Every business owner has an opinion on whether it's a good idea to use debt to operate their company. Two prominent figures in the personal finance industry - Dave Ramsey and Robert Kiyosaki - are well known for their reasonable but opposite views. But, which finance guru's advice should small business owners follow? To figure this out, we created two very similar fictional businesses with one key difference: whether the owner used debt to pay for start-up costs.
Dave's Cash-Based Company
Our first business, "Dave's Cash-Based Company," follows Dave Ramsey's advice and only uses cash flows to fund its operations. It has never had any debt. The owner started the company five years ago with $100,000 of personal savings and a lot of elbow grease. Today, the company generates $120,000 per year in revenues and takes home a cash flow profit of $27,200 per year. The company is stable, meaning it isn't expecting any major growth anytime soon, and is expected to see increases in both revenues and expenses at around 3.25% per year (the estimated rate of inflation) from now on.
Robert's Debt-Based Company
Our second business, "Robert's Debt-Based Company," follows Robert Kiyosaki's advice and uses a combination of other people's money and the owner's money to operate. When it opened five years ago, the owner used $20,000 of personal savings to launch the company. The owner also took out an $80,000 loan. The loan was interest-only for the first five years, then switched to principal and interest payments with a ten-year remaining term. Today, the company generates $120,000 per year in revenues and takes home a cash flow profit of $21,000 per year (after interest expenses). This company is also stable and expects to see increases in both revenues and expenses at around 3.25% per year (the estimated rate of inflation) from now on.
Valuation Assumptions
To figure out what each of these businesses is worth, we did a Discounted Cash Flow analysis - a common valuation method - on each of the two companies. Without going into too many of the details, we relied on the following assumptions (which were based on professional experience and valuation standards):
Cost of Equity (Owner's Required Rate of Return): 15.50%
Cost of Debt (Interest Rate): 8.00%
Long-Term Growth Rate (Inflation): 3.25%
Discount for Lack of Marketability: 8.00%
Cash on Hand (Three Months of Overhead Expenses): $12,500
To see how each of these assumptions are used, here's our Discounted Cash Flow Analysis for Dave's Cash-Based Company and Robert's Debt-Based Company.
***You can skip past these images if you don't like long math problems.***
Dave's Cash-Based Company:
Robert's Debt-Based Company
Value of Dave's Cash-Based Company
We calculated the total value of Dave's Cash-Based Company to be $170,000. All of this value belongs to the owner of the company.
Remember, to start this company, the owner put in $100,000 of personal money and used $0 of debt. So,
Owner's Investment = $100,000
Bank's Investment = $0
Value of the Total Company = $170,000
Value of Owner's Investment (After Building the Business) = $170,000
Outstanding Debt = 0
Five-Year Return on Owner's Investment = 70%
Average Annual Return on Investment (CAGR) = 11.20%
To summarize, the business owner started Dave's Cash-Based Company with $100,000, and after five years, their investment grew to be worth $170,000. This equates to an 11.20% annual return.
Value of Robert's Debt-Based Company
We calculated the total value of Robert's Debt-Based Company to be $196,000. Only a part of this value belongs to the owner of the company.
Remember, to start this company, the owner put in $20,000 of personal money and used $80,000 of debt. So,
Owner's Investment = $20,000
Bank's Investment = $80,000
Value of the Total Company = $196,000
Value of Owner's Investment (After Building the Business) = $116,000
Outstanding Debt = $80,000
Five-Year Return on Owner's Investment = 480%
Average Annual Return on Investment (CAGR) = 42.13%
To summarize, the business owner started Dave's Cash-Based Company with only $20,000, and after five years, their investment grew to be worth $116,000. This equates to an 42.13% annual return.
Conclusion: Results Based on the Numbers
Let's compare the two businesses for a moment. The owner of Dave's Cash-Based Business could hypothetically sell their business and walk away with $170,000 (minus selling fees). That's awesome! And, if the owner of Robert's Debt-Based Business sold their business, they could walk away with $116,000 (minus selling fees). This is great news for either business owner!
On the surface, it looks the owner of Dave's has a more valuable investment. After all, the owner of Dave's is looking at $170,000 while the owner of Robert's "only" has $116,000 of value.
But, don't forget that the owner of Dave's put in $100,000 of their savings to start the company. Basically, the owner of Dave's made $70,000 of capital gains over a five year period. This comes out to an average return of 11.20% per year, so the owner of Dave's beat the stock market! (Note: The average annual stock market return is 10%. See Footnote [1].)
In reality, the owner of Robert's made a higher profit and can brag about having the higher overall return on investment. Remember, the owner of Robert's only invested $20,000 of their own money to get started. And after five years, the owner of Robert's is looking at capital gains of $96,000! Because of the a lower initial investment, the owner of Robert's can brag about their excellent 42.13% annual returns!
Looking at the numbers alone, the owner of Robert's did a better job of growing their business's value.
Conclusion: Results Based on Risk
Keep in mind that while using debt ultimately lead to a more valuable investment and better annual returns, this came with a lot more risk.
What would have happened if the owner of Robert's couldn't grow the business to the revenues and cash flows described in our example? There was a chance the business could have run out of cash while trying to keep up with its debt payments while it was still getting started. In that scenario, Robert's would have likely been worth $0, since a business that's shut down doesn't typically hold much - if any - value. The owner of Robert's would have lost their $20,000 savings, and would still owe the bank $80,000.
The Answer
So, should business owners follow Dave Ramsey's advice (no debt) or Robert Kiyosaki's advice (use debt)? It depends!
For business owners looking to minimize their risk (we all know starting a business is risky enough as it is without adding to it) then following Dave Ramsey's advice seems like the better option.
For business owners who can tolerate risk, are looking to maximize returns, and are confident in their business plan and abilities to achieve their goals, then following Robert Kiyosaki's advice may be the way to go.
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Miranda Kishel
Founder
Development Theory
Footnotes:
[1] James Royal, Ph.D. and Arielle O'Shea, Nerd Wallet, "What is the Average Annual Stock Market Return?" updated on September 14, 2023, located at https://www.nerdwallet.com/article/investing/average-stock-market-return#:~:text=The%20average%20stock%20market%20return%20over,the%20long%20term%20is%20about%2010%25%20annually.
Disclaimers:
Please note that the businesses "Dave's Cash-Based Business" and "Robert's Debt-Based Business" as well as the financial figures and scenarios described in this blog post are entirely hypothetical and have been created for educational and discussion purposes only.
The values, analyses, and conclusions draw in this post are not indicative of real business valuations and should not be interpreted as financial advice. This post is intended to provide a conceptual understanding of different business financing strategies and their potential impacts to a business's value.
Readers are advised to consult with the appropriate professionals for advice and analysis tailored to their specific business circumstances.
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