How much business debt is too much? 5 tips for small business owners
As a small business owner, you’re likely familiar with the need to borrow money. You may need extra capital to cover your usual operations, supplies, and equipment during a slow season. Or you may need funds to grow your company and expand into new markets.
It’s common for business owners to take out small business loans to cover necessary expenses. While debt can be a strategic and valuable tool for growth when managed diligently, excessive debt can lead to serious financial stress. Ultimately, it could even cost you your business.
How much debt is too much for a small business? There’s no one-size-fits-all answer, but there are a few factors to consider.
1. Understand your ratios
When it comes to small business debt, there are a couple figures and calculations you need to understand:
• Debt-to-equity ratio measures the portion of your financing that comes from debt compared to your equity. Equity is defined as the value of your business after subtracting your debts and liabilities. A high debt-to-equity ratio can lead to more debt and increased financial risk. Your healthiest ratio may vary based on your industry, but generally, anything above 2:1 is excessive debt.
• Debt service coverage ratio refers to your ability to cover your small business debts with your business’s operating income. This number gives you more insight into whether you’re generating enough cash flow. A ratio below one suggests that you may struggle to meet your loan obligations, putting your business at higher financial risk.
2. Analyze your cash flow
Where’s your business generating most of its income? How consistent is your monthly cash flow? Is it enough to consistently meet your operating expenses and debt payments?
It’s important to understand and monitor how much revenue you’re generating. Negative or inconsistent cash flow could be a warning sign and can quickly lead to financial distress if you’re carrying a large amount of debt.
3. Check industry benchmarks
Average business debt levels will vary from one industry to the next. Is it normal in your industry for business owners to take on substantial debt? Comparing your business’s debt levels to industry standards can provide valuable insights into whether your debt is within reasonable limits.
4. Assess your risk tolerance
Every company – and individual – has a unique risk tolerance. Keep in mind that your risk tolerance level may be influenced by:
• Industry dynamics
• Market conditions
• Your personal preferences
If your business has a low risk tolerance, it’s important to set and maintain a low debt threshold to ensure financial stability and minimize stress. Businesses and small business owners with higher risk tolerances may be more comfortable carrying a higher debt burden if they’re confident with their current and projected sales and cash flow.
5. Consider growth and future needs
Consider the overall economic climate and your business’s long-term prospects. When economic indicators point to a potential downturn, you may want to reduce your debt to increase your financial flexibility during times of uncertainty.
Borrowing can be an effective option to finance expansion, but you should always strive for a balance between your debt and your expected return on investment. Only take on debt relative to your growth potential to ensure future profitability and stability.
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