Importance of small business owners being prudent with debt management
In many situations, having debt can be detrimental to financial success, but if used and managed wisely, it can provide small business owners with a tool to further grow their business and take advantage of strategic opportunity when it presents itself. On the other hand, poor decision making with, and mismanagement of debt can result in financial burden for a small business owner that can limit growth and even jeopardize the ultimate survival of their business. Effective debt management includes timely repayment of debt obligations, negotiating favorable terms, and being prudent with how much and from whom a small business owner borrows. I note three areas that are benefitted with responsible debt management: Access to financing, Operating profitability, Maintaining financial flexibility. For reference, I also listed some benefits and drawbacks of debt financing. It is important to note that there is no absolute answer on whether a small business owner should obtain debt financing, which is why I listed both its benefits and drawbacks. Each small business owner has their own individual situation, which is why this decision depends on the specific circumstances.
Access to financing
Having access to financing is a key element for the growth of a business (e.g., hiring an employee, investing in marketing, using a recent technology). If using debt is the best decision for the business at a specific time, then small business owners can use business loans, lines of credit, and/or other forms of debt financing. By managing debt effectively, the business can establish strong creditworthiness with lenders, which helps in obtaining more favorable financing terms (e.g., lower interest rates). Conversely, it can be more difficult to access financing going forward when a small business owner does not manage their debt well.
Operating profitability
There are costs (e.g., interest payments, fees) to using debt as a financing vehicle, but responsible debt management helps keep these types of financial obligations manageable. By minimizing debt-related expenses, small business owners can improve profitability and use more cash flow to invest in other growth initiatives for the long-term success of their business.
Maintaining financial flexibility
There are some very unfortunate situations where a small business owner has an excessive amount of debt, which can limit its financial flexibility when it is necessary to respond to items such as economic changes and unexpected challenges. Maintaining an optimal balance between debt and equity financing is part of effective debt management and provides a small business owner the flexibility to adjust to circumstances when needed. It is important for small business owners to not overly rely on debt, which provides them with much more control of their financial situation now and strategic direction going forward.
Benefits of Debt Financing
Access to Capital: With debt financing, a small business owner is provided immediate access to capital and can keep complete control and ownership of their business.
Tax Benefits: Interest paid on business loans can be tax-deductible (depending on specific tax situation and if in line with IRS rules), which can reduce the overall tax liability for a small business owner.
Strengthens creditworthiness: Being responsible with the management of debt can help a small business owner build a positive credit history, which makes access to additional financing much more favorable if needed going forward.
Drawbacks of Debt Financing
Impact of loan repayments on cash flow: Loan repayments (including principal and interest) are required to be paid by a small business owner regardless of the business's operating performance. If these financial obligations are too high, then they can have a negative impact on cash flow, which will result in difficulty covering operational expenses.
Leverage risk: Incurring debt increases a business’s leverage, which increases the financial risk level (strain on cash flow, limits financial flexibility) of a small business owner.
Collateral requirements: Without a small business owner maintaining a significant amount of assets, lenders could require collateral to secure a business loan. By pledging collateral, a small business owner is putting specific assets at risk if they default on their loan repayment.
Reviewing your debt management
Effective debt management by a small business owner is a key to maintaining financial health and operating profitability. Timely repayment of debt obligations, prudent borrowing, and negotiating favorable terms can all help bolster growth and provide opportunities for long-term success. However, being responsible with debt management can take a lot of time and effort. Since small business owners spend so much time running and operating their businesses, I am here to relieve that stress by providing analysis and recommendations for clients in this area of debt management, which is just one part of my overall financial planning process. My debt management review also considers the benefits and drawbacks of debt financing for each small business owner client. It is important to weigh the benefits vs. the drawbacks when evaluating each small business owner’s financial situation.