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Understanding small business loan options and the impact of debt on your organizationâs bottom line can be a complicated process. There are pros and cons to every type of business debt. Since every business has its own business plan, income goals, growth strategies, and cash flow concerns, if youâre considering small business debt to make a large purchase, cover startup costs, or balance out the working capital in your company, youâll want to keep reading as we explore the differences between good business debt and bad business debt.
What is small business debt?
Small business debt is any money or asset that is owed to another company, individual, or lender. Small business debt is sometimes called non-consumer debt because business debt benefits the organization, not just an individual. It is not uncommon for small businesses to take on debt, in fact, according to the most recent Stability Report published by the Federal Reserve, 70% of small business owners have taken on some type of business debt. The report also shares that, in the United States, small businesses are the source of $17.7 trillion of debt in 2022, which goes to show that understanding the impact of good debt versus bad debt is more important than ever.
Entrepreneurs that have both consumer loans and small business loans have a responsibility to separate the funds from business loans and personal loans, although it is sometimes impossible to isolate a purchase for just one purpose. For example, many individuals use some type of financing, like a cash advance, credit card, or equipment financing, to purchase computers for work. Computers may be a business expense, but the business owner is likely to depend on the computer for both business and personal uses. In that example, the debt used to purchase the computers can still typically be considered business debt.
How much debt should a business have
Since each business has its own unique operations, itâs impossible to pinpoint a universal amount of debt that is considered beneficial, or healthy. The best way to understand how much debt is healthy for your small business is to consider annual revenues, monthly cash flow, and long-term goals. In a nutshell, if the business is struggling to cover monthly payments, the debt is unhealthy.
However, even if your small business is generating enough monthly cash flow to cover the payments, there are more sophisticated financial tools available to measure the amount of debt a business should have. Some common ratios used to evaluate a small businessâs amount of debt include the Debt-to-Income ratio and the DSCR.
Debt-to-Income (DTI) Ratio is also called the debt-to-earnings ratio because it generates a percentage of the small businessâs monthly income that is reserved for making payments on existing debts. Calculating DTI is easy; just divide the sum of all monthly debt payments by the businessâs gross monthly income.
The monthly payments included in the calculation may include:
- Commercial real estate loans
- Equipment loans
- Business credit card (minimum payments)
- Business lines of credit
- SBA Loans
The Debt-to-Income ratio is used to evaluate the borrowing power of a business by lenders when applying for new debt. To be considered within the healthy range by financial institutions, small businesses should have a DTI at or below 36%. The ratio is also a great internal tool because it helps leaders understand their ability to cover current debt schedules and their potential to take on new debts.
DTI = Total Monthly Debt Payments/ Gross Monthly Income Ã100
Pro tip: Do not deduct taxes from monthly income when calculating the DTI
Debt Service Coverage Ratio (DSCR)
Calculating your DSCR is a great way to understand debt. This simple ratio can give insight into whether the business can afford the current debt payments and how a new payment may affect your businessâs long-term financial health. It is often used by lenders when evaluating the creditworthiness of a potential borrower.
DSCR = monthly EBITDA/monthly loan payments
Pro tip: Subtract taxes, interest, and loan amortization from monthly income to find monthly EBITDA
If the DSCR is:
- Less than 1.0 â The current loan payments are at risk for default
- At 1.0 â Indicates borrower can cover current payments, but it is not recommended to increase total payment amount.
- Above 1.0 â The financial position of the borrower can withhold the current payments and may be eligible to manage additional debt
The difference between good debt and bad debt
Business debt is an important part of every entrepreneurâs story. Responsible debt management for small businesses allows ideas to evolve into profitable business ventures. Small business loans let organizations achieve their goals, grow, and become sustainable companies. However, not all debt is created equal. Good debt can set business owners up for success and drive their entity to the next chapter, but bad debt can cripple the businessâs ability to cover operating expenses, diminish business credit history, and damage its future eligibility for financing.
So, whatâs the difference? Letâs explore good vs. bad debt.
A lot of small business loans and other types of debt fall into the category of good debt. Determining whether the debt is good or bad requires looking at how the loan affects the business today, the impact on the small business owner, and the long-term implications of that debt. Debt is typically considered good if it is low-interest debt that benefits the entity by increasing either assets or income. Another requirement for a debt to be considered good is that it must be affordable so that the business has no problem making payments according to the repayment terms.
If a small business loan, cash advance, or other debt is negatively impacting your businessâs bottom line or decreasing the businessâs earning potential, then it is bad debt. If a business is not able to make the monthly payment on a loan without neglecting other obligations, it is bad debt. Other characteristics of bad debt include high interest rates and high financing costs. Bad debt is dangerous for startup entrepreneurs and new businesses because being unable to repay the debt will leave the business with a bad credit score, which will hinder future attempts at securing good debt.
Examples of good debt
Any debt that helps your business achieve its goals and can be repaid according to the loan terms can be a good business debt. The right type of business financing can benefit your financial situation by allowing tax-deductible interest payments, low interest rates, better business credit history, and increased working capital. Good business debt work like smart personal financing decisions, like student loans, and home equity loans. Some specific examples of loans that are generally considered good debt include the following.
SBA loans are a business loan option where the funds are partially guaranteed by the U.S. Small Business Administration. Since the government backs up to 80% of these loans, they are low risk for lenders, which translates to lower interest rates and smaller down payments for the borrower. There are several different SBA loan programs depending on the desired loan amount, the purpose of the loan, and the creditworthiness of the borrower. SBA loans are a great short-term or long-term financing option, but the eligibility requirements can be tough for some borrowers to meet.
Commercial Real Estate Financing
Real estate financing helps small business owners get into new or improved workspaces. This type of financing can be used to purchase land, buildings, office space, or to fund new construction. Real estate loans offer low-interest rates and flexible terms based on the loan amount, lender, and creditworthiness of the borrower.
A term loan is a traditional type of business debt where the person borrowing money receives a lump sum upfront and repays the loan according to a predetermined repayment schedule. Interest rates for term loans can be fixed or variable. Fixed interest rates remain the same throughout the life of the loan and variable interest rates fluctuate based on the market rate. Both secured and unsecured term loans are available to qualified borrowers. Secured term loans require that the borrower provide collateral, like real estate, vehicles, or equipment. There is no collateral held from the borrower when the term loan is unsecured, but a personal guarantee or down payment may still be required.
Equipment financing is a helpful financial tool for both startup entrepreneurs and seasoned business owners. The funds received through equipment financing can be used to purchase computers, computer software, landscaping equipment, machinery, kitchen appliances, copiers, or any other business equipment. Since the asset acts as collateral on the loan, equipment financing can offer low-interest, flexible financing to interested borrowers. The term of the loan is determined by the useful life of the asset.
Examples of bad debt
Some debt is easy to classify as bad. For example, personal loans or payday loans are taken out by business owners to cover company expenses typically have high-interest rates and put the ownerâs personal finances in danger because of the personal liability. However, other bad debts can be harder to spot. Some debt starts out as good debt, but if the interest rate was variable or the monthly payments were not made as planned it can quickly become bad debt. Letâs explore some examples of business financing options that can negatively impact a businessâs net worth if not managed well.
Business credit cards
Business credit cards work on the basis that the borrower is approved for a maximum credit line. Borrowers can then use the card for any purchases up to the limit. Monthly payments of interest and principal are made, although only the portion of the payment that is principal will increase the available credit. High-interest credit card debt can become bad if the total balance is not paid in full each month, as the interest begins to add up and can create unmanageable monthly payments. Credit cards that have all the credit limit withdrawn also hurt both the business and personal credit score of the business owner.
A merchant cash advance (MCA) is a fast financing option where borrowers get a lump sum payment upfront and repay the loan with future credit card sales. This is a great financial tool if a significant increase in sales is expected soon. While cash advances are necessary financing tools for some new business owners or those with bad credit, they are an expensive source of funds when processing fees and factor rates are considered.
Lines of credit
A business line of credit is another type of revolving credit, like a business credit card. Borrowers are approved for a line of credit and can draw on the line whenever they need fast funding. Interest rates on business lines of credit are higher than a traditional term loan or SBA loan and are determined by the amount of the credit line, the borrowerâs credit report, and the lenderâs approval requirements. Showing a good payment history and average available credit with a line of credit can help build better business credit, but failure to manage cash flow can easily lead to bad debt.
How to change your small businessâs bad debt vs. good debt balance
The good news about business debt is that it is not permanent. If your small business has more bad debt than good debt, consider debt consolidation, or refinancing, to shift the balance from bad to good. Refinancing is the process of taking out a new loan to pay off one or more bad business debts. The benefits of refinancing include:
- Lower monthly payments
- Longer repayment terms
- The ability to withdraw equity, on real estate or equipment loans
- Simplified accounting with one payment, instead of several
- Lower interest rates on balance transfers
- Fewer financing costs
If you think your business can benefit from refinancing one or more business debts, reach out to Biz2Credit today. Shortly after meeting with Dr. Eduardo Pignanelli, Biz2Credit was able to help him secure $4 million in funding, allowing him to expand his practice and refinance some prior bad debts.