Discover Why Debt Can Be Good for Your Business – And How Much It Can Afford to Assume
Women CEOs tend to be more reluctant than their male counterparts to assume business debt. But not all debt is bad. If you’ve ever wondered whether your business can afford to take on debt, you’ll be surprised and even delighted to know that debt can actually be good for your company.
Your Business Already Has Debt
Business debt is simply one business owing another business money. It’s common — and you’re already taking on debt, probably without realizing it.
For instance, if your vendors provide goods or services and then send an invoice, you’re taking on debt. Billing expenses to a credit card, even if you pay them off monthly, is technically debt.
However, you might have more significant forms of debt such as:
- Carrying a balance on your corporate credit cards
- Auto leases for corporate vehicles
- A mortgage on your office building
- A line of credit to cover cash flow shortages
With some of these types of debt, it’s smart to stop and consider whether your business can afford to take on debt before making a commitment.
“Bad” Debt vs. “Good” Debt
As a general rule, “debt” has a negative connotation. It can imply that your business isn’t doing well.
But in some instances, taking on debt can be good for your business. “Good” debt is debt that leaves your business in a better position in the long run, without negatively impacting your financial position.
For example, taking out a loan to buy a new piece of equipment could be “good” debt if the equipment allows you to serve more customers and/or increase your efficiency. Over time, the investment into equipment could boost your revenue and/or profit.
Another example would be tapping your line of credit to hire more sales professionals. As they start to bring in more customers and close more sales, revenue will go up, allowing you to pay down your line of credit and ultimately increasing profit.
Using Equity vs. Taking on Debt
When considering investments that could help your business grow, you might be tempted to use equity vs. having your business take on debt. However, this approach can be risky in its own way.
Using your cash reserves could leave you in a precarious position if you face a cash flow shortage. Whether you regularly face a predictable cash flow crunch, such as a seasonal decrease in revenue, or you simply want to be prepared for the unexpected (for example, a worldwide pandemic), having adequate cash reserves on hand is a smart move.
Relying only on cash can also slow your growth. Cash reserves are the result of saving your profit. Generating enough profit to fund your expansion efforts could take months, if not years. In the meantime, you’ll be missing out on opportunities that your debt-embracing competitors are nabbing.
Other Benefits of Taking on Debt
In addition to allowing you to maintain healthy cash reserves, assuming business debt offers other benefits, such as:
- Building your company’s credit score. Just as your personal credit score increases when you take out and pay off loans, so too will your company’s credit score.
- Increase attractiveness to lenders. Financial institutions look to your credit history to evaluate how trustworthy of a borrower you will be. Having a record of paying off debt makes you more likely to secure future loans.
- Mitigate your personal risk. If your business fails, having debt in your company’s name could protect your personal assets.
How Much Debt Can Your Business Take On?
You may understand that taking on debt could help fund your plans to grow your company. But just because you can see the potential payoff doesn’t mean that taking on debt is the best move for your business at this time. If you won’t be able to make loans payments or if you’re able to make only the minimum payments on your credit cards, taking on more debt could be a terrible mistake.
An easy way to determine whether your business can afford to take on more debt is to calculate your company’s debt-to-income ratio (DTI). This number compares the amount you owe in debt payments each month with the amount of revenue you generate each month.
To calculate this ratio:
- Add up all of your monthly recurring debt payments. This includes, but is not limited to, mortgage payments, lease payments, and credit card minimum payments.
- Divide the monthly recurring debt by your average monthly revenue.
- The resulting number gives you a percentage that is equal to your DTI score.
For example, if your monthly recurring debt is $25,000 and your average monthly revenue is $100,000, your DTI is 25 percent – more commonly expressed as simply “25.”
Your best bet is to keep your DTI at 35 below. If your DTI is between 36 and 49, you may still be able to get loans, but you may need to provide extra documentation. Anything over 50 will raise red flags with lenders – which should be a warning sign for you as a business owner.
Forecasting Your Debt Repayment
Assuming your DTI is at an acceptable level, the next question you’ll want to ask before taking on more debt is how you plan to repay the debt. This is where your financial forecasts will be invaluable.
Financial forecasting can be a fairly complex topic on its own – and definitely something to cover in a separate article. For now, just recognize that taking on debt without a plan for paying off the debt (and a reasonable expectation that you’ll be able to execute that plan) is magical thinking. Before you saddle your company with more debt, make sure that the investment you’re considering can pay off in a big enough way to allow you to pay off the loan.
Leverage Debt to Grow Your Business
Women entrepreneurs too often limit the growth and impact of their companies by choosing to bootstrap their business growth. But bootstrapping takes time, which mean you’ll be missing out on opportunities to scale your business rapidly while waiting to build up a cash infusion.
By allowing your business to take on debt, you can secure the funding needed to grow your business. Use the information provided above to ensure that your business can safely take on the business debt you’re considering.
If you’d like professional input how much debt your business can reasonably handle, we’re here to support you. Schedule a free, no-obligation Strategies & Solutions Session here.
