The average U.S. small-business owner has $195,000 of debt, according to a 2016 Experian study.
Is that too much — or too little? What’s the relationship between the amount of debt and business success?
“There isn’t one,” contends Kevin Ehinger, VP of Market Operations at global working capital exchange C2FO.
“Obviously, too much debt is a problem,” continues Ehinger, a former banker. “But a modestly leveraged business is no more likely to fail than one with no debt.” The key, of course, is an acceptable amount of debt, but debt can be a tool as well as a liability, he explains.
“All businesses are different,” Ehinger continues. “Some require a lot of capital to get up and running, which means the business could never have [started] without debt. Then there’s the school of thought that using other people’s money is a smarter investment. Some owners of successful private companies pull all the money out of the business and finance with debt so they can use other people’s money.
Debt pros and cons
Some debt is necessary and even helpful for every business. Borrowing money and paying it back on time and in full improves your business credit score, making it easier to get favorable terms from suppliers, vendors and other lenders in the future. Additionally, loan principal and interest can usually be deducted from your business taxes, saving you money. Finally, when you finance growth with debt instead of equity, you maintain ownership and control of your business.
Take on too much debt, however, and your business reaches a tipping point. If you can’t service your debt, your cash flow will suffer, and this can quickly become a vicious cycle. A study in the Journal of Marketing found overleveraged companies have lower customer satisfaction.
Cash flow is the biggest obstacle to business growth for 55 percent of small and mid-sized businesses according to the 2016 Working Capital Outlook Survey conducted by C2FO. More than 40 percent of SMEs surveyed said their working capital needs to be increased from the prior year. However, over one-fourth (29 percent) report having no or limited ability to borrow money — primarily because of high interest rates and the difficulty of getting traditional bank loans. Among those who did get financing, fewer than half (48 percent) got interest rates below 8 percent.
To ensure your business strikes the right balance when it comes to debt, you need to prioritize your debt and monitor your finances.
Prioritize your debt
When taking on debt, prioritize. Focus on purchases or activities that will propel business growth (such as marketing) or are essential to operations (such as machinery and equipment). Always consider the cost of capital and the expected return.
It’s also important to match the terms of the debt to its purpose, says David Worrell, whose company, Fuse Financial Partners, solves financial and operational problems for privately owned companies. “In other words, use short-term debt for short-term uses and long-term debt for long-term uses. If you need to make this week’s payroll, don’t take out a 20-year loan.”
Make major purchases with a longer-term lease or loan secured by the asset you’re buying. While it may be tempting to stretch out your repayment schedule, “You don’t want to be paying for things long after their usefulness is gone,” cautions Worrell.
Monitor your finances
Regularly monitoring your finances helps ensure that you’re staying within the recommended debt-to-equity ratio. Ideally, notes Ehringer, a business would not have more than 1X to 2X leverage. He cautions about going above that mark.
“Banks monitor leverage very closely,” Ehringer warns, noting that lenders often include loan covenants allowing them to call default on your loan if you exceed their leverage limit. “There’s good reason to be underleveraged as a point of strategy so that when you need money, you have a balance sheet that allows you to get it,” he says.
Rudy Maki, Vice President at C2FO, recommends using the debt service coverage ratio as a way to assess debt. The debt service coverage ratio measures the company’s ability to service principal and interest payments through cash flow. “At a minimum, the business should be generating 1.25x the cash flow required to service all debt,” says Maki.
The debt limit varies by industry
Keep in mind that the appropriate amount of debt varies by industry, Ehringer explains. For example, if you’re in a high-risk industry that’s extremely vulnerable to economic hiccups, you’ll need to be more cautious about taking on and managing debt. The same is true if you have customers with long payment cycles where your loan payments are due every 30 days, but it takes your customers three months to pay you. In these instances, strategies like invoice payment acceleration can provide access to working capital without adding debt.