Business Loans

Guide to Business Debt

Oct 13, 2022 • 10+ min read
Business woman taking care of her finances
Table of Contents

      The word “debt” has a negative connotation for some small business owners since it conjures images of credit card bills and unpaid invoices. However, debt isn’t necessarily a bad thing. As a business owner, you may even take on debt to fund the expansion and growth of your businesses by applying for a small business loan, line of credit or other type of financing.

      As a business owner, debt isn’t necessarily a bad thing — you may even take on debt to fund the expansion and growth of your businesses.

      When to Use Business Debt

      You should consider business financing (also known as debt) when you can use it to help you increase your profits by more than the interest expenses.

      For example, say you have an old and inefficient widget-making machine. A new machine could cut your costs by $20,000 per year, but it would cost $100,000 you don’t have today.

      Under the personal finance mentality, you would start putting aside extra money until you have the $100,000. This means no interest, but it also means $20,000 per year in lost cost savings.

      Instead, you need to look at the numbers.

      Let’s say borrowing the $100,000 would cost you $8,000 per year in interest over the next five years. The new machine would also last ten years. That gives you a total cost savings of $200,000 ($20,000 x 10) minus $40,000 ($8,000 x 5) in interest minus the $100,000 machine cost. Let’s say, for example, that it would otherwise take you a whole year to save that much money. If you took out the equipment loan, you’d end up $60,000 ahead.

      The numbers will vary based on your exact situation, but often times, you just need to do the math.

      Reasons to Take on Business Debt

      1. You Need to Grow Your Assets

      The money you spend on your business doesn’t just disappear into the void. If it does, you may need to rethink your spending. Each charge to your business lowers the amount of cash you have while increasing your assets. This is the basic principle of double-entry bookkeeping. 

      The risk of taking on small business debt through external funding can often be justified because that debt directly feeds the goal of growing the value of your business. The debt you take on enables you to increase your sales in ways you couldn’t before. Once you pay off that debt, you can focus on your profits. 

      2. You Plan to Increase Your Marketing Efforts

      Marketing agencies, contractors, and employees provide value to your business in multiple ways. They create physical assets like your website and social media profiles, which drive traffic and customers to your stores. They also create campaigns that promote your brand and products, increasing your sales and brand equity.

      You can take out good debt to invest in marketing as long as you have a target ROI (return on investment) to work toward. For example, if you bring in $500 in sales for every $50 you spend on digital ads, you have a 10:1 ROI. You can also track the gross margin of the items you sell to ensure you are turning a profit from your marketing efforts. 

      Marketing can help you grow your sales, which will drive up your revenues and help you pay down your debt faster. 

      3. You Want to Improve Your Business Credit Score

      Every organization has a business credit score, also called a commercial credit score. Like a personal credit score, this rating determines how reliable your business is to lend to. If you are a young business or have outstanding debts, you might have a small business credit score. This could make it harder to secure loans or credit cards while driving up the interest rates you are given. 

      While you can’t fix your business credit score overnight, there are ways to improve it over time. You can pay off your outstanding debts and pay back loans within a set window of time. This proves to lenders that you care about your finances and can reliably follow a payment schedule. 

      If you have multiple sources of debt, consider working to consolidate them. You may be able to take out a loan to pay off these debts, leaving you with just one monthly payment. Meet with an accountant or financial advisor first to see if this would be an effective way to improve your credit score and set your business up for success. 

      Improving your credit score now will make acquiring debt cheaper over time. You can enjoy lower interest rates and more favorable payback periods. 

      4. You Don’t Want to Bring on Shareholders 

      There are multiple ways to fund your business beyond taking on debt. For example, you can invite investors to buy into your business and bring on shareholders who will earn a portion of your profits. These options have become more popular recently thanks to the mind-boggling venture capital funding in search of startup unicorns. 

      In some cases, it may be better to take on debt for your business without inviting individuals to buy into it. You can do whatever you want with a business loan as long as you pay it back in set installments. A business credit card gives you the flexibility to spend money without gaining approval first. Plus, taking on debt might be cheaper than bringing in venture capital. You can deduct any interest you pay on your taxes and may find more favorable interest rates in SBA (Small Business Association) loans over private investments.

      Are There Other Things to Consider Before Taking On Debt?

      Taking on business debt is largely a numbers game, but it’s still an investment, and as with any investment, there is some risk. Risk is not necessarily a bad thing, but you do need to manage it responsibly.

      Here’s what you should consider.

      Time to Increase Revenue

      You may feel certain that you’ll increase your revenue, but watch out for gaps between when the revenue starts coming in and when your payments start. If you have to start loan payments before you get the added revenue, you could find yourself in a cash crunch leading to a loan default. Have a plan in place to make these early payments or structure the loan to delay when you start repaying.

      The Certainty of Your Forecasts

      When you compare your potential revenue increase, it’s very rarely a certainty. Even with a firm order contract in place, your projections are simply estimates until the revenue actually hits your bank account.

      Some factors to consider include:

      • Do you have contracts in place, or are your forecasts based on potential new sales?
      • How stable are your current and potential customers?
      • Is your business heavily influenced by market cycles?
      • How much internal or external data do you have to back projections based on business judgment?
      Your Own Risk Tolerance

      When you’re looking at your forecasts, you need to decide your risk tolerance. Do you want to be conservative and take a minimal risk, or are you willing to bet the business?

      A conservative approach might involve using worst case sales numbers and borrowing no more than you can repay using current cash flows. A very aggressive approach might use optimistic sales numbers and borrowing an amount that will require you to hit those sales numbers to repay the loan on time.

      Your Credit Score

      Taking on additional debt will have an impact on your credit score. As you may already know well, the amount of debt you have as a percentage of your total available credit is one of the factors that go into calculating a personal credit score.While you may work hard to keep your business and personal finances separate, this can still have an impact on your business later on, especially if you try to get more financing. Most lenders will look at both your business credit score and personal credit history if you apply for a loan or other type of financing, so it’s important to take care of those scores and consider the impact of any new debt you take on.

      Tips for Lowering Your Business Debt

      If you find that your business debt is too high, there are some things you can do to lower it. Here are some tips to help you lower your deficit and stabilize your finances while at the same time, growing your business:

      Draw a Better Picture of Your Debt

      Make sure all transactions like the inflow and outflow of cash are well recorded. Understanding your cash flow will help you better determine a timeline for paying off your debt.

      Consider consulting an accountant to help provide an expert assessment and a third-party perspective of the financial status of your company.

      Once you determine your total debt, account for the expenses you allocate for on a monthly basis.

      Be Strategic About Debt Reduction

      Have a plan. Once you have identified the total amount of debt you want to pay off, make a critical expense plan. This will allow you to create necessary adjustments in your monthly spending that will help you attain your goal.

      Set an income target wherein, a percentage of which is intended for debt payment. Or, specify an income strategy wherein, the income of a particular line, for example, is dedicated to the debt payment.

      If your monthly income is fluctuating or variable, you may need to adjust your strategy on a regular basis.

      Find a Way to Increase Income or Sales and Decrease Expenses

      Work on your marketing strategies to set prices that can boost your sales, keep customers coming back, and capture new ones.

      You can also think of diversifying your business with new products or modifying your current products or services.

      Inform your customers when price changes take effect. This encourages additional orders and extra revenue for you.

      Make sure that your operating costs are adequately monitored. Having an accurate picture of your daily costs allows you to scale back in the areas that will impact your bottom line the most.

      Explore Debt Reconstruction

      Review your loan terms. A surplus payment can significantly help reduce your load, but check first if there are any fees associated with paying early.

      Talk to your lenders. You may be able to negotiate with suppliers or creditors. Ask for a discount for early payments or negotiate some of the terms of your debt.

      Consider consolidating loans. If you have several, you may be able to combine them into a lower-interest loan with only one creditor instead of several.If you’re struggling to pay off your debt, there is still hope. Of course, it’ll require a bit of work and some time, but there are ways you can pay off your debts and reclaim control over your financial situation.

      How to Pay Off Business Debt

      1. Make a Plan

      It’s hard to get out of debt when you’re constantly playing catch up. Get ahead of your finances with a game plan. Create a budget to help you see where all your money is going.

      Make your debts your priority. Then, start seeing where everything fits in your cash flow. Start with the most essential business items first. With a brand-new budget and reprioritization, you may find that you have enough cash flow to take care of your business debt payments.

      2. Reduce Spending

      Look at your budget and your cash flow statement to find nonessential expenses. If you have costs that aren’t absolutely necessary, cut them from your expenses. Start with the small things, like:

      • Parking spot subscriptions
      • Expensive unused software licenses
      • Heating and cooling on the weekends
      • Extravagant company parties
      • Catered meals and fancy snacks

      If cutting smaller expenses doesn’t make a big enough dent, start looking at your larger costs: rent and payroll. Do you need an office? If not, end your lease as soon as possible to recoup a sizable amount each month.

      Instead of hiring new employees, can you hire contract workers? These workers don’t require expensive benefits or overhead—plus, you can always cut back on work if your cash flow gets tight. 

      3. Increase Sales

      If you run out of expenses to cut from your budget, start looking at ways to boost your revenue. Extra money each month will help cover your debt payments and keep your business moving in the right direction.

      Look at your marketing programs to identify the winners and the losers. If a campaign is underperforming, cut your spending and reallocate it to a channel with a higher ROI. For example, if you’re struggling to win customers on Facebook, but your YouTube ads are thriving, push that Facebook budget over to YouTube—even if that means temporarily stopping your Facebook investment.

      Take a look at your inventory. If you have old products taking up room on the shelves, sell these items as quickly as possible by putting them on sale or including them as add-on purchases to your big-ticket items.

      Consider raising your prices. You’ll want to remain competitive, but explore how a price hike could impact your revenue. Imagine what a 10% price increase could do for your bottom line. If you’re in an industry like retail, you’ll notice the financial gains while it’s unlikely your customers ever will.

      4. Secure Financing

      While it’s not a good strategy to fight debt with debt, some forms of financing can help you out of a tricky situation. 

      Sometimes money today is more valuable than money tomorrow. Specific forms of financing can give your working capital a much-needed boost, giving you breathing room to take care of your expenses while paying off your debts.

      If you’re desperate for cash now, a merchant cash advance lets you trade tomorrow’s earnings for money today. It’s not cheap financing, but it can help you get out of a bind if your cash flow is hurting.

      Another financing alternative is accounts receivable financing. Accounts receivable financing (also known as factoring) lets you liquidate your IOUs. If you’re waiting on customers to make their payments while your debts stack up, use factoring to accelerate your cash flow turnover.

      Look at your other financial assets. For example, do you have a business credit card or line of credit you can use? Allocate those credit lines strategically in your budget to ensure you can use them responsibly while also paying them off before they accrue interest.

      Talk to your lender about refinancing your existing debts. You might be able to secure a lower interest rate or extend your terms to reduce your monthly payment.

      5. Save Less

      It’s critical to save for a rainy day, but it’s more important to get out of deep water first. You’ll need to find the delicate balance between paying off your debts and saving cash.

      Your debts’ interest rates are likely a lot higher than your savings account’s rate. You’ll save money in the long run by paying off your debts sooner.

      However, don’t completely neglect your cash cushion. You’ll still want to make investments toward your savings to prevent an emergency from shutting down your business.

      6. Automate Payments

      Make your debt payments first. Don’t wait to buy this and that—it’s easy to get distracted. To avoid budgeting mistakes, automate your payments. This will take one more thing off your plate and ensure your business is taking care of the essential expenses first.

      Reclaim Financial Control

      Debt can be debilitating, but don’t let it slow your business down. Remember, debt isn’t a bad thing (far from it). You don’t necessarily need to get out of debt—you just need to control it.

      Even if you’re an entrepreneurial shop of just a few people (or even a shop of one!), thinking as a business may mean considering taking on strategic debt. When you take on debt in a strategic, planned fashion, you are taking steps to set yourself up for success in the future.

      About the author

      Lendio's team of experts is here to help you with every nook and cranny of your business. We'll make sure you have the best advice for financing, operations, management, hiring, and much more.

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