Small businesses often rely on debt to fuel growth and manage cash flow. However, it's crucial to strike the right balance. In this blog we take a closer look at responsible borrowing and its impact on long-term financial health for your business.
Why Businesses Need Debt
Let’s start by saying straight off the bat that debt isn't inherently bad. In many cases, small businesses rely on loans to get started. It can provide:
- Growth Capital: Secure the funds needed to invest in new inventory to meet growing demand, purchase cutting-edge equipment to enhance productivity, expand into new markets, or launch impactful marketing campaigns. Explore how you can access cash advances.
- Cash Flow Management: Bridge the gap between payables and receivables, cover unexpected expenses like repairs or emergencies, and smooth out seasonal fluctuations that impact revenue. See how you can successfully manage your cash flow.
How to Avoid Falling into Debt Traps
While debt is necessary at some times, there are ways to manage your finances so that business debt is manageable and strategic. Here is how to avoid debt traps.
- Create a Realistic Budget: Develop a detailed budget that accurately tracks your income and expenses. This allows you to identify areas for improvement and anticipate potential shortfalls.
- Build an Emergency Fund: Having a financial cushion can help you weather unexpected expenses or downturns without resorting to debt.
- Explore Alternative Financing Options: Consider grants, crowdfunding campaigns, or angel investors as potential sources of funding that don't require taking on debt.
- Negotiate with Lenders: Don't be afraid to negotiate with lenders for better interest rates, longer repayment terms, or more flexible funding and payment solutions.
So, What is an Acceptable Amount of Debt for a Company?
Unfortunately, there's no magic number. However, you can use these as a guide to understand what your ideal debt level depends on.
- Industry: Capital-intensive industries like manufacturing, medical, and pharmaceuticals often have higher debt norms compared to service-based businesses.
- Business Stage: Startups and rapidly growing companies often carry more debt to fuel expansion than mature, established businesses.
- Cash Flow: Your ability to consistently generate cash flow to cover debt payments is crucial. A common guideline is to keep total debt payments below 30% of your gross income.
How Much Debt Can a Business Handle?
To answer this, we need to consider several key factors.
- Debt Service Coverage Ratio (DSCR): The DSCR ratio compares your net operating income to your total debt service payments. A DSCR of 1.25 or higher signifies that you have sufficient income to comfortably cover your debt obligations.
- Working Capital: This is the difference between your current assets (like cash, inventory, and receivables) and your current liabilities (like accounts payable and short-term debt). Positive working capital indicates you can meet your short-term financial obligations.
- Collateral: If you have valuable assets to pledge as collateral, you may be able to secure larger loans. However, be cautious about risking essential business assets.
How Much Debt is Too Much? Warning Signs My Business May Be Over-Indebted
While some debt is healthy for business cash flow, if you have any of these warning signs, you might have too much business debt.
- I Have Difficulty Making Payments: Consistently late or missed payments are a major red flag that your debt load might be unsustainable.
- Our Debt-to-Equity Ratio Is Above 2:1: This means your business is heavily reliant on borrowed funds compared to owner's equity, increasing your financial risk.
- We Have a Declining Credit Score: Late or missed payments will negatively impact your business credit score, making it harder and more expensive to borrow in the future.
- Our Relationships with Our Suppliers is Strained: If you consistently pay your suppliers late, and you notice your relationships with suppliers are taking strain, you could be over-debted. This not only could damage your reputation, it can potentially disrupt your supply chain.
- We Miss Growth Opportunities: If you are missing opportunities and potential because you have high debt payments that consume resources, this is a warning sign that you are over-indebted.
- My Personal Finances Are Strained: If you take on personal debt or are depleting personal savings to cover business expenses, it is a sign of financial distress.
How to Manage Business Debt Effectively
- Consolidate Debt: Combining multiple debts into a single loan with a lower interest rate can simplify repayment and reduce your overall interest costs.
- Prioritise High-Interest Debt: Focus on paying off debts with the highest interest rates first to save money on interest and accelerate your debt reduction.
- Automate Payments: Set up automatic payments to ensure you never miss a due date, avoid late fees, and maintain a positive credit history.
- Communicate with Lenders: If you're facing financial difficulties, be proactive and communicate with your lenders. They may be willing to work with you to find a solution.
How to Take Out a Small Business Loan, Responsibly
Responsible borrowing is essential for long-term financial stability and growth. When you understand your debt capacity, make informed borrowing decisions, and proactively manage your debt, you can harness its power to fuel your business's success and your ambitions, while safeguarding its future.
Merchant Capital offers a unique funding solution for small businesses in South Africa, tailored to your business’s cash flow.
Here's how it works:
- Apply: Complete a straightforward online application. The process is designed to be quick and user-friendly.
- Get Approved: Based on your credit and debit card sales history, Merchant Capital will assess your business and present you with a personalised funding offer that aligns with your revenue patterns.
- Access Funds: Once approved, the funds are swiftly deposited directly into your business bank account, giving you immediate access to the capital you need.
- Repay: A predetermined percentage of your daily card sales is automatically deducted to repay the funding. This flexible repayment structure ensures that your payments align with your cash flow, easing the burden during slower sales periods.
The bottom line
Business debt requires a careful balance and a well-informed strategy. While debt can be a powerful tool for growth, it's crucial to understand your limits, make informed decisions, and manage your obligations responsibly. By taking a proactive approach to debt management, you can leverage its benefits while safeguarding your business's long-term financial health.
Remember, you don't have to go it alone. When considering business debt, partner with a lender you can trust – one with a proven track record, a deep understanding of your industry, and a commitment to your success. Merchant Capital stands out as a reliable partner for small businesses in South Africa, offering flexible funding solutions that adapt to your unique cash flow patterns. Our approach to responsible lending can empower you to achieve your goals without compromising your financial stability.
Choose the right lending partner, choose Merchant Capital, and you will confidently leverage business debt to unlock your business's full potential now, and in the future.