One of the first steps entrepreneurs are advised to take when starting a new business is to build company credit. Not only is credit essential to a business’ operation, it is also a great predictor of how successful that business will be, according to one study.
Finance professors Rebel Cole of Florida Atlantic University and Tatyana Sokolyk of Brock University in Ontario conducted a survey using data from the Kauffman Firm Surveys. The Ewing Marion Kauffman Foundation collected annual data from about 5,000 companies that started in 2004.
The study compared what type of loans businesses took out, if any, and contrasted this with survival rates and revenue. Businesses that took out business bank loans had much better results when compared to businesses that didn’t take out any loans at all, or businesses whose owners took out a personal loan, the study found.
The study offered a theory about why this is the case, but first, here’s a look at the results.
A company that used a business loan from a bank for startup financing reported nearly twice as much revenue after three years as a startup of similar size that took on no debt. A company that was financed by some form of personal debt had, on average, 57 percent less revenue than the company that hadn’t borrowed at all.
Another notable trend emerged when examining survival rates. Companies with business debt had a 19 percent higher chance of surviving past three years than debt-free companies. When comparing businesses with personal debt versus companies without any debt, the business with personal debt had a marginally higher survival rate.
Cole and Sokolyk suggested that businesses who are willing to go through the process of applying for a bank loan, which takes up time and resources, would also be more willing to put the time and resources into growing the business.
However, there’s another possible explanation. Since businesses receiving bank loans are vetted in the underwriting process, it might be reasonable to say that businesses receiving bank loans were of a higher quality and were more likely to grow significantly.
“If you’re able to get a loan in the name of the business, then the bank is actually taking a look at the business,” Cole explains.
If business lending is such a good predictor of performance, then why does personal borrowing predict poor performance? The study once again said bank selection could be a possible explanation, particularly if a bank does not think a business is strong enough to extend credit to. Therefore, a business owner will seek out personal credit.
Furthermore, when a business is limited to a personal line of credit, that often doesn’t allow enough room for necessary growth.
Finally, there is such thing as too much debt. Companies that took on high debt were also more likely to fail, the study found. So responsible borrowing is an important component of the survival of a business.