Just like it’s difficult to imagine buying a home or even a car without a mortgage or car loan, small business owners often find that small business loans or financing is essential to grow their business.
But how much business debt is healthy? It’s an important question for the financial health of your business, so let’s dive into ways to use debt strategically.
What’s a Healthy Level of Business Debt?
Some business owners believe that debt is bad, and focus on growing only using the money the business brings in. Others have heard that successful businesses leverage debt and will get and use as much debt as possible to grow their business.
Those are two extreme ends of the scale. Many entrepreneurs fall somewhere in between. For them the amount of debt they are willing to use is based on the risks and rewards involved. Writing for the Harvard Business Review, Richard I. Levin and Virginia R. Travis state:
“…in the private corporation, leverage theory doesn’t always apply. The owners’ attitudes toward personal risk—not the capital structuring policies public companies use—determine what amounts of debt and equity are acceptable. The level of debt, for example, is often determined by the extent to which the owners will assume personal financial risk.”
They go on to share this insight:
“…the old bromide that you do not use short-term debt to finance fixed assets is nonsense in small, privately held companies. In a growth spurt, these organizations get capital any way they can and use it any way they need to.”
In short, every small business is unique, and there’s no one-size-fits-all answer to the question of how much debt is “healthy”. However, a healthy level of business debt is typically defined as an amount that a company can manage to pay back without sacrificing its operational integrity or financial stability.
What is Business Debt?
Business debt can take a number of different forms:
A line of credit is one of the most popular types of small business financing, often for working capital needs. Lines of credit are typically short-term loans with a predefined borrowing limit. As you pay it back, the funds are replenished and can be used again. Think of LOs as similar to how your personal credit cards work.
Ideal for business owners who need a specific amount of money, term loans have durations usually between 2 to 5 years, with some larger loans even stretching up to 20-25 years. The repayment amount generally remains consistent, making them preferred for longer-term financing.
This type of debt can be helpful for financing everything from tech equipment to industrial machinery. It can help protect cash flow, and may offer tax incentives as well as asset protection benefits.
If you only think of your credit card as a convenient payment method, you may be missing out on an important benefit: access to a line of credit. Many business credit cards offer an underlying line of credit that can be used for short-term financing. For example, a business credit card with 0% intro APR can be used to finance purchases for up to a year (depending on the terms) with no interest.
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Debt crowdfunding offers loans pooled from funds from individuals or institutional investors. They offer a lot more flexibility than traditional bank loans but require great marketing to be successful.
As mentioned earlier, it’s hard to buy a home without a mortgage today, and it can be hard to acquire commercial real estate without commercial real estate loans. These loans can allow business owners to purchase real estate for a restaurant, service business, manufacturing facility and more.
Many B2B businesses invoice clients and wait to be paid. Sometimes that wait can be 60 days or more and, in the meantime, the business may find itself scrambling to pay its own bills. With this type of financing you assign your invoices your invoices to an external entity at a reduced rate to get immediate funds. That company then collects. Alternatively, these invoices can back your financing.
Merchant cash advances, or business cash advances, offer a cash advance against anticipated sales. Daily or weekly payments then come out of future sales. This type of financing is very fast, and doesn’t require good credit, but can be pricey.
The SBA guarantees a variety of SBA loans including 7(a) loans, SBA Microloans, and Export loans. These loans offer good terms but the application process can be involved, and a personal guarantee will usually be required.
These small loans, usually for a few thousand dollars, are often made through non-profit Community Development Financial Institutions to borrowers who would otherwise have trouble getting access to capital.
If your business purchases supplies, it may be able to get those supplies on credit, rather than paying in full upfront. This type of credit is very short term; net-30 terms, for example, gives the business 30 days to pay. But it can be helpful for cash flow and if the account is reported to business credit bureaus, can help establish business credit.
Personal loans to the business can be another form of debt, and are common with startups or businesses in rapid growth stages.
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What Is Good vs. Bad Business Debt?
In the small business context, good debt contributes to the business’s financial health while bad debt is a drain on resources.
Good debt is used strategically, with a clear vision of generating higher returns or value in the long run. This may include:
- Investments for Growth: Borrowing money to finance expansion projects, procure essential equipment, or launch new product lines can be considered good debt if these investments are expected to yield higher profits in the future.
- Managing Cash Flow: Sometimes, businesses might face seasonal fluctuations or temporary disruptions in their revenue streams. Good debt can bridge these short-term cash flow gaps, ensuring that operations run smoothly and obligations are met on time.
- Temporary Needs: Whether capitalizing on a timely market opportunity or covering immediate expenses before a known inflow, borrowing for temporary needs that have been thoroughly assessed can be strategic and beneficial.
Bad debt often causes small business owners to run into trouble. Often bad debt is a reaction to a crisis or poor planning, and the business owner hasn’t clearly thought through the implications to the bottom line. For example:
- Covering Losses: Continuously borrowing to cover operational losses is a red flag. While occasional borrowing to navigate times of slow cash flow is understandable, consistently relying on debt to offset losses indicates deeper issues in the business model or strategy.
- Overspending: Borrowing funds without a clear purpose or spending beyond what’s necessary can lead to unnecessary debt. An example would be getting luxury office space or leasing a luxury company car, when something more modest would do.
- No Plan for Repayment: One of the most glaring signs of bad debt is taking on debt without clearly understanding the repayment terms, cost and time to pay it back. Is there room in your budget for monthly payments or even daily payments, if required? This not only increases the chances of default but can also lead to compounded interest, penalties, and a deteriorating credit score.
Examples of Good Business Debt
Here are some examples of where debt may be considered good debt in a small business context:
- A term loan or commercial real estate loan used to open a new location justified by strong demand.
- Leveraging credit card debt to ramp up an online ad campaign that’s bringing in a lot of sales with a good return.
- Leasing equipment, vehicles, machinery, restaurant equipment etc. that will ultimately contribute to profitable sales.
- Using a line of credit to hire temporary employees to cover a busy season or fulfill a big job or order.
- Getting inventory financing or a line of credit to purchase inventory for the upcoming season with a strong likelihood of successful sales.
- A small business loan or credit card used to purchase equipment at a deep discount.
Examples of Bad Business Debt
Here are some examples of where debt becomes bad debt for the business:
- Using credit cards to cover basic operating expenses without enough sales coming in.
- Getting a line of credit to cover the owner’s personal expenses, again without any clear path to repayment.
- Borrowing to cover losses without addressing the underlying problems; either slow sales and/or high expenses.
- Financing a new product line without data to support the market for that product or service.
- Borrowing to pay essential expenses like taxes or salaries because you haven’t budgeted for them.
Business Debt Ratios Good vs Bad
In addition to the guidelines we’ve talked about so far, there are some specific metrics that are often used to evaluate a business’s debt levels. These ratios are ones banks and other lenders may take into account, and can be helpful as a guideline. Keep in mind, of course, that what’s right for your business can vary.
The basic formula for debt-to-equity ratio is:
Debt-to-equity ratio = total debt/total equity
Generally, a debt-to-equity ratio of 1 to 1.5 is considered acceptable for many businesses. This would mean for every dollar of equity, the business has one to one and a half dollars of debt. However, it is essential to consider industry norms and individual business circumstances.
But when you look at various industries, the amount of debt the business carries may vary significantly. For example, the Stern School of Business lists unadjusted D/E ratios for businesses in a wide variety of industries here and they include:
|Brokerage and Investment Banking
|Furniture and Home Furnishings
|Real Estate (Operations & Service)
Again, what’s ideal for one business may not be ideal for another. In addition to industry benchmarks, debt levels may also vary by stage of business and economic conditions.
Startups or newer businesses may have higher ratios because they often need to borrow to fund startup costs and fuel growth. In contrast, established businesses might have lower ratios as they’ve had more time to accumulate profits and equity.
Economic conditions are another factor. Higher interest rates, for example, often slow borrowing while low interest rates may incentivize businesses to borrow as much as possible.
The basic formula for debt-to-assets ratio is:
Debt-to-assets ratio = total debt/total assets
Where total debt is the sum of all short-term and long-term liabilities and total assets includes everything the company owns, both tangible and intangible.
A high debt-to-assets ratio (approaching 1 or 100%) means that a significant portion of the company’s assets are financed by debt. This suggests that creditors have a large claim on the company’s assets, which can be concerning in terms of financial risk, especially if the company struggles to manage its debt obligations.
(It’s worth noting that creditors often place UCC liens on assets when they make loans or financing. Check your business credit reports to make sure this information is accurate.)
A low ratio debt-to-assets ratio—under 0.5 (or 50%)—is often seen as healthy as it indicates that more of the company’s assets are financed by equity— either by the owners or generated through operations. This scenario is often less risky to creditors, and it also offers the ability to extend financing secured by assets that aren’t already pledged elsewhere.
Debt Service Coverage Ratio
The basic formula for debt service coverage ratio (DSCR) is:
DSCR = net operating income / total debt service
Where Net Operating Income (often referred to as Earnings Before Interest and Taxes, or EBIT) represents the business’s income from its operations while Total Debt Service is the sum of all the business’s debt obligations for a given period, including both principal and interest.
- A DSCR of 1 means that a business’s net operating income is exactly equal to its debt obligations. Essentially, the business is just breaking even in terms of being able to service its debt.
- A DSCR greater than 1 indicates that the business generates sufficient income to cover its debt obligations. The higher the ratio, the more comfortably the business can manage its debt.
- A DSCR less than 1 suggests that the business does not generate enough income from its operations to meet its debt obligations. This is a warning sign for lenders as it indicates potential default risk.
Again, what’s “good” for your business will depend on your industry, where your business is in its lifecycle, and even how you are using debt. If you’re trying to qualify for a small business loan, keep in mind that lenders prefer a DSCR of 1.25 or higher—meaning if you have a $1,000 in debt obligation, you have at least $1,250 in net operating income.
Why Healthy Debt Isn’t a Defined Amount
When it comes to taking on debt, business owners always balance risk and reward. Again, there’s no magic number or ratio that every business should strive for.
Keeping tabs on your debt, along with other financial metrics like cash flow, profits, and accounts receivable, gives you helpful information you can use to think through what makes sense for your business and helps you avoid too much debt.
Your goal should be to use company debt strategically, to grow your business or to solve temporary cash flow issues. If you find your business continually digging itself deeper in debt with no clear way out, it’s time to regroup.
Here are options if you are having trouble paying your business debts.
How To Create a Plan for Taking on Healthy Debt: Be Strategic
If you want to use business debt the right way, create a plan. When you’re considering debt, you’ll want to be able to answer these questions:
- How will the business use this debt to make money?
- How much will the debt payments be, and how often are they due (monthly/weekly etc.)
- How long will it take to pay it back?
- Will the business still make a profit after the cost of financing is taken into account?
- What risks do I take with this debt (for example, personal guarantees)?
These questions are best answered when you have a clear handle on your business finances. Business financial statements are extremely helpful here, so make sure your business bookkeeping is up to date.
It’s also a good idea to have a clear handle on your business cash flow, so you feel confident about whether you can afford to take on new daily, weekly or monthly debt payments.
It’s also helpful to set policies on acceptable debt levels and uses of debt, before you need to borrow. This will provide a framework if you run into a situation where you need to make a quick decision. You can always override it but the policy will give you a starting point for that decision-making process.
It can also be helpful to talk with your business mentors, financial advisors or your accounting professional. They can’t make decisions for you, but they can provide an objective overview of your situation, and hopefully ask good questions that help you to make the right choice for your business.
One of the best ways you can help your business prepare for debt is to investigate financing options before you need to borrow. Give yourself the time to find out what’s available. If you wait until you desperately need financing, you’re at risk of getting less-than-ideal terms.
Finally, line up a line of credit before you need it and you’ll have financing available when cash flow is tight.
How Nav Can Help
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This article was originally written on November 28, 2023 and updated on November 29, 2023.
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