December 16, 2021 | Last Updated on: August 3, 2023
For many small businesses, debt presents a tempting yet vexing menu: too much and you might collapse under its weight; too little and you can starve. This guide will break down the pros and cons of getting a small business debt; contrary to popular belief, debt can be the right choice depending on how it is used.
The word “debt” makes many non-business owners uncomfortable. It represents an obstacle toward the freedom and success they want in life. But is debt bad for a small business? Make no mistake, debt can be a great asset to a business when used correctly. But when used recklessly, debt can sink a business.
That’s why it’s crucial to examine the effect that taking on debt will have on the bottom line of a business. In other words, what type of Return on Investment (ROI) can realistically be expected? Businesses should also have a sound strategy to pay down their debt.
The average small business debt is $195,000. While this number may sound daunting, the amount of debt alone is not indicative of a problem. Rather, the danger zone is when a small business owner uses a significant amount of expenses to service existing debt rather than being invested in the business. This means that a business is on the path to debt and expenses growing faster than revenue.
It’s difficult to quantify how much debt is ok for a small business with a number. In short, any debt that’s tied to a growth strategy for the business is acceptable. The problem debt is money that’s spent without any thought about its effect on the business.
Is it good for a business to have debt? Yes, debt can be a great help, especially when starting a business. In fact, studies show that 69% of small businesses uses financing to reach their goals, whether it’s to invest or expand, cover operating expenses or refinance.
Expansion. Debt can allow small business owners to hire additional employees, build stronger relationships with vendors, invest in new equipment or facilities, and any other operational needs that may arise. Investing into the business can lead to new or increased sources of revenues and quickly pay for itself.
Lower Financing Costs. Debt requires small business owners to make defined payments on a set schedule for a specific period of time. This results in debt having lower financing costs than equity in the business.
Improved Credit Score. Using credit to make small purchases and then paying off the debt before the due date is an excellent way for small business owners – especially those with startup businesses – to improve their business credit score. As a business grows, it’s inevitable that larger purchases may be needed. Building a better credit score can be a huge asset in getting the credit needed down the line.
Lower Taxes. A small business in debt can lower its tax bill since, according to tax laws, it’s possible to deduct interest payments against revenues.
Manage Business Cycles. Seasonal businesses need to navigate through slow periods. Even with proper planning, there are times when some debt may be necessary until business turns around.
High Interest Rates. Interest rates associated with loans and other forms of debt can be high enough to negatively impact the ROI small business owners need to make the debt worthwhile.
Lower Credit Rating. Incurring debt can lower the credit rating of small business owners, especially if the owners are borrowing large amounts of money.
Cash Flow Problems. Debt is typically repaid in equal installments until it’s completely paid off. If a small business owner experiences a drop in income, the need to pay down a consistent amount of debt on, say, a monthly basis can lead to cash flow issues.
ROI is a metric that denotes the amount of profit that’s been made from an investment. When it comes to business, ROI comes in two versions, depending on when it’s determined: anticipated and actual. In the case of whether or not a business should take on debt, anticipated ROI is a useful guide.
That’s because the decision of whether to incur debt should extend beyond interest rates and the overall cost of the capital being borrowed. The Return on Investment – or ROI – is a crucial component to consider. ROI is a measurement of the benefit to the business from the investment, relative to the cost. Anticipated ROI is used to determine if the project is worth doing. It uses estimated costs, revenues and other factors to determine how much is likely to be gained from the investment.
To accurately calculate anticipated ROI, business owners must realistically evaluate the gain they hope to achieve from the investment. The formula to calculate ROI is as follows:
(Gain from Investment – Cost of Investment)/Cost of Investment.
Business owners need to consider the APR in the cost of the investment. The APR is the total annual interest payable on the loan, averaged over the length of the loan. Fees and service charges should also be included. ROI allows business owners to examine the net benefit of an investment, rather than just its cost. Online calculators are available to help small business owners properly calculate ROI.
Here are a few common examples of common small business debt:
Small Business Administration (SBA) Loans. The SBA works with lenders to provide term loans to small businesses. While the SBA doesn’t lend money directly to small businesses, it provides a framework that makes it easier for small businesses to get loans. The loans typically have lower interest rates, and the SBA reduces risk to lenders by guaranteeing the loan.
The SBA’s most popular loan is a general small business loan called 7(a). But there are SBA loans that can be used for real estate, equipment or in the case of disaster. The SBA also offers microloans.
Small Business Term Loans. These loans provide a one-time infusion of cash that’s repaid with interest over an agreed-upon time period. Small business term loans are similar in nature to the SBA’s 7(a) loan, but typically have higher interest rates since they don’t have the backing of the SBA. Banks and alternative online lenders offer these loans. Approval can be fast and collateral may not be required.
Small Business Lines of Credit. A line of credit is not a loan. With a small business line of credit, business owners are approved for a certain dollar amount they can draw on as needed. By contrast, loans offer a specific amount up front. And, unlike a loan, lines of credit only charge interest on what was drawn on, not the entire amount of the line. APRs for a line of credit may be higher than those of a loan, and lines of credit may charge a fee of one to three percent whenever the line is borrowed upon.
Small Business Credit Cards. In addition to offering a convenient way to finance short-term expenses, small business credit cards are a good way to keep personal and business expenses separated. Small business owners can build a strong credit history and improve their credit score by opening a business credit card, using it for purchases and repaying the charges in full and on time.
Small business credit cards can help smooth out cash flow and can be helpful when it comes to filing taxes. But, like any financing option, there are pros and cons to small business credit cards.
Fixed debt for a small business is a permanent debt, or a debt that continues for an extended period of time. Payroll, rental payments, insurance and property taxes are examples of fixed costs that remain for the life of the business.
Loan repayment is an example of a fixed debt that continues for an extended period of time. This type of fixed debt is also known as installment debt, which is a debt in which the same amount is paid every month.
Paying down small business debt is not a one-size-fits-all approach. There are two main strategies to do so: debt stacking method or snowball method. The main difference between the two is how a business lists its debts.
With a debt stacking plan, debts are listed according to interest rate, going from highest to lowest. By paying the loans with the highest APR first, the business pays less interest as it attempts to pay off its debt. Conversely, a debt snowball strategy pays off the debt with the smallest balance first.
While snowball and stacking plans differ in approach, the premise is the same. Both plans require that a business rank all of its debts and pay the minimum on each obligation, with any extra money going toward paying a specific debt.
There are pro and con to both plans. With debt stacking, a business can save money on interest and shorten the amount of time it takes to pay off the loan. But, because the loans debt stacking targets are the loans with the larger amounts, it can still take a long time to pay them off and see any significant drop in debt.
Debt snowball, meanwhile, yields more immediate results since the smaller debts can eliminated faster. This can be a great motivator for a business owner to continue to pay down debt. Of course, if even the smaller debts of a business are significant in size, it may take time to see results and the business will pay much more interest than it would with a debt stacking plan.
The popularity of debt consolidation among consumers has caused many small business to ask, “Can you consolidate business debt?” The answer is yes, through a small business debt consolidation loan. This option involves a small business consolidating its different forms of debt – such as loans, credit cards and any other debt – into one monthly payment. Consolidation may also result in paying a lower interest rate.
The process of debt consolidation involves taking out a new loan to pay off a variety of existing debts. The new loan is typically is a longer-term loan than the loans and debt that it pays off. As a result, business owners who use this option by themselves take more time to pay off their obligations.
There are two types of debt consolidation loans: secured and unsecured. Secured debt consolidation loans use collateral. These types of loans are typically offered by banks and credit unions.
Collateral can include assets such as equipment or property, and is used to help guarantee repayment of the loan. In case of default, the collateral will be taken by the bank or credit union to cover the remaining balance of the loan. Because of collateral, secured debt consolidation loans tend to have better interest rates than unsecured debt consolidation loans, which don’t require collateral.
Because no collateral is required, unsecured debt consolidation loans are normally easier to get. Unsecured loans are available online through alternative lenders. But the tradeoff for this convenience is that unsecured loans have higher interest rates than secured loans do. This is because the lender doesn’t have claim to collateral to ensure that the loan is paid back.
Another popular option for managing small business debt is refinancing. Whereas consolidation involves combining multiple debts into one outstanding loan, the purpose of refinancing is to get a better deal on an existing debt. Small business owners refinance to get a better interest rate, payment schedule and payment terms of a loan or other credit agreement that’s already in place.
Longer term loans can create a lower monthly payment. Lower interest rates can save a business money by accruing less interest over time. Business owners can refinance to borrow a larger amount of principle while keeping their monthly payment the same.
Refinancing can make sense when interest rates drop, and business owners can take out a new loan at a lower rate in order to pay off the existing loan.
Since SBA loans tend to have lower interest rates, it makes sense to consider refinancing with an SBA loan. But can you pay off debt with an SBA loan? The answer is yes, given certain parameters. For more details, consult the SBA guide to situations where refinancing loans can be applicable.
The answer to whether a small business is better off with consolidation or refinancing depends on the unique situation of each individual business. A business that’s swamped with a variety of loans and payment schedules can simplify and perhaps minimize its debt through consolidation. Refinancing, on the other hand, may be the best course of action for a business that’s weighted down by one loan with a high APR. In some instances, it may make sense for a business to consolidate debt and refinance at the same time.
Since APR includes all fees and service charges payable on a loan, it provides a more accurate cost of the investment. A lower interest rate on a debt consolidation loan or refinancing doesn’t necessarily mean the overall cost of the loan will be lower. In addition, the length of the loan can also have a big impact on how expensive repayment of the loan can be.
In their eagerness to eliminate debt, small business owners can cost themselves more and be charged with a loan prepayment penalty by paying off a loan early.
To avoid this scenario, borrowers need to understand that loans often come with a penalty for paying off the loan early. This clause is designed that borrowers pay the full amount of interest that the lender expects to receive from the loan. But, even with prepayment penalties, it may still make sense for small business owner to consolidate or refinance. With the right loan, the new loan may still save them money in the long run even after the fees are paid.
The four types of prepayment penalties are:
Flat-rate penalties typically charge a lump sum based on the terms of your loan for paying off the loan early. The lump sum penalty makes it easy to determine if paying off the loan early is worthwhile.
Percentage penalties charge a percentage of the loan’s remaining balance. If, for instance, the balance of the loan is $10,000 and the penalty is 25 percent, the penalty would be $2,500 in addition to the $10,000 owed.
Reducing penalties are usually found on longer-term, fixed rate loans. As the remaining time left on the loan grows shorter, the penalty for prepayment penalty is further reduced.
Short-term prepayment penalties are typically not specified in short-term loan agreements. That’s because short-term loans don’t amortize, so there’s no distinction between principal and interest. As such, short-term loans charge all of the interest that the original loan agreement called for, whether or not the loan is paid off early.
Of course, one way for a small business to cut into its debt is to collect outstanding balances that it’s owed. But, to do so, small business owners need to understand the small business debt collection laws in place. For instance, debtors need to have received written notice that the collection process has begun at least five days before they are contacted about the debt. Other collection law intricacies include:
For more information on small business debt collection laws, click here.
The Small Business Debt Relief Extension Act was passed in September 2020 to help small businesses that had suffered financial hardship as a result as a result of the COVID-19 pandemic. The bill extends emergency debt relief for small businesses with an SBA-backed loan through February of 2021 and, in some cases, beyond that date. This includes 7(a) loans, 504 loans and microloans.
The act also provides an additional seven months of debt relief for the most vulnerable businesses and those businesses that operate in fields that have been most affected by the pandemic: educational services, arts, entertainment, recreation and hospitality industries.
In addition, the availability of debt relief on new SBA loans has been extended for a full year. The objective of this extension is to encourage job growth and creation for small businesses.
The Small Business Debt Relief Extension Act uses funds appropriated under the CARES Act. As such, it requires no new spending by Congress.
Now that we’ve covered the different advantages that a debt serves for a small business, this should hopefully remove some of the stigma attached to taking on debt. Depending on your business’ needs, there are many debt options to consider and different strategies to repay it that works for you. The bottom line is that as long as the debt has a positive ROI, which can be tracked using financial calculators, then it is the right move to make.
