Debt is a great tool for business growth. But how does it work, how much should you have, and what type should you have?
Used in the right way, debt is an incredibly useful business tool. However, having too much debt, or the wrong kind of debt, can be financially damaging for businesses.
Find out how much debt your business should have, what kind of debt you should be looking into and how to avoid the pitfalls of debt below.
Equity financing and Debt financing
Before thinking about how much debt a business should have, it is useful to understand the business financing options available. These can generally be split into two types, equity and debt financing:
Equity finance involves selling an ownership interest in a business to shareholders. There are no fixed repayments, but shareholders can participate in the profits of the business.
Equity finance is commonly provided by the founder and their family and friends in the early stages of a new business. As the business grows, it may be possible for other investors to add equity capital to the business, particularly if the growth prospects are very positive and more equity can help the business grow quickly.
Debt finance is finance from a bank or lender. A business borrows money (either secured or unsecured) and is required to pay this amount back with interest to the lender. The lender does not have any ownership interest in the business.
How equity and debt financing works
For young businesses, the initial investment in setting up the business and the large negative free cash flow that is common in the early days is often financed by equity capital. Most commonly, Australian SMEs will draw on the resources of the founder, friends and family until the business is in a position to borrow money from a business lender such as a bank debt provider.
For bootstrapping companies that manage expenses frugally and make shrewd decisions around resource allocation, equity financing can be enough to grow a sizeable business without needing additional debt funding in the early stages. More commonly though, businesses require debt financing for fixed assets like equipment before they have reached a happy state of having free cash flow.
Isn’t having debt bad for my business?
Debt in and of itself is not bad for businesses. Even some of the world’s biggest and most positive cash flow generating businesses have debt - companies like Apple, Walmart and Toyota. For these large businesses, debt is an important piece of their funding activities, and is used appropriately after taking into account factors such as the borrowing cost and potential tax benefits of deductible interest expenses.
While it can be bad to have too much debt, or to have interest payments that are overly burdensome, the right level of debt that takes into account the needs of your particular business can be useful and beneficial.
How much debt should your business have?
This is a complicated question and depends on a range of factors including how much cash you have to service the debt, how stable your revenues and other expenses are and how much risk your business has, etc.
That being said, to determine just how much debt your unique business should have, you can start by analysing both your cash flow and free cash flow. By analysing this data, business owners can see how much their company generates from day-to-day operations, what’s being invested in and how much debt they're paying down or taking on.
- Cash flow is the amount of money moving through your business, both coming in and going out. Cash inflows can be from activities like customer sales, while cash outflows can be from expenses such as payroll and rent. Your cash flow is usually positive or negative.
- Free cash flow is the cash flow that’s generated from the normal operating activities of a business less any capital expenditure used to invest in, and maintain the assets of the business. Generating free cash flow is a great outcome for any business as it can be used to pay dividends to the owners, expand operations or pay down debt.
It often takes businesses many years to generate free cash flow, and for as long as a business has negative free cash flow, it is necessary to supplement cash flow either through equity or debt financing.
Examining a business’ balance sheet and income statement can also help business owners find the right level of debt, by highlighting a business’ current debt levels and its ability to repay. Two examples are:
- The Debt to Assets Ratio, which is total debt divided by total assets, indicates the proportion of assets currently being funded by debt. If this ratio is low, then there may be room to increase debt levels, but if the ratio is high then there may not be.
- The Debt Service Coverage Ratio, also known as the Interest Coverage Ratio, is the business’ earnings before interest and tax, divided by its interest expense. A higher ratio indicates that the business is able to more easily service its current debt levels with its earnings, which means that there is room to increase debt levels if needed.
While there is no cut-and-dried answer to the question of how much debt a business should carry, examining your cash flow, balance sheet and income statement together can assist in arriving at a level that is suitable for your situation.
What is the right type of debt for your business?
The type of debt that is right for your business will depend largely on your business’ financial standing and credit rating, its length of trading, annual turnover and unique business model. All of these factors are important to consider carefully when deciding what type of debt finance is right for your business.
Unsecured business loans
An unsecured business loan is a form of business cashflow finance that is not secured by working capital or any other form of asset, such as residential or commercial property.
Unsecured business loans can be expensive forms of finance, as they pose a high risk to the lender. Usually, you will also be required to have a good credit rating and/or a high annual turnover and a long term in business to procure unsecured finance.
Secured business loans
A secured business loan is a form of business finance that is usually secured by commercial or residential property.
Generally speaking, it's cheaper to borrow if you can provide some form of security to the lender. This allows the secured lender to charge less than unsecured business loans as it's more likely that the loan will be fully repaid.
Asset based finance
In between unsecured business loans and real estate backed loans is asset based finance, which uses assets that your business owns as security for the loan. The main examples of asset based finance are invoice finance and equipment finance.
When looking to finance your business, it's best to match your loans with the use of the funds. If you are looking to buy some long-term equipment, an equipment loan that is repaid over the life of the equipment might be best. If you are looking to increase working capital to help your business grow but don't want to use your home as security, then using invoice finance to bring forward cash flow from your outstanding invoices could be the answer.
By embracing the power of cloud accounting software, modern invoice finance providers like Earlypay are making invoice finance easier than ever before. If you'd like to learn more about invoice finance with Earlypay, please contact our friendly team on 1300 760 205.