What Is The Optimal Level Of Debt For Your Small Business?
Small businesses and solo entrepreneurs aren’t afraid to borrow. With interest rates at record lows it makes sense to fund your business with a little bit of credit. Borrowing money to expand the business can genuinely boost the returns on your investment and let you keep 100% control of the firm. But what ratio of debt-to-equity is appropriate for a small business?
Finding the right capital mix for your small business is tricky. You need to consider a number of factors, including your personal appetite for risk and the interest rate you’re offered while getting approved for a small business loan. Here’s what you should know:
The most important factor is the rate of interest you’ll pay on any loan you take for the business. If the business has a good credit rating you might have access to a reasonable interest rate for borrowings. Interest rates for the average small business in America can range from 6% to 9%. But the rate you’re offered depends on the amount, the credit rating, and the lender.
The second most important factor is the amount of profits your business earns. The bank or lender you approach for the small business loan will check to see if your business has the capacity to keep paying interest on time. You can use the same ratio they use to check if the loan you’re getting is sustainable - the interest coverage ratio. Take the pre-tax profits your business earned last year and divide it with the amount of interest you will have to pay annually. So if your business made $30,000 in pre-tax profits last year and the interest on your loan is likely to be $10,000 a year, the interest coverage ratio is 3x. The higher the ratio, the better.
The whole point of raising money is to business grow, so you need to factor in the growth rate to see if the amount of interest you’re paying can be sustained with the amount of growth the business will experience over the years. If there’s a good chance the business will be a lot bigger in a few years, you can probably afford to borrow more.
Finally, the amount of risk you’re comfortable with plays a key role in determining the amount of money you can borrow. Borrowing will constrain the amount of freedom you have while running the business. You can’t take risky decisions or suddenly change the business model if you’ve borrowed money. If you’re disciplined enough to meet interest payments on time and understand the risks of bankruptcy, go ahead and take the plunge.
For most businesses the optimal amount of debt depends on these four factors. The right amount of debt won’t cost you much, won’t strain your cash flows, and will help your business grow faster. Usually, a debt-to-equity ratio of 0.5 or less is ideal.