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Business debt can be nothing to worry about or very harmful, depending on how you use it. When you use it properly, debt can be a tool to help your business to grow. If you let your business debt get out of control, it can stop that growth, make it much harder to secure financing, and make any financing that you are able to get a lot more expensive.
But how do you know when your business debt has reached an excessive level and might start causing you a problem?
Warning Signs
Badly controlled cash flow is usually the first sign that you have a problem. If you don’t have sufficient cash flow, it can be very difficult to get supplies and materials. If your vendors put you on a credit hold, you will find it almost impossible to deliver your products or services in a timely manner.
A business with poor cash flow will struggle to pay its expenses. This means that you won’t be in business for much longer.
Don’t let it get to this point. Before you start struggling to make payments, you will start to see your accounts payable (A/P) increasing and your bank balance decreasing. Measure these two numbers every week to get enough warning to find a solution before your cash flow begins to cause you a serious problem.
If your money troubles are caused by someone else owing you money, you can use a payment agreement template to try to solve the issue.
Simple Financial Ratios To Keep Debt In Check
There are a couple of financial ratios that you can work out to help you keep an eye on your business debt.
The Debt Service Coverage (DSC) ratio is used by banks to decide whether or not they will lend you money. Your DSC is your operating profit per month, divided by your total monthly debt payment obligations. Most banks ask for a minimum value of 1.25, so you should try to keep yours above this point.
You can also make use of a metric called the Acid Test. For this, take the current assets on your balance sheet and divide them by your current liabilities. If this number is less than 1.0, then your finances are moving in the wrong direction. You should aim to keep this number closer to 2.0.
Pay attention to any short-term debt you have. Short-term debt is debt that needs to be repaid within 12 months. Closely watch your credit card debt or vendor credit that you have too. Long-term debt, which is usually secured by assets like property, should still be kept an eye on, but it is usually not as urgent.
If you have too much debt, it will put you out of business in the end. Too much borrowing can lead you to this result too. Too much debt is usually a sign of much deeper problems in your business that need to be addressed.