Impact of Debt on Small Businesses
Contents
The Heavy Burden: How Debt Can Weigh Down Small Businesses
Taking on debt is often a necessity for small business owners looking to get their companies off the ground. Loans and credit cards provide access to capital that can be used to cover startup costs, inventory purchases, hiring new employees, and more. However, debt also comes with risks that can seriously impact the long-term success and sustainability of a small business if not managed properly.
The Double-Edged Sword
Debt is something of a double-edged sword for entrepreneurs and small business owners. On one hand, it provides vital access to capital that might not otherwise be available. Most small businesses just starting out do not have significant reserves of capital or strong enough cash flows to fully self-fund growth and expansion efforts (). Debt bridges this gap.However, taking on too much debt or the wrong kinds of debt can also weigh a company down. Interest, principal payments, and fees can become onerous over time. Highly leveraged companies often struggle to stay nimble and flexible in the face of changing market conditions or economic downturns.As small business owner John Smith comments on Reddit:
“I took out a lot of loans early on which allowed me to open my doors faster. But now the monthly payments are killing my cash flow. I’m struggling to reinvest in the business because so much money is going out the door to creditors.”
This highlights the delicate balancing act that small business owners must perfect. Debt can be rocket fuel for growth when used judiciously. But it can also be a heavy weight dragging down even established companies when allowed to pile up unchecked.
Common Sources of Debt Financing
There are a few common sources of debt financing that small business owners typically rely on ():
- Business Credit Cards: Credit cards are an extremely popular financing option thanks to how fast and easy they are to obtain. However, interest rates tend to be high and it’s easy to rack up more debt than initially planned.
- Term Loans: Term loans provided by banks and alternative lenders provide a lump sum upfront and are repaid in regular installments over a set period of time. They often require collateral and come with strict repayment schedules.
- Lines of Credit: Lines of credit provide access to a pool of capital that can be tapped as needed. Only interest is paid on the outstanding balance each month. The flexibility is beneficial but can also lead to overspending.
- Equipment Financing: Loans used specifically to purchase equipment like machinery, vehicles, or technology systems. The equipment itself usually serves as collateral for the loan.
Of these, term loans and business credit cards tend to be the most commonly used varieties of financing for small businesses. A 2020 study by Fundera found that 44% of small business owners carry credit card debt while 41% have outstanding term loans.
Warning Signs of Excessive Debt
How can small business owners recognize when they are carrying too high of a debt load? There are a few key warning signs to watch out for ():
- Difficulty Making Payments: If loan and debt payments are consuming an outsized portion of cash flow, it’s likely time to rein things in. As a rule of thumb, debt payments should not exceed 8-12% of revenue.
- Falling Behind: Missing payments or only making the minimum payments month after month indicates excessive debt levels. This can damage credit scores and cut off access to additional financing.
- Relying on New Debt to Pay Off Old Debt: Being dependent on new debt to roll over existing obligations is a major red flag. This “robbing Peter to pay Paul” tactic signals a severely overleveraged position.
- Inability to Invest in Growth: Excessive debt repayments can crowd out opportunities for business investment and growth. If there is no capacity left to fund expansion efforts after servicing debt, the burden may be too great.
Business owners who find themselves exhibiting multiple warning signs should take proactive corrective action before the situation deteriorates further.
Strategies for Handling Debt
The good news is that small business owners have options when it comes to getting debt under control (). Some key strategies include:Reducing Expenses
- Review budgets for any non-essential expenses that can be cut back without major impacts on daily operations or revenue generation. Every dollar saved is another dollar that can be put towards paying down balances.
Renegotiating Terms
- Speak with lenders about renegotiating to longer repayment terms, lower interest rates, reduced minimum payments, or temporarily deferred payments. This helps ease the burden and free up cash flow.
Consolidating Debt
- Consolidate multiple high-interest debts into a single, lower-interest loan or line of credit. This simplifies repayments into one monthly payment.
Refinancing
- Swap out short-term, high-interest debt like credit cards for longer-term, lower-interest loans that reduce interest expenses over time. Home equity loans are one option.
Alternative Lending
- Explore alternative online lenders which cater specifically to small businesses with options like merchant cash advances or invoice factoring. These can provide working capital without requiring collateral.
Seeking Investments
- Bringing on investors through selling ownership stakes provides an influx of capital that can be used to both pay off debt and fund growth plans.
The Long-Term Impacts
What happens if small business debt remains unchecked and continues growing? The consequences over the long run can be severe ().At best, excessive debt repayments hamper opportunities for business growth and expansion by consuming cash flows and profits that could be invested elsewhere. Companies carrying large debt loads often struggle to build momentum.More concerning are the risks of default and bankruptcy. Missed payments and covenant violations give lenders significant power including seizing assets put up as collateral or forcing liquidation. The result is businesses shutting down and owners losing everything.And even if businesses avoid complete failure, struggling under a debt burden for multiple years takes a significant toll. Owners experience constant financial stress trying to keep the business afloat which can negatively impact mental and physical health. Talented employees also tend to jump ship from companies in perpetual financial distress.The key takeaway is that small business loans provide short term gains but require prudent long term planning based on realistic growth projections and repayment abilities. Otherwise, gaining leverage through debt can quickly turn from a competitive advantage into a liability threatening the very existence of the business.
Finding the Right Capital Mix
Rather than taking an all-or-nothing approach to small business financing, the healthiest strategy is finding the right mix of debt and equity ().Minimizing reliance on any one source of funding reduces risk. Pairing debt financing with personal savings, retained business earnings, equity investments, and other sources ensures stable access to capital that doesn’t overwhelm the business’ finances.Additionally, lining up contingency plans for refinancing debt or securing additional investments in case of unexpected events is wise. This guards against ending up in an illiquid situation unable to service debts during periods of economic contractions or industry disruptions.Planning ahead and actively monitoring the debt burden from the outset helps business owners ride out turbulent periods while continuing to nurture growth over the long run.
Conclusion
Used strategically and in moderation, debt provides the capital access small business owners need to turn their dreams into reality. However, left unchecked, it can quickly become a liability with the potential to sink even thriving companies.By keeping close tabs on their leverage levels, being proactive about restructuring debt when warning signs appear, and securing diverse sources of financing, entrepreneurs can wield debt to drive growth while avoiding pitfalls.The journey to building a successful small business is filled with enough challenges even when finances are stable. With careful planning, capital can be secured to meet needs without creating an albatross that weighs down the balance sheet and distracts focus from long-term goals.