When you run a business, whether you’re a startup or you’ve been in the game for a long time, you’re almost definitely going to need to get money from other people at some point. You might want to expand your business, knowing fully well that demand is there, but don’t have the cash on hand to speed up production - that’s when taking on some debt can be a boon.
Not All Debt Is The Same
You’ve purchased the raw goods needed to manufacture your product. You get an invoice that’s payable within the first 90 days. You might look at this as a type of debt - after all, you do owe your supplier money. What’s interesting about this kind of debt is that there’s almost never any interest on it, so there’s a pretty heavy incentive to paying it off as late as possible. You can use the materials you’ve been supplied to create and sell products, and use the money you make to pay your supplier back.
Conversely, if you get a bank loan, you’re going to have to pay interest. The ways in which banks calculate how much they’ll lend you and what the interest rate will be can vary a lot; we’ll take a look at some of the methods they might use in the next section.
When you’re considering how much debt is too much, it’s important to keep in mind that different debts will affect your business differently. When you’re not paying back bank loans, interest is going to pile up and you’re going to have a hard time finding people to lend to you in the future. When you don’t pay back suppliers, you’re not only hurting your reputation, you’re damaging your reputation with that supplier - sometimes beyond repair.
How Much Debt Is Too Much?
There’s no fixed dollar amount for how much debt is too much. You can use a number of hands-on approaches to know if you have too much debt. Are you missing monthly payments? You probably have too much debt. Are you constantly stressed about your debt levels? You probably have too much debt. Some of the guidelines used for business debt are quite similar to those used for personal debt - when it’s too much, you can often feel it.
How you feel isn’t the only tool available to determine if you’ve got too much debt. There are a lot of metrics used by the financial industry to evaluate the health of your business. One of the most commonly used is the debt ratio. How much debt does your business have and how many assets do you have? You almost always want to have some debt - it shows that you’re willing to borrow money to spur growth. That debt, however, should always be far less than your assets.
Banks might also look at your debt-to-EBITDA (earnings before interest, taxes, depreciation and amortization); useful for knowing whether you’ll have the earnings to service future debt, but flawed in that sometimes interest will be a substantial portion of your debt. This method also fails to account for common tax mistakes small businesses make, which can add up to a lot.
Banks also look at your credit rating. Sometimes your company won’t have the necessary profile to be loaned money; sometimes, you might be able to secure a loan, in which case the bank would look at your credit profile. Be careful, of course - getting a loan in your name puts your credit at risk (instead of your company’s, which may limit your liability).
When you’re trying to determine if you have too much debt, it’s not a bad idea to look at these metrics in the same way banks do. Compare your debt ratios to other businesses; if you’re above the average for your industry, it’s likely you have too much debt.
Managing your small business debt can be broken down into three things: taking on the right amount of debt, paying off the right debts, and handling situations where you’ve taken on too much debt.
Knowing how much debt is too much isn’t simple, but you can use facts, figures, guidelines, and feelings to try and figure it out. All debt that you take on should be backed by a plan - you should know how you’ll use that debt to increase your income. You should plot best, average, and worse case scenarios for the plan you’re trying to finance with the debt. You should have enough assets to pay off your debt, if needed. Whatever you plan to do with your debt should bring in more money than the debt plus the interest paid.
You’ll also want to take on the right debts. Look for low interest loans that can be paid back over a long period of time. Compare the different types of loans, consult with financial advisors, and compare as many different rates as you can.
You want to monitor your debts as your business grows; as your debt ratios improve, it’s possible to refinance loans with better terms. This can enable you to grow your credit rating while simultaneously decreasing the amount of interest you have to pay.
When it comes to paying off debts, it’s important to look at the terms of each debt and determine which ones should take priority. Things to look for include steep consequences for defaulting, high interest rates, and the importance you place on your relationship with the lender. After all, if you only have one supplier for a niche product, you might give that debt precedence over even a high interest loan.
When you have too much debt, there are a number of options at your disposal. Understanding what debt can be written off can help you decide whether you want to restructure your debts, negotiate with your creditors, or file for bankruptcy. While filing for bankruptcy is generally a worst case scenario, there are times that it’s the most appropriate option. Before that, you’ll want to pursue negotiations or debt consolidation.
About the Author
Kiara Fulham is a blogging enthusiast who loves applying her knowledge of finance and marketing to new content pieces. She is always open to sharing her experiences with local businesses and uncovering all the engaging content that converts viewers into customers. Currently, she works in the marketing department at Bookedin.