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Updated: July 27th, 2020
Something you may have learned as a business owner is that debt in and of itself is not necessarily a bad thing. Eventually, you’ll need a capital infusion to expand into a new location, overhaul an existing store, or invest in equipment or talent. You’ll quickly find that accessing financing is the most efficient way to do so.
But when you find yourself swimming with the creditor sharks with no lifeline in sight, that’s a telltale sign you’ve gotten in over your head. Cash flow can be tight day-to-day, to begin with, juggling supplier payments and payroll. But when you factor in credit cards, lines of credit and loans, things can quickly spiral out of control.
If you could determine beforehand how much debt a company should have, you could save yourself some trouble as a business owner. We have comprised some debt management tips specifically for small business, to help you.
Before we get into how much debt a company should have, let’s take a look at the different kinds of debt. For instance, perhaps after purchasing materials for your business, you receive an invoice saying that payment is due within 90 days.
Next, you’ve got a business loan on which an interest rate is attached. As long as you’re only paying the minimum due each month, only a percentage goes toward the principal. Then, the interest is going to balloon in size.
When experiencing a cash pinch, which one do you delay? If you don’t pay the supplier, your relationship will likely become strained. So, you could jeopardize your ability to order from them again in the future. On the other hand, skipping loan payments will quickly place your loan in default. By recognizing the signs of too much business debt sooner than later, you can avoid finding yourself between a rock and a hard place.
Just like no two businesses are exactly alike, neither is the threshold for too much business debt. There are some anecdotal signs, however. These will make it abundantly clear whether you’ve bitten off more than you can chew:
If the sleepless nights aren’t enough to convince you that you have too much business debt, you could always rely on accounting metrics. These firm numbers determine whether you have a strong or weak balance sheet. They are a series of acronyms and ratios that give lenders a snapshot of how well you’re servicing your current obligations.
When it comes to determining how much debt a small business should have, a debt-to-income ratio calculation can help. That’s because it reflects the amount you owe each month vs. the amount you earn. To calculate, add up your monthly expenses and divide by total gross monthly income. You don’t need your debt to be zero — remember, some debt shows you’re not afraid to take chances to grow your business. Just avoid having the debt surpass your income at all costs.
Ideally, you want a debt-to-income ratio to hover at 36% or lower. If it’s a little higher, that’s okay; just keep it below 50%. At this range, your debt is more manageable. You will have more arsenal in the tank when it comes to negotiating your interest rate on future business loans.
Another metric that reflects the health of your balance sheet is EBITDA. This acronym is a fancy way of saying earnings before interest, taxes, depreciation, and amortization. You’ll find this number in the earnings reports of big companies, but it’s relevant to businesses of all sizes. It’s a reflection of your cash flow, and the higher the result, the better. You can calculate EBITDA either of these two ways:
Last but not least is your credit score. Just like your personal finances, your business also has a credit score assigned. Both will come into play when it comes to evaluating how much debt a company should have. Your business score will be in a range of 1-100, the higher end of which is a reflection of someone who knows how to manage their debt.
Or you could compare your business with that of the broader small business community. In the U.S., the average small business carries $195,000 of debt, according to Experian, in a 2016 study, the latest data available. Keep in mind that this is an arbitrary number not measured against income or revenue. Thus, it should be taken with a grain of salt to determine if you have too much business debt.
If your business’s financial health isn’t where it needs to be yet, there are steps you can take to manage it. These include:
If you can refinance debt to get a lower interest rate — especially in the current low-interest-rate environment that we expect to last for a while — this could also help ease the burden of too much business debt. If possible, compare your debt ratios to your peers operating in the same industry to gauge how you measure up in your industry.
Jessica Holcomb is the Content Marketing Manager at Funding Circle, specializing in small business marketing and social media. She has a degree from the Fashion Institute of Design and Merchandising. Prior to Funding Circle, Jessica was a Marketing Manager at a successful social games company and a freelancer for many small businesses in the Bay Area. Her work can be seen in top retail, gaming, and financial small business resource sites.