If utilized properly, debt-based financing can be an essential tool for business survival and growth. Case in point, the SBA recently announced that it had provided $44.8 billion worth of small business funding through more than 61,000 loans in FY 2021 alone. SBA Administrator Isabella Casillas Guzman believes the money went to good use connecting SMBs (including minority-owned, veteran-owned, women-owned, and underserved enterprises) with the resources they need to thrive.
However, if managed poorly, business debt can quickly get out of hand and go from a business lifeline to a financial nightmare. A recent survey by Goldman Sachs points out that 41% of SMB owners are concerned for their business’s future due to the high level of debt they accumulated before and during the COVID-19 pandemic.
The problem with too much business debt
Too much debt imposes short-term and long-term financial pressure on a small business. A heavy debt load can easily stall a business’s operations or, in the worst-case scenario, cause it to shut down for good. Here are some of the risks and dangers of accumulating unmanageable levels of business debt:
- The repayments draw heavily from the existing revenue streams, causing severe cash flow instability.
- Debt pilling can create a vicious cycle of perpetual debt.
- Too much debt can lock your business out of lucrative financing and partnership deals.
- A heavy debt load puts the business at high risk of default, which may attract devastating consequences.
- Sometimes the only way out of unbearable debt is by declaring bankruptcy.
How to know if your business has too much debt
How much debt is too much, or at what point does debt become an issue? Well, there's no straight answer to this because every business perceives and handles debt in its own way. But in the words of Robert Kiyosaki, “bad debt takes money out of your pocket, and good debt puts money into your pocket.” Another general rule of thumb says that a business has too much debt if it’s overleveraged, meaning the debt profile exceeds the operating cash flow. Unfortunately, many entrepreneurs realize this when it’s already too late.
However, small businesses show several warning signals as they sink deeper into dangerous levels of debt. Let’s look at the early telltale signs that your business has too much debt:
Falling behind on payments
Getting overwhelmed by payments is one of the most obvious signs of having too much debt. Delaying or missing bills and loan payments means that your business’s cash inflow is struggling to match the outflow. In other words, the debt is too demanding to service with the business’s limited revenue.
The worst thing about falling behind on payments is that it exacerbates the initial problem, creating a positive feedback loop. Skipping or delaying payments often attracts additional fines and higher rates (in variable interest debts). So, every missed payment increases the debt for the subsequent payment cycle, making it even harder to pay. Inconsistencies in repaying business debt, especially installment loans, only make the debt load heavier.
So, watch out for overdue bills, bounced checks, and payment reminders from creditors. Take a close look at your cash flow if you notice any of these signs; they often indicate excessive debt.
Dwindling savings
It’s important for every business to stash away some cash for future use or for a rainy day. And you should only draw from it when it’s absolutely necessary. But, if the business’s income isn’t enough to meet payment obligations, the debt will inevitably start eating away at the savings.
Draining your savings to pay off debt is a risky and unsustainable repayment strategy. What happens when the savings run out before the debt clears; how will you repay then? Plus, you’ll have wasted your valuable financial cushion on debts that should not have been a problem in the first place.
If your cash reserves are dwindling due to overwhelming loan or bill payments, you have a serious debt management problem on your hands.
Borrowing to pay other debts
Are you taking on more debt to pay off previous debts? That's the beginning of the vicious debt cycle we mentioned earlier. It’s easy to get tempted into settling old loans with new ones. The justification is that the new debt buys you some extra repayment time. But the truth is, it doesn’t improve your financial situation at all; if anything, it only makes things worse. Trading one debt for another basically extends the problem and postpones the inevitable.
This is also an expensive and unsustainable way to manage debt. For one, each new debt will have to be larger than the previous one to cover the additional fees and interest. Second, what happens when you hit your borrowing limit or run out of places to borrow?
Getting caught in this debt trap says you're already too deep in debt, and it's time you stopped digging.
Unhealthy financial ratios
Although there’s no standard way to determine how much debt is too much, here are four insightful financial metrics that can help you draw the line between good and bad debt:
Debt-to-EBITDA ratio
This is the ratio of the total debt to earnings before interest, taxes, depreciation, and amortization (EBITDA). It’s a simple calculation that essentially quantifies your ability to pay off incurred debt. The lower the debt-to-EBITDA ratio, the better your debt repayment ability, while anything higher than 4 is a potential red flag.
Interest coverage ratio
The interest coverage ratio measures how well you can pay the interest due on your outstanding debt over a given duration. It’s calculated by dividing the total earnings before interest and taxes (EBIT) by the interest incurred during a set period. A higher figure is better; an interest coverage ratio below 1 means the business cannot meet its interest obligations.
Debt service coverage (DSC) ratio
The DSC ratio measures a firm’s cash flow against the outstanding debt load. Dividing the net operating income by the total debt service gives you an idea of the money available to settle debts. A DSC ratio below 1 indicates insufficient cash flow to do so.
Acid-test ratio
An acid test divides an enterprise’s short-term balance sheet assets by the immediate liabilities to give a quick snapshot of its capacity to cover outstanding debts. The variables in the calculation solely depend on the balance sheet entries. The higher the resulting figure, the better.
Debt-to-income (DTI) ratio
DTI ratio compares what your business owes against how much it earns. It generally shows you how much of your income goes toward debt. A DTI ratio above 50% means you’re spending too much on debt.
You're having a hard time qualifying for loans
Most lenders won’t finance businesses that already have too much debt. Lenders carefully analyze your financial ratios, including the ones we’ve just listed, as part of borrower evaluation every time you apply for financing. If the figures fail to meet the expected benchmarks, the lender may not qualify your business for financing, especially loans.
Check your debt profile if everything else checks out (credit score, business history, cash flow, etc.) and you still can't qualify for financing.
What then?
What should you do after noticing any of these signs? First of all, heavy debt is not a business death sentence, provided you can wiggle your way out of it. Luckily, there are a couple of different ways to get out of debt safely. Here are five debt management strategies that could work for your business:
- Debt consolidation
- Debt restructuring
- Debt refinancing
- Advocated debt settlement
- Non-debt business financing
The good news doesn’t end there. You can avoid unnecessary debt risks altogether by shopping for favorable small business funding with Lendzero. It’s pretty simple too. Lendzero prequalifies your business for multiple financing deals, including non-debt offers, and negotiates for the best terms on your behalf. It’s a quick and convenient way to find borrower-friendly financing, which is a huge leap toward low-risk business funding. Sign up today and try Lendzero for yourself.
