Business debt can be either helpful or harmful to your business, depending on how you use it.
When you use it properly, debt can be a tool to help your business grow. If you let your business debt get out of hand, however, it can hinder the growth of your business, make it much harder to find financing, and make any financing that you are able to obtain more expensive.
But how do you know when your business debt has reached an excessive level and might start causing you a problem? Here’s how you can get a handle on your business debt before it gets out of control.
Warning Signs That Your Business Has Too Much Debt
Poor cash flow is almost always the first sign that you have overextended your business. If you don’t have sufficient cash flow, it can be very difficult to get your supplies and the materials that you need to serve your next client.
If your vendors reduce to COD terms or put you on a credit hold, you will find it very difficult to deliver your products or services in a timely manner.
Ultimately, a business that has poor cash flow will have trouble paying their basic expenses and even making payroll. This means that you likely won’t be in business for much longer if you don’t get the problem fixed quickly.
Don’t let it get to this point. Long before you start struggling to make your payments, you will start to see your accounts payable (A/P) increasing and your bank balance decreasing.
If you measure these two numbers every week, you should be able to get plenty of warning to find a solution before your cash flow begins to cause you a serious problem.
Simple Financial Ratios To Keep Debt In Check
There are a couple of simple financial ratios that you can calculate to help you keep an eye on your business debt and whether it’s getting out of control, in the same way, that you can use a refinance calculator to work out changes to your mortgage.
The Debt Service Coverage (DSC) ratio is used by banks to decide whether or not they will lend you money and is one that you should closely monitor at all times.
Your DSC is your operating profit per month, divided by your total monthly debt payment obligations. Most banks will require you a minimum value of 1.25, so you should try to keep yours well above this point.
You can also make use of a metric called the Acid Test. All you need to do is take the current assets on your balance sheet and divide it by your current liabilities. If this number is less than 1.0, then you heading in the wrong direction with your company finances. You should aim to keep this number closer to 2.0.
You should pay close attention to any short-term debt that you have. Short-term debt is debt that must be repaid within 12 months. Sometimes categorized as current liabilities, these will usually include your Accounts Payables.
You will also need to keep a particularly close eye on any credit card debt or vendor credit that you have. Long-term debt, which is usually secured by assets like property, should still be kept an eye on, but it is not as urgent.
Confirm That Your Numbers Up-To-Date and Accurate
Make sure that the financial statements that you used to calculate your metrics are up-to-date and accurate.
You will need to be hands-on about this. It’s not uncommon for business owners to completely ignore their balance sheets, usually because they just don’t know how to actually read one.
If this is the case for you, it is a good idea to get help from a CFO or analyst. You shouldn’t let your bookkeeper run these important numbers. If the bookkeeper has been making mistakes with your data entry, then you will end up working with bad numbers.
Instead, get a CFO or a financial analyst to go over your business finances on a periodic basis. Don’t just leave this important review to a CPA or an accountant.
Most accountants are more focused on tax issues, so won’t be able to do a good enough job of communicating the management issues that can sometimes be turned up in your financial statements.
Track Your Numbers Week-Over-Week And Look For Trends
Whichever metric you decide to use, the important part is that you are tracking that metric weekly. Chart the trend so you can see any problems that might be coming your way.
It is a good idea to plot your ratios on a graph, so you can see the trend line and how it changes over time.
If you use the dashboard of your account software to plot your ratios, then you must make sure you look at the actual numbers, not just at visual indicators of changes like red, yellow, or green lights. Check the numbers, as color-coding won’t always tell you clearly which way the number is actually trending.
How frequently should you be reviewing your financial ratios? This will depend on how volatile your numbers actually are and how much control you want to have.
For a small business that is in relatively good financial shape, you can monitor key debt ratios and financial or operational key performance indicators (KPIs) once a month is probably enough.
If you notice that any of the metrics that you are tracking start to trend downward, then you should start monitoring them weekly or more often, instead of once a month. More importantly than this, you also need to do something to counteract it as soon as you spot a downward trend.
If you have too much debt, it will put you out of business in the end. Too much borrowing can lead you to this result too. Too much debt is usually a sign of much deeper problems in your business that need to be addressed.