And how to tell if it’s a problem or not.
Debt is a nearly unavoidable part of modern life, and small businesses are no exception. But debt can be intimidating. Use too much of it, and you’ll be in trouble. But if you avoid debt entirely, you’re leaving opportunities for growth on the table.
How do you know when to take on debt, when to avoid it, and when you’ve bitten off more than you can chew?
The basics
- Debt isn’t automatically a bad thing, but there are risks
- Debt can be a positive thing when it lets you put extra investment into your business, beyond what would normally be possible
- If you take on too much debt, there are ways of getting out from under it
Is debt a bad thing?
Debt is an ominous word for a lot of people, and it’s true that there are risks associated with taking on debt. But not all debt is created equal. Depending on the type of debt and what it’s used for, debt can put you in a hole or take your business to the next level.
There’s an old adage about spending money to make money, and that’s where debt can play an important role in your success. You just want to make sure that anything you borrow has a purpose for your business.
Good debt
In general, you want to borrow money on favorable terms, and you want that borrowed money to go towards things that improve the long-term growth of your business. The specifics can vary depending on your situation, but education, equipment, and real estate tend to be good value adds. When used this way, taking on debt can allow you to invest in your business beyond what you’d otherwise be able to.
If that debt is accompanied by low interest rates and generous repayment options, that’s productive, constructive debt and it’s a normal and healthy part of the life of a business. When your investment into the business will do more to increase your income than the debt will cost you, that’s a good trade. Keep building that credit rating!
| 📑 Note: This one’s for the advanced class, but it can be wise to take on debt below market rates. If you feel like you have a safe 7% return in the market, and you can get a loan at 3%, it may be a good idea! |
Bad debt
You want to avoid the kind of debt that puts you in the red without really adding to the value of your business. You don’t just want to take on debt, you want to invest it in the future.
It’s also a good idea to avoid debt on unfavorable terms, such as high interest rates, fees, or aggressive repayment terms. Predatory loans from pseudo-payday loan companies like SoFi and OnDeck can be tempting, but it’s usually not worth it.
Short-term debt is often more risky than long-term debt, with interest rates and repayment terms that are usually something to avoid. However, there are situations in which taking on a short-term debt can be a good idea.
For instance, if you’ve already accepted a lot of orders, but don’t have the inventory to fulfill them immediately, you can use short-term debt to complete the order and secure some revenue (although it’s better to plan ahead and avoid that situation entirely).
The biggest problems arise when you’re using short-term debt to cover long-term obligations, like rent or payroll. That’s a sign that things have gone wrong in the business.
How much debt is too much?
Most small businesses will carry at least some level of debt, and it can be hard to tell where the line is drawn. Here are a few signs your debt situation may be getting out of hand:
- You’re struggling to pay interest on the debt
- You’re missing payments
- You’re running out of cash
- Your credit rating is going town
A quick rule of thumb: you want your debt to income ratio to stay well under 50%.
How to get out of debt
If you’re carrying a counterproductive amount of debt, there are a few ways you can work on getting things under control.
First, know how much debt you’re carrying. You have to have an accurate idea of what you’re dealing with before you can make any headway.
Next, take careful control of your budget. Look over your financial information and eliminate unnecessary costs.
Identify high priority debt first – highest interest rates or payments, biggest consequences for not paying – and act accordingly. It’ll all be uphill from there.
Finally, renegotiate terms. You can refinance, consolidate your debt, or set up a payment plan.
The bottom line
Debt can be a dirty word, but it doesn’t have to be a bad thing. If you make sure your debt is the kind that helps your business grow, and not the kind that slows you down, you’re in good shape.
Need a little help getting ahead with your business? Set up a call with the team at DiMercurio Advisors for expert assistance with bookkeeping, tax prep, and more.
