Summary: A heavy debt load can leave a small business vulnerable to financial problems. They won’t be able to respond to changing market conditions or business emergencies. Unfortunately, many small and midsized companies fail due to excessive debt.
Everyone agrees that too much debt is bad. Despite this, there is disagreement over the amount of debt considered safe. While some debt can be beneficial, it depends on the type of debt, its use, and its objective.
This article covers an approach to using business debt and offers actionable guidelines to avoid having excessive debt. We cover the following subjects:
- Is there a safe amount?
- Types of debt
- Strategy for longevity
- Suggestions to ensure longevity
- Get competent advice
1. Is there a safe amount of debt?
There is no specific safe amount of debt that works for every company type and every situation. Actually, there isn’t even a consensus among experts about what a ‘safe’ level of debt is.
Some experts caution that all debt is bad. Others insist that companies should have debt since it can increase business returns. So, who is correct? This situation can be confusing for small business owners.
We think the best approach is for companies to use the smallest amount of debt possible to achieve their objectives. This advice sounds simplistic, but it is not. It is hard to implement, and companies often do it incorrectly. That is why many professionally managed companies fail due to excess debt.
A big part of this problem is that companies typically have two competing goals: longevity and growth. Unfortunately, one comes at the expense of the other.
a) Longevity vs. growth
Business owners want their companies to stay in business for a long time. But on the other hand, they want to grow as much and as fast as possible.
These objectives are usually contradictory. You can try to grow quickly at the expense of safety. Alternatively, you can operate your business “safely” at the expense of growth. Few companies can operate safely while growing quickly.
How does this relate to debt? The debt needed so your company can stay in business for as long as possible (e.g., longevity) is not the same as the level needed to grow as much as possible.
b) The drawback of aggressive growth
Companies that focus on growing as much as possible typically spend a lot of money pursuing new opportunities. They typically use debt to finance their plans, maximize returns, or both. This situation can lead to companies that have too much debt.
A lot of debt leaves a company vulnerable to financial problems or failure. These cash flow problems typically come to light during recessions, when sales go down and sustaining debt becomes difficult.
2. Types of debt
There are several ways to categorize debt. We prefer to look at debt based on whether it supports longevity or growth. It can support both objectives in some cases. However, this is rare and seldom long-term.
a) Debt to stay in business (longevity)
This type of debt is needed to keep the business operational. For example, manufacturing companies replace or upgrade machinery as it becomes obsolete. They need the machinery to stay in business.
Most companies finance the purchase of machinery with a loan or equipment financing. This debt could be qualified as “needed to stay in business.”
Other examples of this type of debt include financing used to acquire tools, renovate facilities, etc. This debt cannot be avoided. These investments are needed to stay in business and remain competitive.
b) Debt to grow the business
This type of debt is needed to pursue growth opportunities. We prefer to label this type of debt as ‘optional.’ Companies have the option to pursue a growth strategy that requires debt or not. It’s a management decision based on their objectives.
Examples include any debt incurred to launch new product lines, deploy to new locations, expand facilities, or acquire competitors. Debt used to finance these opportunities carries the potential for great rewards. However, these projects could become expensive failures.
3. A strategy for longevity
No single strategy will work for every company in every situation. However, there are some guidelines you should consider before taking out a business loan.
The main principle is to use debt selectively and strategically. If necessary, use it to finance transactions needed to stay in business. You have little choice.
Where possible, finance growth opportunities with the company’s retained earnings rather than debt. Only use debt to pursue a growth opportunity if the returns are high and the risk is very low.
Never use so much debt that the investment could jeopardize your ability to stay in business if it fails. This leaves your business vulnerable.
This strategy restricts the number of growth opportunities you can pursue. The company won’t grow as quickly as it could. However, it has advantages. It is easy to understand, simple to implement, and leads to a more financially resilient company.
4. Suggestions for financial longevity
We have often worked with companies that have financial problems and too much debt. We noticed similarities, and their problems typically fell into three areas. Many of their problems could have been avoided, or at least lessened, by following three simple guidelines.
a) Build a cash reserve
An adequate cash reserve is a hallmark of companies that last long. Having enough cash on hand to handle emergencies is an essential safety net. The cash reserve buys you options and time to overcome the emergency and move forward with the business.
Each business owner must decide the right size of their reserve based on needs, industry, circumstances, and risk tolerance. A month or two of expenses is probably the minimum. However, more is better.
b) Match the financial product to its purpose
Using the right product for the problem you are trying to solve is essential for success. A common mistake for small businesses is that they often use the wrong financing products. This can lead to long-term and expensive problems.
For example, companies often use a loan to solve most of their financial needs. However, this strategy can be counterproductive since loans have a specific purpose. Loans and similar term products are well suited to buy assets, such as equipment, machinery, etc. The loan covers the asset’s high initial cost and allows the company to repay it over time.
A loan is not the best solution for cash flow problems. They may work well initially, but their usefulness drops as you pay the loan back.
Cash flow problems are not fixed, like the price of an asset. They vary, tend to be ongoing, and are better solved with a revolving line of financing, such as a line of credit or invoice factoring.
c) Beware of “easy debt”
Businesses have access to many types of financing. Some financing products are easy to get and require minimal documentation. This can enable some business owners to incur more debt than their companies can manage.
Getting out of this problem is difficult. Refinancing the loan with more “easy debt” seldom works. It often creates more problems because “easy debt” tends to be very expensive.
In some cases, companies have stacked multiple lines at the same time. It often leaves companies in a worse financial condition.
5. Get competent financial advice
There is no single or easy way to determine which type of debt, or how much, is right for your company. Make the decision carefully since it may have longstanding consequences for your company.
Consider getting competent financial advice if you are unsure how to proceed. We strongly recommend meeting with a CPA experienced in small business financing. They can help you make the right choice for your business.
Disclaimer: This article is for information purposes only. It does not provide legal or financial advice. Seek advice from a professional if you need it.