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What is the Right Amount of Debt for Your Business?

Finding the right amount of debt for your business can be a daunting task. While it can provide significant growth opportunities, there’s a risk of tipping the scale and ruining your business with too much debt. We offer some tips on how to find the right amount of debt for your company.

Types of business finance

Business finance can be broken down into two main categories — debt and equity. Equity financing is basically where you provide part ownership in your organisation in exchange for money. The most apparent downside to equity being the loss of ownership and control of the business you put your blood, sweat and tears into. 

The other option is debt finance. Generally speaking, debt financing is when you take out a loan — such as debtor finance, line of credit, credit card or equipment finance — which can be secured using an asset as collateral, or unsecured. The loan comes with a repayment term and interest payments, and is often preferred over equity finance predominantly because you retain ownership of your business, finance is available quickly, and you get to choose between short or long-term debt.

Is Debt bad for a business?

The answer to this depends entirely on how you manage your debt and the amount you take on. While finance can be the leg-up businesses need for expansion or managing cash flow, too much debt can have devastating consequences — so too can debt that is too expensive. The whole point of being in business is to make a profit. Having too much debt can severely erode your profit margin. 

Suppose you’re struggling to keep up with expensive loan repayments, having to put everything on your credit card, and noticing your profit margin declining. In that case, finance can very quickly become bad for your business. But on the flip side, if your finance is managed well, debt can be a necessary and good thing for a business, helping to facilitate expansion and assisting in managing the incomings and outgoings of day-to-day business operation — we explain this more below.

How to reduce your business debt:

If you find your business can’t keep up with credit card and loan repayments, it might be time to reduce the debt to avoid going out of business. 

Some possible ways to reduce your business debt are to:

Consolidate Loans: Trying to manage repayments for multiple loans with different interest rates and repayment terms can become costly and inefficient. Consolidating your debt means you refinance into a single loan to payout your existing debt. Once your business debt is consolidated, you’ll only need to focus on the one loan, which helps with budgeting, cash flow and managing interest rates.

Eliminate the most costly debt first: Needless to say, the most cost-effective forms of debt are the easiest to maintain, so paying off the most expensive loans first can help you to save money in the long run. To determine which is the most costly form of debt, it helps to compare the interest or comparison rates. Keep in mind that the length of the loans will factor into your budgeting. For example, a long-term loan with a lower interest rate than a short-term loan may still end up being the most expensive product based on the higher number of repayments you’ll make. It may help to seek professional advice regarding which loan should be paid off first.

Take on more work: It’s an obvious concept; if you want to pay off debt, then you’ll need more money. Taking on more work will help to increase your revenue, so you’ll have more money to reduce any expensive finance. But this is a bit of a catch 22; taking on more work can lead to more business expenses which you may not have the cash flow to cover. This is where debtor finance comes into play — more on that next.

How to grow your small business using finance

When looking to grow your business, one of the performance metrics to keep an eye on is your working capital. A measure of your working capital indicates whether your business has enough assets to cover short-term operating expenses, so growing your working capital is essential for growing your business. Working capital increases by either increasing assets — such as cash or your client’s unpaid invoices — or decreasing liabilities — such as reducing your level of debt. Having more working capital to play with means you can hire more employees to scale your business or increase your inventory.

Unpaid invoices are part of working capital, but there’s a very big difference between unpaid invoices and cold hard cash in your hand — you can’t pay your employees or expenses with unpaid invoices! So, where can the money come from to manage your cash flow and keep growth ticking along? Business finance, and specifically invoice finance, can use your receivables (your client’s unpaid invoices) as collateral for a loan. Invoice finance bridges the gap between your last job and your next job before the money rolls in, so you can move along to the next job while waiting for your customers to pay you.

When deciding how much debt to use in your business, it’s a very subjective decision that depends on analysing your business goals, objectives, administration processes and structure. It’s all about finding the right balance to suit your businesses needs and the right type of loan — make sure good debt doesn’t become bad debt for your business. 

If you'd like to learn more about invoice finance, equipment finance or trade finance with Earlypay, please visit us at earlypay.com.au or contact our friendly team on 1300 760 205.

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Topics: Debtor Finance