Small business growth requires a certain amount of debt. That additional funding can help a small business expand its operations, spend more money on product development and marketing, or survive a slump. But how much is too much? If the business doesn’t generate the sales to cover loan payments, it may find itself hustling to cut costs or, at worst, in bankruptcy.
Dileep Rao, clinical professor at Florida International University, and a former VC and venture financier and business consultant, offers one golden rule of business debt: “Only borrow what you can pay back with certainty.”
Here are some other points to consider when determining whether your business has too much debt:
Determine your debt-to-equity ratio
The amount you owe creditors compared to how much equity you have in the business determines debt-to-equity ratio. Industry norms for debt-to-equity ratio vary, so it’s best to identify a debt-to-equity ratio that suits your business. This data can help you determine whether you should pay down debt or move forward and finance that second location.
Understand your finances
Even businesses that just emerged from bankruptcy may receive loan offers from lenders. Don’t be swayed. “They often want to take over collateral,” says Rao.
Instead, use your balance sheet and cash flow statements to help you make borrowing decisions. If you don’t understand these statements—learn. “If you’re not finance smart, you’re not going to get to the next level,” says Rao. “Know how to use financial statements to develop a stronger business. Your accountant shouldn’t be the only one that knows.”
Analyze cash flow
If you have high profits but not much cash on hand, you may have too much debt. Making principal payments on loans is essentially a transfer between accounts, so paying back principal isn’t reflected in profits figures.
To reverse sluggish cash flow, it may make more sense to pay off the debt slowly to free up available cash. On the other hand, you may need to borrow to bolster cash flow if you don’t have much debt to begin with.
Know your industry risk
When you need to boost cash flow or finance an expansion, borrowing makes sense—but only within the limits of your business. Analyze the amount of risk involved in your business and industry. “If you’re a startup, the uncertainty is very high,” says Rao. “What certainties do you face?” Businesses in a volatile industry, such as technology or energy, should maintain less debt than more stabile industries, such as consumer goods, which can handle more debt.
Borrowing can make good financial sense for a growing small business, “but only when money is used productively,” says Rao. “All debt has cost. The business owner should consider the return on the money they borrow and how certain that return is.”
If you want to finance that expansion or hire a few new salespeople (both wise reasons to borrow), remember Rao’s rule and “only borrow if you’re sure you can pay it back.”
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