What's the Best Use of Your Borrowing Power?

I just talked to a business owner the other day who has grown her startup nicely - 15% a year or so - up to revenue of a bit over $2.5MM.  Now, (in the service business,) the venture is at the point where she could accelerate its growth.   Through managing expenses and getting paid for  added value, the business has some positive cash flow.  This "borrowing power" can be used to generate cash - once.  But that cash has to be used to grow cash flow faster - much faster - than the payments due to the bank. 

Obviously.

New equipment?  Expanded service force?  New salespeople?  Nope.

She wants to triple her current occupancy costs and build a new building.  There may be some efficiencies to be gained, but at a huge cost.  If the company is 15% EBIT, Every $1 in new debt obligations has to be supported by $6.60 in new revenue.  If occupancy costs, as an example, go from $45,000 to $135,000, that's almost $600,000 in new sales - just to stay even with the business as it is today.  (On revenue of $2.5MM, that's a 24% increase just to pay the bank.)

Is this really the best use of the business's borrowing power? 

Comments

[Andy Black]

I think there may be more to this situation than is presented. I would assume (carefully) that the entrprenuer has a need for the new building becasue of current capacity issues. If there current capacity is limiting their growth then this investment in capital could be worth it. I would hope that if she plans to triple her occupancy costs, she plans to do the same to revenues. The concern would be what other expenses are associated with an increase in capacity.

[Tim]

Andy, nice to hear from you! Yes, you would of course think that the business would grow. THe issue is that the business will have to grow at a rate far exceeding their historical growth rate. And the argument is, of course, that more space will allow them to do that, albeit no orders are in place today. The big question is that if the business misses the building is a large fixed cost for years to come. Why not rent for a couple of years, prove out the growth model, then build? This eliminates the major part of the risk, but may add some intermediate cost. in my mind a small price to pay...