In opposition to what you’ve most likely been taught in the past, debt isn’t always a bad thing. It just depends on the type of debt you incur. For example, taking out loans to attend college is a good form of debt because in the future this will result in a high return. Racking up credit card bills to pacify your Manolo Blahnik shoe habit, on the other hand, will not. You may end up having the best-dressed feet in town, but it will come at a very significant price-to your paycheck as well as your credit score.
There is an easy, basic formula that will let you know what type of debt you have: good debt results in positive cash flow; bad debt does not. Now that the difference between good and bad debt is clear, the next issue is whether your company should take on debt. Again, since taking on debt is acceptable if it’s good debt-that is, it will result in your company’s ability to bring in more money-you must first determine if it is, in fact, good debt. Obviously, taking out a loan to build another location, increase the size of your current one, or even out your cash flow because your business is cyclical may all be good reasons for taking on debt.
If you decide to borrow, the next issue you will face is how much debt you can reasonably afford-or, more accurately, how much you should realistically borrow. To determine this you need to analyze your own company’s cash flow as well as industry conditions. This is an important step because you do not want to borrow more than you will be able to pay back. If you are unable to pay back your loan, you will end up in a worse financial situation than you were in when you started the process.
Remember, looking at your industry is important. The type of industry you are in will significantly impact the amount of debt you should have, or even whether you should have debt at all. For instance, the more volatile your industry is, the less debt your company should have because it will need to be flexible so it can rapidly change to be in line with current trends. If your industry is less volatile, then the converse is true.
An important aspect of discovering the financial health of your business comes in the form of the debt-to-equity ratio. The ratio is equal to your total liabilities divided by your equity. The lower the ratio, the better off your company is because it demonstrates its ability to withstand difficult financial times. (This ratio is also affected by the industry the company is in.) After you determine this ratio, you will have a better idea of how you should proceed. You may discover that the best course of action is to pay down debt and hold off on taking out a loan. Or you may discover that this is the best time to take out a line of credit and move your company forward.
Keep in mind that the fact that you shouldn’t take on more debt or the fact that you don’t have a very good debt-to-equity ratio certainly doesn’t mean that lenders won’t be more than happy to finance your endeavors. They are businesses as well, and just as you are attempting to increase your profits, they are too. Be careful, or you may find yourself taking out credit lines that are not only unreasonable but also not in your best interest.
The bottom line is this: you are responsible for making the best decisions for your business. Only you know all of the details about your company’s financial health and whether taking on more debt or trying to pay it off is the best option. Only after you analyze your company’s financials and your industry can you determine the best course of action.
