How Much Debt is Too Risky?
Many of our small business clients have negative preconceived notions about debt: they believe it’s either risky or unnecessary.
While there is some truth to both (because there’s indeed something like “too much debt”), owners must take an objective look at their capital needs and understand how the right level of debt can make a difference in creating value and decreasing capital costs.
Do I Have Too Much Debt? FAQs
First things first, let’s answer some questions to clarify the concept of debt and analyze closely what can be considered too much debt.
How Much Debt Does The Average Person Have?
According to Northwestern Mutual’s 2018 Planning & Progress Study, the average American now has about $38,000 in personal debt, excluding home mortgages. This includes debt in credit cards, student loans, car loans, and personal loans.
How Much Debt Should I Have for My Income?
So, how much debt can you afford, or how much should you take? Of course, this depends on your income. There is a standard formula that lenders use to determine when debt can become a problem. It’s called the debt-to-income ratio, or DTI.
The DTI takes into consideration 2 main factors:
- Your recurring monthly debt. It refers to the payments you are expected to make every month towards your debt: mortgage or rent, car payments, credit cards, student loans, personal loans, etc.
- Your gross monthly income. It is how much you make every month before taxes, insurance, Social Security, etc., are taken out of your paycheck.
Get ahead of your lender. Learn how to use the Debt-To-Income Ratio and calculate how much debt you can assume before applying for a loan.
How Much Debt is Too Much?
Most financial advisors say a DTI higher than 20% is too much and can cause financial problems. Others say 28% is acceptable. There’s no golden rule here: the level of debt where you feel comfortable will ultimately depend on your spending habits and the expenses you can reduce to pay your debt.
What Happens If You Have Too Much Debt?
Having too much debt can lead to numerous additional financial problems. You’ll struggle to save money, miss payments, or even suffer calls from debt collectors. You may be forced to borrow from family and friends just to stay afloat, not to mention the emotional stress that can even affect your loved ones.
What do you do if you have too much debt?
Fortunately, there are many debt management programs that can help you fix this problem. They will work alongside you to find a way to help you eliminate your debt.
How Much Credit Debt Is Bad?
It’s considered “bad” if you find yourself in a situation where you have to use more than 10% of your monthly income to pay towards your credit cards. For example, if your monthly income is $3,000, your credit card payments should never exceed $300.
As you can see, assuming too much debt or accumulate too many different debts can put you in an uncomfortable and hard-to-handle position. However, assuming the right amount of debt can reap numerous benefits for you and your business. Let’s see it.
Debt Is Risky, But Not Necessarily in a Negative Way
By definition, any capital investment in the business has inherent risk and upside potential.
Capital investments come in the form of equity and debt. Equity is riskier and more costly than debt. From the equity investor’s perspective (or, in this case, small business owners), owners are the last to get paid in business. Therefore in tough times, small business owners take-on all the downside risks of the business. However, owners benefit from limitless upside when a business thrives.
Conversely, debt is less risky than equity. To minimize downside risk, lenders look for collateral and strong cash flows to ensure the payback of the loan. Corresponding with limited downside risk, the upside risk of a lender is capped at the loan’s interest rate, costing the debt holder less money to grow his/her business compared to equity. Furthermore, interest paid on debt provides a tax shield to owners, resulting in incremental cost savings not available with equity. So, in fact, debt is less risky and less costly for owners.
While debt is cheaper than equity, too much debt can result in high costs of financial distress during periods of low cash flow generation. The trick is finding the right balance between equity and debt.
We know this sounds intuitive, but a small business owner should never take on more debt than the business can payback. For instance, a small business should only take on $1 of debt (and interest obligations) for every $1.25 the company generates in cash, leaving the business with enough cash flow “cushion” to pay off lenders during downtimes. With the right balance of debt and equity, small business owners can optimize the cost of their capital structure.
Debt has Benefits
So you think your business has great cash flows and doesn’t “need” debt to finance its day-to-day activities. Your business may even generate some excess cash flow to finance growth initiatives.
There are three BIG benefits of debt to the small business owner. First, debt is a cheaper way to accelerate the growth of your business. Access to debt increases the capital available to reinvest and accelerates your business’s growth while also benefiting from the cost benefits outlined above. Second, debt is a great way to relieve cash “stuck” in working capital. Too often, cash is stuck in your business in the form of inventory, employee payables, and accounts receivable.
Debt is a great way to relieve unnecessary cash flow restraints and redeploy capital in growth opportunities. Finally, debt is a great way for small business owners to diversify their investment portfolio outside of their core business. Too often, we see small business owners cutting checks from their personal accounts to grow their business.
Remember what we just said about equity being expensive? If a small business owner is truly confident in the upside potential of a certain growth strategy, why not raise debt to fund growth at a limited cost? Sometimes is better to keep your personal money outside of the business as a diversification strategy to save for a rainy day, or another limitless opportunity.
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