Similar to how it’s hard to picture owning a house or even a car without a mortgage or auto loan, small business owners frequently discover that financing or loans for their enterprises are necessary in order to expand.
However, the question of how much debt is healthy for a business is crucial to the financial well-being of your enterprise, so let’s explore some strategic ways to use debt.
Debt plays a crucial role in the financial landscape of many businesses. It can be a valuable tool for funding growth, expansion, and acquisitions. However, excessive debt can also lead to financial instability and even bankruptcy. Determining the right level of debt for a company requires careful consideration of various factors, including industry norms, financial health, and business goals.
Assessing the Debt Burden: Key Indicators
Several key indicators can help assess a company’s debt burden and determine whether it’s carrying too much debt:
- Debt-to-equity ratio: This ratio compares a company’s total debt to its total equity. A higher ratio indicates a greater reliance on debt financing. A debt-to-equity ratio exceeding 0.6 is often considered a red flag, suggesting a higher risk of financial distress.
- Debt service coverage ratio: This ratio measures a company’s ability to meet its debt obligations. It compares a company’s earnings before interest and taxes (EBIT) to its interest expenses. A ratio below 1.0 indicates that the company may struggle to meet its debt payments.
- Interest coverage ratio: Similar to the debt service coverage ratio, this ratio measures a company’s ability to cover its interest expenses. It compares a company’s operating income to its interest expenses. A ratio below 1.5 suggests potential difficulties in meeting interest obligations.
- Current ratio: This ratio assesses a company’s short-term liquidity. It compares a company’s current assets to its current liabilities. A ratio below 2.0 may indicate difficulty in meeting short-term obligations.
- Quick ratio: This ratio is a more stringent measure of a company’s short-term liquidity. It excludes inventory from current assets, as inventory can be difficult to convert to cash quickly. A quick ratio below 1.0 suggests potential liquidity issues.
These ratios provide valuable insights into a company’s financial health and its ability to manage its debt burden However, it’s crucial to consider these ratios in conjunction with other factors, such as industry norms, economic conditions, and the company’s specific circumstances.
Industry Benchmarks and Contextual Analysis
Comparing a company’s debt ratios to industry benchmarks can provide valuable context. Some industries inherently require higher levels of debt due to the nature of their operations or capital-intensive assets. For instance, utilities and telecommunications companies often have higher debt-to-equity ratios than technology or retail companies.
Additionally, economic conditions can significantly impact a company’s ability to manage its debt. During periods of economic downturn, companies may experience reduced revenues and profitability, making it more challenging to meet debt obligations. Conversely, a robust economy can provide companies with greater financial flexibility and facilitate debt repayment.
Tailoring Debt Levels to Business Goals
The optimal level of debt for a company also depends on its specific business goals and strategies. Companies pursuing aggressive growth strategies may require higher levels of debt to finance expansion and acquisitions. Conversely, companies focused on debt reduction and shareholder value may prioritize lower debt levels.
Ultimately, determining the right level of debt for a company is a complex decision that requires careful analysis of various factors, including financial ratios, industry norms, economic conditions, and business goals. By considering these factors, companies can make informed decisions about their debt levels and manage their financial risks effectively.
Additional Considerations for Managing Debt
Beyond assessing debt levels, companies can implement several strategies to manage their debt effectively:
- Diversifying funding sources: Companies should strive to diversify their funding sources to reduce their reliance on any single source of debt. This can include a mix of bank loans, bonds, and other forms of financing.
- Negotiating favorable terms: Companies should negotiate favorable terms for their debt, including interest rates, maturities, and covenants. This can help reduce the overall cost of debt and improve financial flexibility.
- Maintaining a strong credit rating: A strong credit rating can help companies secure lower interest rates and more favorable terms on their debt. Companies can maintain a strong credit rating by consistently meeting their financial obligations and managing their debt levels prudently.
- Monitoring debt levels regularly: Companies should regularly monitor their debt levels and key financial ratios to identify potential risks and adjust their strategies as needed.
By implementing these strategies, companies can effectively manage their debt and ensure that it remains a valuable tool for growth and financial stability.
What Is Good vs. Bad Business Debt?
In the context of small businesses, good debt helps the company stay financially stable while bad debt depletes resources.
Strategic use of good debt is guided by the goal of long-term value generation or higher returns. This may include:
- Investments for Growth: If borrowing money is anticipated to increase profits in the future, it may be a good idea to do so in order to finance expansion projects, buy necessary equipment, or introduce new product lines.
- Managing Cash Flow: Seasonal variations or brief interruptions in a company’s revenue sources can occasionally occur. These temporary cash flow gaps can be filled with sound debt, ensuring that business operations function smoothly and obligations are fulfilled on time.
- Temporary Needs: Borrowing for well-evaluated temporary needs can be a wise and advantageous move, whether it’s to take advantage of a timely market opportunity or to pay for current costs before a known inflow.
Trouble for small business owners is frequently brought on by bad debt. Bad debt frequently results from a crisis or ill-planned expenditure, and the business owner hasn’t fully considered the effects on the bottom line. For example:
- Covering Losses: It’s a warning sign if you keep taking out loans to pay for operational losses. While it makes sense to borrow on occasion to get through periods of slow cash flow, continuously using debt to cover losses points to more serious problems with the company’s strategy or business model.
- Overspending: Unnecessary debt can result from borrowing money without a clear goal in mind or from spending more than is necessary. For instance, renting a fancy corporate car or acquiring opulent office space when something simpler would do
- Lack of a Repayment Plan: Taking on debt without a clear understanding of the terms, cost, and timeframe for repayment is one of the most obvious indicators of bad debt. Can you afford to make the necessary monthly or even daily payments if they are due? If not, you run the risk of defaulting, which can result in penalties, compound interest, and a declining credit score.
Debt Service Coverage Ratio
The basic formula for debt service coverage ratio (DSCR) is:
Net Operating Income, also known as Earnings Before Interest and Taxes, or EBIT, is the amount of money the company makes from its operations; on the other hand, Total Debt Service is the total amount of money the company owes for a specific time period, including principal and interest.
- When a company has a DSCR of 1, its debt obligations and net operating income are exactly equal. In other words, the company is barely breaking even when it comes to paying off its debt.
- A DSCR of more than one means that the company makes enough money to pay off its debt. The greater the ratio, the easier it is for the company to pay off its debt.
- A DSCR of less than one indicates that the company’s operations do not bring in enough revenue to cover its debt payments. For lenders, this is a red flag because it suggests a possible default risk.
Once more, what’s “good” for your company will vary depending on your industry, the stage of development of your company, and even how you use debt. Remember that lenders prefer a DSCR of 1 if you’re trying to qualify for a small business loan. 25 or above, which indicates that you have at least $1,250 in net operating income if you owe $1,000 in debt.
How Much Debt Is Too Much In America?
FAQ
What is an acceptable level of debt for a company?
How much debt is too much for companies?
How much bad debt should a company have?
What is a high debt ratio for a company?
How much business debt is too much?
There is no straightforward answer as to how much business debt is too much — it depends on the type of debt you’re carrying and the kind of business you run. How well you’re able to manage that debt matters, too.
Is business debt a bad thing?
Most business owners understand that debt isn’t necessarily a bad thing. Taking out a business loan, line of credit or business credit card can help you manage and repay your business-related expenses. According to data from Statista, 17 percent of small and midsize businesses have outstanding debt that ranges between $100,000 and $250,000.
How much debt does a small business have?
In the U.S., the average small business carries $195,000 of debt, according to Experian, in a 2016 study, the latest data available. Keep in mind that this is an arbitrary number not measured against income or revenue. Thus, it should be taken with a grain of salt to determine if you have too much business debt.
How do you know if your business has too much debt?
How well you’re able to manage that debt matters, too. For instance, if your business regularly misses payments or runs out of cash before the month is over, that’s a sign you have too much business debt. If your business debt exceeds 30 percent of your business capital, this is another signal you’re carrying too much debt.