Many of our small business clients have negative preconceived notions about debt: it’s either risky or unnecessary. There is some truth to both and yes, there’s something like “too much debt”. But it is imperative that owners 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.
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 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 debt-to-income ratio (DTI):
Recurring monthly debt ÷ gross monthly income = debt-to-income ratio
The result is expressed as a percentage.
Your recurring monthly debt (the first part in the equation) 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.
Gross monthly income (the second part in the equation) is how much you make every month before taxes, insurance, Social Security, etc. are taken out of your paycheck.
Get ahead of your lender. Use the Debt-To-Income ratio to 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 depend ultimately on your spending habits and the expenses you can reduce to pay your debt.
How Much Debt Does The Average Person Have?
According to the 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.
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, you’ll miss payments, or even suffer calls form 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. Keep reading What Happens When You Don’t Pay Your Debt? for more info.
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 perspective of the equity investor (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 risk 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 interest rate of the loan, costing the debt holder less money to grow his/her business when 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 a $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 the growth of your business, 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. Last but not least, 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.