The most effective strategies that can help you decide how much debt you should take to expand your business include the following:
Evaluate your business plan
Before taking on debt, review your business plan and determine the specific reasons for needing the funds. What are your growth objectives, and how will the debt contribute to achieving them?
Ability to service the debt
The ability of the business to service or pay off the debt is the most crucial consideration when deciding on your company’s debt level. The business needs sufficient cash flow to pay down its debt.
The business should also have a solid history of paying off debt on schedule. The creditworthiness of the business is an additional crucial consideration. This covers the company’s financial history as well as its credit score. Before extending credit, financiers will want to know that the business has a track record of sound financial management.
Calculate the debt service coverage ratio
Determine whether your business can comfortably service the debt. The debt service coverage ratio (DSCR) measures your ability to make debt payments from your operating income. A DSCR above 1.0 indicates that you have enough income to cover debt payments.
Consider collateral and personal guarantees
Understand the collateral requirements and personal guarantees that may be associated with the debt. Be prepared to offer assets or personal guarantees if necessary.
Assess the cost of debt
Compare interest rates, fees, and terms from different lenders to find the most cost-effective financing option. Understand the total cost of borrowing.
Assess market conditions
Lastly, when deciding on your company’s debt threshold, it’s critical to take the state of the market into account. Conduct market research to discover if your business is likely to benefit from the expansion that you intend to use the debt for.
Reducing debt amounts could be the best course of action to avoid financial issues in the event of excessive interest rates or unfavorable economic conditions. We strongly advise all businesses partnering with lenders to take into account these extra variables in addition to these fundamental ones.
Consider collateral and personal guarantees
Considering collateral and personal guarantees is a crucial aspect of taking on debt for your business. Doing so will help you assess the overall risk tolerance of your business.
A personal guarantee is a commitment, often by the business owner or key stakeholders, to personally repay the debt if the business cannot. It essentially ties your personal assets and creditworthiness to the business’s debt obligations.
Lenders may require personal guarantees when the business is relatively new, has limited assets, or is considered risky.
Personal guarantees can be a significant personal financial risk, so consider the potential consequences carefully.
When dealing with collateral and personal guarantees, you must understand that offering collateral or a personal guarantee increases your personal financial risk. Weigh the benefits of obtaining the loan against the potential consequences if you cannot repay it.
If you’re uncomfortable with the idea of personal guarantees or putting significant assets at risk, explore alternative financing options like unsecured loans, equity financing, or grants. These options may not require collateral or personal guarantees.If you’ve provided personal guarantees, regularly review your business’s financial health and take steps to reduce the need for personal guarantees as your business grows and becomes more financially stable.
Stress tests your finances.
Conduct stress tests to understand how your business would perform under different scenarios, including worst-case scenarios. This helps you assess your ability to service debt even if your revenue or market conditions take a hit.
Perform a risk assessment
Evaluate the risks associated with taking on debt. Consider factors such as interest rates, repayment terms, and potential economic fluctuations to predict your risk tolerance. A higher level of debt may increase your financial risk.
Source: Cosmo Politian
