase something related to the operation of the clinic. It could have been equipment or marketing campaign costs. But if the equipment is not being used to capacity or the marketing campaign did not produce an abundance of new patients, then the value did not outpace the cost of the loan by an optimal margin.
You see, the goal is to get the greatest rate of return with the lowest cost so profits are maximized.
To guide you in the profitable use of credit, there are three factors that determine when and how a person should borrow money. They are income, appreciation, and tax benefits.
- Income – Money should really be only borrowed against assets that produce an income. Commercial and investment real estate and other business operations produce income since the asset is used to provide a valuable service to another for money. This income can then be used to service the debt owed on the asset. Personal assets such as primary residences, cars, and personal lines of credit do not produce income.
- Appreciation – One may borrow money against assets that would, over the long-term, appreciate in value. Even if the use of the asset did not provide enough income to pay off the debt, the eventual sale of the asset would be at a higher value in the future so the debt could be retired upon sale. Commercial and investment real estate have the potential for appreciation as well as businesses as they grow in value through expansion. Primary residences may or may not appreciate in value. Consumable assets such as cars, boats, and personal credit lines do not appreciate but decline in value.
- Tax Benefits – The government will pass laws that allow certain types of indebtedness to have preferential treatment in the tax code. When you borrow money for business purposes, the interest and other costs may be tax-deductible. In addition, depreciation on certain business assets, like equipment and property, can effectively lower the cost of borrowing by lowering taxes due.
When determining whether to maintain debt or not, you will have the greatest chance of profit if ALL 3 factors exist in the borrowing decision. If the debt is against an asset that has all 3 factors, maintain the debt. If you have less than all 3 factors, pay it off quickly.
You want to have as much space as possible between the cost of the loan and the return generated from the loan proceeds. If you buy assets that appreciate in value, provide income and tax advantages, then you maximize the distance between the cost of borrowing and the net returns generated from the use of that money.
This method allows you to create a financial cushion between your monthly debt service requirements and the uncertainty of income and expenses due to changes in health care reform and the effects of adverse economic events on your practice.
When asking the question “To borrow or not to borrow?” Remember these 3 factors and you will be fine.
- Christopher Music, MBA, RFC
Wealth Advisory Associates
601 Cleveland Street, Suite 501
Clearwater, FL 33755