Every business needs money to fund its operations, expand into new markets, purchase new equipment, and launch new products or services. Depending on the scale of the project, the money will either come from the business or other sources like banks. When a business takes money from external sources to fund a project, it is said that the business has gone into debt. Debt incurred by a business is known as corporate debt. Corporate debts can come in the form of bank loans, promissory notes, bonds, or commercial papers. These financial instruments can be leveraged by businesses to raise capital.

In exchange, the lenders (bank or private investors) gain through interest paid on the loan. The loan plus interest is expected to be fully repaid on a fixed date known as the Maturity Date. This method of borrowing to finance business operations is known as Debt Financing. While debt financing can be helpful in growing and expanding a business, too much debt can be detrimental. This is why entrepreneurs need to know how much debt the business can handle before borrowing money.

Debt Financing: Pros and Cons

Although it can be a useful way for a business to get funds, there are risks associated with debt financing. Each debt a business receives is expected to be repaid with interest. Debt repayments are done regularly irrespective of how the business is performing. That is, whether the business is profitable or not, it is obligated to pay its debts as agreed. If the business fails to meet its debt obligations, it faces bankruptcy or other consequences like forced acquisition and a fall in stock price. At this point, the business is said to be over-leveraged

Over-leverage occurs when a business takes on more debt than it can afford to pay back.

Another risk of debt financing is the increase in the cost of capital. When a business takes a debt, it has to ensure the profit generated is enough to pay back what it owes. The metric to determine this is known as the Cost of Capital. This is the minimum rate of return or profit a business must generate to become profitable.

The cost of capital is calculated using the weighted average Costs of Debts plus Costs of Equity. Too much debt will increase the cost of capital, meaning that a business will have a bigger financial burden to bear. It may seem as if the cons of debt financing outweigh the pros, but this depends on the business’s ability to manage its debts. In the next section, I’ll discuss four ways a business can effectively manage its debts and avoid over-leverage.

5 strategies to effectively manage debt

Debt can be an effective tool for growing a business. However, it needs to be managed effectively, or else, it could become a trap that can jeopardize the business’s future. Debt management involves timely payment, close monitoring, and debt control, as well as strategic use of debt for profitable business ventures. Here are 5 effective debt management strategies.

Know how much debt your business can handle

Debt management starts with knowing how much debt your business can handle. This is known as the debt capacity of the business.

Debt Capacity is the total amount of debt a business can take and repay according to the terms of the debt agreement

Debt capacity can be assessed with the help of the balance sheet. This is a financial statement that shows the assets, liabilities, and equity of the business. Another financial statement that may be helpful in the assessment of a business's debt capacity is the profit and loss statement. This shows how much money the business is making after the expenses have been deducted. Both financial statements can help you know how much debt a business can take without endangering its future.

Sometimes a business’s financial forecast may not turn out as expected. In such cases, the business finds itself in financial distress and struggles to repay its debts. One way businesses can avoid bankruptcy at times like this is by renegotiating the terms of their debt. In the business world, this is known as Debt restricting or refinancing.

Debt restructuring is a process where businesses renegotiate the terms of their debt agreement to avoid defaulting on their debts

Some strategies used in debt restructuring include, reducing interest rates, extending payment terms, or cutting loan balances.

Understanding Debt to Equity ratio

One of the most effective metrics for monitoring a business’s performance is the debt-to-equity ratio. This is simply a ratio of the total debt of a business to its equity. A business with a high debt-to-equity ratio is said to be leveraged. Although this term can be used to also describe a business with a lower debt-to-equity ratio, highly levered firms indicate that most of the business’s operations are debt-financed. While a business with a lower debt-to-equity ratio relies more on equity to finance its operation.

A high debt-to-equity ratio can spell doom for a business with poor cash flow. However, it can also increase the business’s return on equity. It all comes down to the nature of the business. A business can be highly leveraged as long as it has enough cash flow to service its debts. If not, the business can lean more on equity to finance its operations and keep debts to a minimum (lower debt-to-equity ratio).

Adopting alternative means to finance your business

Debt is not the only means of financing a business. In the previous section, I hinted at equity financing, that is, using equity to finance business operations. Aside from equity, here are other ways a business can cut down on debts.

Leasing instead of buying - a business can opt to lease equipment or machinery instead of buying if it is more profitable to do so (short term). Leasing is safer when the business isn’t sure of the investment outcome. At the end of the lease period, the business owner can decide if it is worthwhile to borrow money and buy the equipment or not.

Reinvesting earnings - retained earnings is money the business has made but not yet paid out as dividends. This can be reinvested into the business as an alternative to borrowing.

Have a debt repayment plan

Don’t simply assume the business will pay off its debt. If you decide to borrow and invest in your business, you should consider having a plan on how to repay the debt. Planning will help you look deeper into the business’s finances and know if and how it will pay back the debt.

In conclusion, debt can be an effective way to grow your business, but poor debt management can easily ruin your business. This is why knowing how to manage debt is a critical skill for entrepreneurs to learn. This article outlines 4 strategies for debt management including knowing how much debt the business can handle, debt restructuring, understanding debt to equity ratio, and having a debt repayment plan. This list is not exhaustive but is a good place to start if you want to effectively manage your business debt.

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