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How Much Business Debt is Appropriate?

The amount of business debt a company can handle is significant, especially if that company is going to be doing some large-scale business transactions. If that company is going to be handling large amounts of money, they need to know how much business debt they can handle. This can make or break the company’s reputation.

Before getting into the “How Much Business Debt is Appropriate” model of how much business debt a company can handle, it would be wise for the company to look at their current cash flow.

The Necessity for Debts

It has been said that no business survives without incurring debt. Others have even stated, “There is no ‘big’ business out there that is obligation free.” While this may be an exaggeration, it does emphasize how loans play a crucial role in the survival of any business. Whether it is to expand operations, to purchase equipment, increase working capital, or to cover operational costs, a loan can supply you with necessary funds in no time.

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Most businesses exist today because they were initially funded by a loan to start with. When there not enough funds in the business to support certain business ventures, a loan becomes a solution. The subject of loans is an interesting one, even more so is the quantity used to represent it. Economists have developed a mathematical way of calculating a company’s “debt situation” in a very versatile manner as the number is inevitably used to indicate many other things about the company as well. This is discussed in the next section

A Measure for a Debt of a Business

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The “debt situation” of a business or company can be determined by a debt ratio value. This value reveals whether or not a business or company has loans and how the total credit finances compare to its assets. This ratio is calculated by dividing the total liabilities of the business and the total assets of the business. To recap: liabilities are the financial obligations of a business such as salaries, taxes, notes, all these are payable accounts (the business is required to pay). The loans (debts) fall under this category – usually classified as tax payable at the balance sheet.

An asset is any item of value (resource) owned by a business. This covers many categories and includes vehicles, real estate, computers, and the like. This are classified as tangible assets. Intangible assets include intellectual property, product formula, copyrights, trade names, and the like. The ratio between liabilities and assets, therefore, is, in simple terms, a number that indicates how much a business is indented relative to how much it has. It represents the financial health of a business. Some see it as a measure of financial leverage of a company or a measure of solvency of a company. It really does not only signify the relative debts of the company to its assets, it is something more, as well shall briefly see in the next section.

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What Debt Ratios Mean

As a measure for the stability of your business, debut ratios are very important, both to the business and to other outside parties interested in the business. In investment, for instance, potential investors would be interested to know the financial health of your business before they put their money on it. This is, in most cases, used to decide whether the stock of the business is a good investment. Determining a good debit ratio for (say) investments is not an easy task. Generally, lower ratios reflect a better debt situation of a business, but that is just half the story. Not all debts taken by a business are out of desperation; some debts can also be regarded as opportunities. For instance, businesses can take on debts even when they have assets that could very well cover their expenses. This is a calculated financial move by the business when they know they can obtain a better rate of return on the money than what they would be paying out in interest. This is known as a “good debt”. It has interesting financial implications to outside parties interested in the business. Indirectly, good debts can improve the returns of investors in the business.  

Bad debt is the exact opposite of this. It means a business is heavily reliant on debt to run. This is not at all a good indication for your business, but it is also suicidal either. In financial terms, it just means a higher risk for investors. An ideal debt ratio of a number very close to 0 may put off investors. Although this indicates that a business is self-sustaining, it may also translate to the limited return of investments passed on to shareholders. Not financing increased operations through borrowing tells investors they cannot expect huge returns due to the potential of a better rate of return from loan money. Most investors, however, would be comfortable with a debt ratio of 0.4 or lower. A debt ratio of less than one would indicate business stability, and a debt ratio of greater than one indicates the company is buried in debt. 

How Much Should a Business Borrow?

The answer to this question is non-direct and highly subjective. Suffice to say, however; keeping your debt ratio between 0.5 and 0.2 is safe enough. This will guarantee future business investments should potential investors want to put their money in your business. Also, the number reflects a manageable debt that is unlikely for you to get in over your head with it. But you should not be put in a box by a debt ratio value. If there is a financially viable possibility to expand your business or increased, you should not limit yourself with a debt number. Lenders tend to get uncomfortable with a high debt number, and that is understandable, but it is not the whole story. 

There are other factors considered in handing out loans from such as credit scores, collateral, and others that can still fill the void of a poor debt ratio. Also, as we have seen, a poor debt ratio does not necessarily reflect a “bad debt” ratio; if fact, we correctly used a high debt ratio that may attract investors.

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James Kanja
James Kanja
Kenyan-based blogger who has an interest in social media,Marketing,human interest stories. Email [email protected]

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