No entrepreneur can infuse enough capital in his business to help it expand and reach heights. Bootstrapping the company is an excellent idea for initial days, but when you need to grow, you have to opt for business finance options. The most common route for any company to acquire money is debt.
Is it bad to acquire debt?
The only other way your business could get finance is either through VC funding or through a new partner. In either case, you have to sacrifice a part of your ownership. This could be a big risk for several businesses. Therefore, debt comes as an easy solution. You can get debt financing from friends, government or other lenders.
You only have to part with a certain amount each month from your earnings. Some debt schemes, like those from the government, can also provide you rebates. Of course, debt repayment has nothing to do with your company’s profitability. Your creditors will have the first right over your earnings, however big or small they may be.
Debt can give equity holdings leverage
Debt can be used efficiently by companies to increase the ROE on their stocks or equity. Let’s understand this with an example. If a company has $1 million in equity capital and earns $100,000, its ROE will be 10%. However, if the business has only 50% equity and the rest of the capital comes from debt, the ROE will rise to 20%. Here is how. In the first case, ROE was calculated on $1 million of equity capital, and the earnings were only $100,000 or 10% of the total equity.
In the second case, the company still had total $1 million in the capital but only half of it in equity. This means that the company earned $100,000 on $500,000 of equity and gave a 20% ROE. This is a simplified example, but debt financing helps all businesses similarly.
How much debt is too much debt?
With more debt, the liability of a company is bound to increase. With more debt, the company’s balance sheets start leaning in one direction, eventually increasing liability to a significant extent. This could do damage to the company’s profits, and sale of assets may become necessary to sustain the business. Sometimes, if the debt amount gets too high, creditors might hire a commercial debt collection agency (you can search here to find one) to help them acquire back the amount they are owed. These collectors would then get in touch with your company, with daily calls and emails, until they can figure out a plan to help you pay your debt.
To ensure that you don’t land in this loop, find out your debt to equity ratio. If your debt to equity ratio is 2:1, it means that you owe a debt of $2 on every $1 of equity. Find out what is your industry’s standards in this ratio to check whether you have too much debt.
To ensure that your business keeps running smoothly, keep paying off your old debts. In this way, even if you take fresh debts, you will keep your creditworthiness high. Doing this will also ensure that your debt doesn’t pile up and make you more vulnerable to bankruptcy or sale of assets. Ideally, don’t take a debt if you don’t have a plan to pay it off.