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Business debt can be helpful or harmful, depending on how much you acquire and how you use it. Here’s how to strike a balance for business success.
For most business owners, acquiring debt is an inevitable part of starting or growing a venture. A 2021 survey by Statista found that 74% of small to mid-sized businesses in the United States carry some debt. The most recent data available from the Federal Reserve, published in 2017, puts the average small business loan in the US at $663,000.
Some debt can be necessary for business success. For example, repaying debt on time and in full can improve your business credit score, making it easier to get favorable terms from your own suppliers, vendors and other lenders in the future. Another benefit is that you can usually deduct loan principal and interest from business taxes, which saves you money. Financing business growth with debt rather than equity also lets you maintain ownership and control of your business.
Debt is often a necessary tool for business growth — the key is to ensure that your debt obligations don’t deteriorate cash flow. How do you know when your business’s debt is supporting growth and when it has become a liability? Here are some signs to look for and tips for strategic debt management.
There is no magic number when it comes to determining a healthy amount of debt. All businesses and industries have different financial needs. For example, some businesses require a lot of debt to start, especially if they need expensive equipment and other significant capital expenditures before they can turn a profit. However, poor cash flow is usually the first sign of too much debt. In the US, poor cash flow is responsible for 82% of business failures.
Here are some signs that your business might have too much debt:
While there is no ideal number for the debt itself, there are key financial ratios to aim for. The debt service coverage (DSC) ratio and the working capital ratio are two valuable metrics that you can use to determine whether your debt level is manageable.
DSC is used by banks to evaluate loan eligibility, and it is calculated by dividing your operating profit by your total monthly debt payment obligations:
Debt Service Coverage (DSC) Ratio = Monthly Operating Profit / Monthly Debt Payments
Most banks require a minimum DSC value of 1.25. If your ratio dips below this, your business has most likely overextended its debt responsibilities.
A working capital ratio is calculated by dividing your current assets (such as cash flow, invoices and inventory) by your current liabilities (such as accounts payable).
Working capital ratio = current assets / current liabilities
“Current” liabilities include any debts that must be repaid within 12 months. This often includes short-term debts such as credit card debt and vendor credit. Any working capital ratio less than 1.0 is a red flag, while a ratio closer to 2.0 indicates that you can manage debt obligations while maintaining cash flow.
If your business is concerned about acquiring too much debt, you may be wondering how to approach borrowing, especially during inflationary periods when interest rates rise. A banking crisis — such as the 2023 global bank failures, including Silicon Valley Bank and Signature Bank — typically makes credit much harder for small to mid-sized businesses to access and afford. If your business needs financing, here are some things to consider before you acquire more debt.
Financing eligibility requirements will most likely increase during times of economic uncertainty. Loan applications are logged on your credit report, so apply for financing strategically to avoid hurting future eligibility. You could consider alternative financing options if your business credit score isn’t high enough to meet banks’ and other traditional lenders’ requirements.
Another consideration is how you plan to use the debt. Prioritize investments that are essential to business operations or have promising growth returns. You should also pair the type of debt with the corresponding investment. For example, leverage a working capital loan for short-term expenses such as payroll, and save long-term business loans for long-term investments such as business expansion.
Lastly, consider factors that are unique to your business and industry. If you run a seasonal business or operate in a sector that is vulnerable to economic disruptions, it’s wise to be more cautious about taking on and managing debt. Timing is another factor: If your buyers have 90- or 120-day terms but your debt requires monthly payments, you could run into cash flow issues even if your business is profitable. In this case, alternative solutions such as an early payment program may be better suited to your debt and cash flow management strategies.
Acquiring too much debt can quickly become a vicious cycle: as your business’s cash flow decreases, you can’t make debt payments and require even more debt to keep the business running. The good news is that there are several debt-free strategies your business can implement right now to avoid getting to this point.
Whether or not your business has too much debt, economic downturns can make it even harder to secure the funding needed for business continuity and growth. Early payment programs are more affordable and accessible for small to mid-sized businesses, enabling you to control and maintain your cash flow during uncertain times. Learn more about early payment programs through C2FO.
This article originally published June 2017, and was updated May 2023.
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