CHICAGO — Effective borrowing practices can help businesses like dry cleaning companies get up on their feet, purchase new equipment when necessary and take advantage of situations, such as buying out a competitor, when they arise. With such a powerful tool, however, comes dangers that can damage or destroy the business if caution is not used.
This was the message of Juliana Ramirez, an accounting expert, entrepreneur and small business bookkeeper for more than 20 years. Ramirez recently conducted a webinar, hosted by the Service Corps of Retired Executives (SCORE), on the topic of business debt management.
In Part 1 of this series, we examined some debt management basics, including the different types of loans and credit available to small- to mid-sized businesses like most drycleaning companies. Today, we’ll continue by looking at how debt can affect a business, and how owners can get a true picture of their current debt.
How can Debt Affect a Business
“First and foremost, debt can have an impact on cash flow through debt repayments,” Ramirez says. “A substantial portion of revenue may go towards servicing debt, reducing the amount available for operational expenses and investment.”
Interest cost is also something to consider.
“Interest on borrowed funds can be a major expense,” she says, “particularly for high-interest debts like some credit cards and short-term loans.” High levels of debt can also lead to cash flow constraints, limiting the ability to manage day-to-day expenses.
The amount and types of debt can also have an impact on the company’s credit rating, as can a poor payment history.
“A poor credit rating can limit access to future financing,” Ramirez says, “or result in higher interest rates for new loans, further accelerating financial challenges. Late or missed payments on debt obligations can negatively impact the business credit rating. And, a high credit utilization ratio is often seen as a sign of financial stress.”
In short, while borrowing is a tool that can help build a business, Ramirez also warns owners to keep in mind that it can be a double-edged blade.
“Excessive debt can force businesses to focus on short-term financial survival rather than long-term strategic planning and growth,” she says. “Debt can also have an impact on our psychological wellbeing. Managing high levels of debt can be stressful for business owners, potentially impacting decision making and overall business management.”
Balancing the benefits of debt against its potential downsides is key to maintaining a healthy and sustainable business, Ramirez says, and if they haven’t done it already, she urges owners to know where they stand when it comes to their current debt load.
Steps to Evaluate Current Debt
1. Create a Debt Inventory — “This is listing all of your debts by compiling a comprehensive list of outstanding debts,” Ramirez says, “including loans, credit cards, lines of credit and any other forms of debt. It is also important to know the details for each debt, and note who the lender is, the total amount owed, the minimum monthly payment and the due date.”
2. Understand Rates and Terms — “Understand the interest rate, because it affects the total cost of the debt over time,” Ramirez says, “and ensure that you understand the repayment terms, including the loan maturity date — that means when it’s due or when you are expected to complete that obligation — and any charge regarding early-bird payments. This is very important, especially when there are fees associated with paying the debt early.”
3. Prioritize by Interest Rate and Type — “First, list your high-interest debt,” Ramirez says, “because these are typically more costly over time. Also, understand the difference between secured versus unsecured debts. Understanding which debts are secured, meaning they are backed by collateral, and which are unsecured, meaning you don’t have to ‘worry’ about your assets if it’s unpaid.”
4. Calculate Total Debt Payments — “It’s important to note what it takes to meet monthly obligations.” Ramirez says. “This will give you a clearer picture of how much of your cash flow goes towards debt repayment.”
5. Review Loan Agreements — “Make sure that you are able to review your loan agreements,” Ramirez says. “Read the fine print, review the terms and conditions of each debt, and pay attention to any fees, penalties or conditions that may impact your repayment strategy.”
6. Assess Impact on Cash Flow — Ramirez says that being able to calculate your debt-to-income (DTI) ratio allows you to understand how much of your revenue is going towards debt repayment. “Calculating this DTI — a comparison of your monthly debt payments to your monthly gross income — is an important step to understand how much of a business revenue is being used to repay debt.”
To calculate DTI, first calculate your monthly debt payments — everything you put toward your debts. This includes the payments for loans, credit cards, lines of credit, and any other debt obligations. Then, determine your monthly gross income. This is your revenue before any deductions, taxes or expenses. To get your DTI, divide the total monthly debt payments by the monthly gross income and then multiply the result by 100 to convert it to a percentage.
If a business has monthly debt payments of $2,000, for example, and a monthly gross income of $10,000, the DTI ratio would be (2,000/10,000 ) x 100 = 20%.
“A lower DTI ratio indicates a healthier financial situation, as it suggests that a smaller portion of the business’s revenue is tied up in debt repayments,” Ramirez says. “Generally, a DTI ratio of less than 30 to 35% is considered good, but this can vary depending on the industry and the specific circumstances of your business.”
Understanding this debt-to-income ratio helps in making informed decisions about taking on additional debt, she says, as it provides a clearer picture of the current financial burden of debts on the business’s income.
7. Credit Score — Your credit score will dictate the types of future loans and interest rates available to your business, Ramirez says, so it’s important to know what your credit score is to see the impact that it will have on your business.
8. Collateral Risks — “These are risks associated with secured debts,” Ramirez says. “Consider the implications of failing to repay secure debts, which could lead to the loss of your collateral. Your collateral could be any of the assets that bring value to your business. It could be a particular vehicle or a particular piece of equipment or machinery that you have secured for a loan.”
9. Develop a Repayment Strategy — It is important to prioritize repayments based on your evaluation, Ramirez says, and advises owners to prioritize which debts to pay off first, and to consider factors like interest rates and impact on cash flow.
“By following these steps, you’ll gain a comprehensive understanding of your debt situation,” Ramirez says. “This knowledge is crucial for making informed decisions about debt management and repayment strategies, ultimately helping you to improve the financial health of your small business.”
Come back Tuesday for the conclusion of this series, where we’ll explore different strategies to pay off debt, how to negotiate with creditors and final thoughts on the topic. For Part 1, click HERE.
Have a question or comment? E-mail our editor Dave Davis at [email protected].
