Marginal Productivity of Debt, an Important Lesson.

Debt can lead towards growth.  Very often it does.  Very often it doesn’t.  Let’s examine.

Let’s say you are the owner of a factory producing highly specialized parts for a government entity.  You produce very quality parts for years and suddenly demand for your product skyrockets as other end users discover your company. Suddenly you are in desperate need to hire additonal employees, purchase larger capital equipment or move to a facility which will allow you to produce more to meet the growing demand.  Since you are a young growing company it would make sense to go to a lender and finance your growth.  You do the analysis and the increased revenue from these new customers will easily cover your monthly debt service, and add additional profit to the bottom line.  The added debt load to your balance sheet could make a huge positive impact for your company in the long run, so you do it.  Simple.  Economics 101, right?

Now let’s look at it from the other side of the spectrum.  You are a struggling company.  An automobile parts manufacturer that just lost some of their largest most high margin customers.  You are starting to juggle your vendor debt and you just stopped taking a paycheck.  Your working capital is being depleted rapidly and you know you need to take action quickly.  So you run to your trusted lender and ask for a working capital line of credit.  You somehow get the loan only to see yourself in a worse situation six months later as the salesperson you hired can’t land the big contracts you need to support the added payroll burden and the debt service from the new debt.  You go back to the bank for more cash but this time you get turned down.  Ooops!

So why did you take on the additional debt to begin with?  The first example is easy to understand for everyone.  If you need more capital and the debt you take on will facilitate growth, yes this makes sense.  However the second example is the business owner who does not understand the DIMINISHING MARGINAL PRODUCTIVITY OF DEBT.  It’s a mouthful, but all it means is that for every new dollar of debt you take on, the output resulting from that debt produces less and less of a positive result.  If this get too far, each dollar of debt can produce a negative return.

This is exactly what the politicians in America don’t understand, as well as many business owners I speak with. Currently in America every new dollar of debt we take on is actually producing a negative return to our GDP.  Just recently has it gotten to this point, as our policy makers have tried to solve every problem by borrowing and spending money we don’t have.  The added burden of our nations debt service is weighing us down, not to mention the widespread waste as our dollars are not being invested in productive means that produce a return for our nation.  The eventual result is the same for our country as it is for that poor business owner in the second example, eventual default.

Take a look at the chart below taken from Nathan’s Economic Edge.  Take this as a warning sign for yourself as a business owner, and as a citizen of this nation.  We don’t need more debt if it doesn’t result on increased productivity. Learn this lesson.  Thank you.