For small businesses, debt is essential; it’s often the best way of financing growth. When you take on debt, you signal stakeholders that you’re willing to take on risk to push your vision forward. What’s more, if you’re being lent money, it shows that financial institutions are willing to trust you – a sure sign that stakeholders should trust you, too.
When you’re managing your debts, it’s essential that you look at them relative to your bottom line. One could argue this is true of all financial transactions your business undertakes, but it is especially true of debt.
Debt relates to your bottom line in two ways – what it produces for your bottom line and what it takes away from your bottom line. You improve your earnings primarily through increasing revenue or cutting costs; debts affect both costs and revenue.
Debt and Revenue
From the onset of your business to any expansion you want to undertake, you’ll almost certainly need to take on some amount of debt. Debt allows you to expand beyond what your resources would normally allow, speeding up growth. Debt enables you to purchase the right tools for your small business so you can get off the ground faster. Entrepreneurship is a race between you and other business owners, so you need all the speed boosters you can get.
When you take on debt, you should have a clear vision of how that debt is going to increase revenue. Sometimes, the calculation is clear: you have 100 customers who want your product but you only have the cash on hand to make 75, so you take on debt to make the other 25. You’re selling 25 more than you would have otherwise, so the impact on revenue is clear.
More often than not, however, calculating how debt will affect your revenue isn’t so easy. You might predict that clients will pay more for products made with higher grade materials, but your estimate might turn out to be wrong. That’s why you should always create a best, average, and worst case scenario for how much revenue you’ll generate, plotting revenue trajectories based on data and past experiences.
Your debt ratio is a simple calculation: your total debt divided by your total assets. You always want your debt ratio to be below 1; in other words, you want to have more assets than you have debts.
The reason that this is important to lenders is easy to understand; if you have more debts than assets, it’s hard for lenders to guarantee they’ll actually get their money back. What’s considered a “good” debt ratio varies by industry; compare high performing companies in your industry to get an idea of what lenders find acceptable. Playing it safe, a debt ratio of 0.5 means you have twice as many assets as you have debts – a nice place to be.
Debt and Costs
When it comes to cutting costs, debt can play an important role. You can use your debt to finance automation and other cost-cutting measures. Expanding your operation can also cut costs thanks to economies of scale.
While debts can increase efficiency and decrease costs, they come with their own set of inefficiencies – namely, interest. Interest is inherently inefficient; you’re paying for money, after all. When you’re calculating how your debt will affect your bottom line, increase revenue, and decrease costs, it’s essential that you keep interest rates in mind.
Lenders will look at a number of metrics to determine how much to loan your business, including your debt ratio, EBITDA (Earning before interest, taxes, depreciation and amortization), and how long you’ve been in business. With any ratio, lenders will look at how that ratio has fluctuated over the history of your company; a snapshot of your company in the present is never sufficient.
To decrease your interest rates, then, it’s essential that you improve your bottom line consistently over time. Fortunately, debt helps you do exactly that. Successfully using money you’ve been loaned to improve your business will make lenders more likely to lend again. That’s why it’s essential to take on debt often, though it may seem counterintuitive.
When your company becomes bigger and more profitable, you can use your growth to renegotiate interest rates with banks. Look for loans often, compare prices, and don’t be afraid to go back to a lender and refinance if you think you can get better terms on the loan.
There are debts that don’t charge any interest – namely, when you have accounts payable. Suppliers may well have a late fee, but they’ll rarely charge you within the first month. When you have 90 or more days to pay off a supplier, focus on other debts first, and pay them towards the end of the 90 days. Avoid paying on the latest day possible, though; giving them some berth shows courtesy and improves your relationship.
Too Much Debt
While a good debt ratio and growth can decrease your interest rates, bad debt ratios and declines in profitability can increase your interest rates and make it difficult for you to pay back your debts. In these circumstances, refinancing can be difficult because you’re unlikely to get better rates. There are still a number of avenues available to you. First, focus on paying off the debts with the highest interest. You might also consider consolidating your loans or negotiating a lower payment with your creditors. This can be difficult to do on your own, so you might opt to get help with debt management.
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