Debt Isn’t a Bad Thing, When It’s Manageable Debt financing can help you grow your business while maintaining full control of the company.
By Alan Corbet
Almost all small businesses today have debt. Does that mean all small businesses need debt? It depends. But every business owner will say they need cash in order for the business to run, and a good portion of that cash usually comes in the form of debt. Debt comes in many varieties, including long-term loans, lines of credit, temporary lines of credit, revolving lines of credit (credit cards), swing loans, real estate purchase loans, letters of credit, loans with balloon payments and loans with interest-only requirements. But when it gets right down to it, there are basically two types of debt: short term and long term.
Purpose of Loan Determines Type Lenders typically match the type and term of the loan with the loan’s purpose. In other words, they’ll want to use a term loan (usually for longer than one year) to fund the purchase of assets that will expire over some defined period. Assets with short useful lives should be matched with short-term loans. For example, if you are purchasing fixtures, vehicles or other fixed assets, you will want a loan for about the same period the value of the asset is fully depreciated. Since these types of assets lose value over time, you want the debt to be paid off prior to the asset having no value. The same holds true when financing temporary needs for capital. In a perfect world, you would collect cash from your customers at the same time you need it to pay your suppliers. But since the world doesn’t work that way, lines of credit are often used to fill the gap that exists between the time when you have to pay cash for things, such as inventory and labor, and when you receive money back from customers through sales of goods.
Matching Loan Type and Asset Why is it important to match the type of loan with the type of asset? It’s not just your lender’s requirements—it’s also good business. That way, when you have an asset that depreciates in five years and you pay off the debt before that time, you are in a better position to borrow again when you need to replace that equipment. If you still owe money on an old piece of equipment, you may have a harder time qualifying for more debt. Lenders don’t want to loan money for assets when you haven’t paid off the depreciated asset you are replacing. When you cannot replace needed equipment, you start to lose productivity for your business and compromise your ability to make money and be profitable.
How Much Is Too Much? If you have had your business for any length of time, you have probably incurred debt. But you need to ensure you do not fall into the category of too much debt. How much debt is too much? When measuring financial risk to a business, one of the first items reviewed is your “debt-to-worth” ratio. Debt-to-worth ratio measures the degree of financial risk to which your company is exposed. Debt financing involves contractual responsibilities for interest and principal. These payments must be made on established dates regardless of the company’s level of cash flows. Naturally, the more debt financing employed, the greater the amount of interest and principal payments that must be met, and the greater the risk that cash will not be available to meet them. Debt financing is a mixed blessing. Your business does benefit from the use of funds, but creditors expect their payments on time. When your debt levels increase, you start to lose the capacity for future investments in the company.
Calculate Debt-to-Worth Ratio Total debt-to-worth ratio is calculated just as it sounds. Take the total amount of debt you have and divide that by the net worth or equity of the company. If this ratio exceeds two, you basically have twice as much debt as you have equity. That isn’t bad, but it does means you are at risk. The risk is that you cannot always guarantee your total assets can be liquidated if your bank demands payment of a loan. This is a key ratio your creditors will look at, and creditors want this ratio to be two times or less. But there is good news. Since you have debt instead of taking equity investments into your company from a third party, it means you maintain control. Company owners can lose their control over the operation when investors’ equity exceeds their own. But with debt, you are in control. The analysis you must make is about the management of your debt. Are you doing the best for your company’s future? Review your types of debt and make sure they match the purpose they were intended for. Having business debt can be good as long as you keep watch to ensure your money is working for you to increase profits, not expenses. Alan Corbet is an accountant for employee health benefits with Metzler Bros. Insurance. He has extensive experience helping small business owners get their start or expand their business. You can reach him at (816) 421-6116 or
