If you’re an entrepreneur, you’ve probably heard the expression, “It takes money to make money.” The premise of this message is clear: Capital investment is necessary to make a profit. This adage is especially true for small businesses. You can’t grow your business to the next level without sufficient capital, and that money doesn’t appear out of thin air. It usually means incurring debt in one form or another.
According to a study by the National Women’s Business Council, female entrepreneurs routinely under-capitalize their businesses. Fewer women than men apply for business loans and when they do, they ask for less money.
You can feel more confident about taking a loan and put your business on the path to success by understanding the difference between good and bad business debt. Understanding this distinction will also help you determine how much debt to take on.
Good Debt vs. Bad Debt
Good debt is debt that you take on in order to eventually increase your business’ profits. As long as the loan will help your business earn more income than you’re paying in interest and fees, it’s considered a solid return on investment.
Good debt includes essentials for getting your business up and running, such as computers, equipment, inventory, and other assets. Aside from such physical necessities, good debt also includes long-term investments in your business, like expanding your workforce. For example, if you take out a $100,000 loan to hire salespeople, they may eventually end up increasing your business’ bottom line far beyond the initial loan amount.
Whereas good debt offers a positive return on your investment, bad debt is unsustainable. It will not increase your business’ income and may even produce a negative cash flow. The entrepreneur who purchases more inventory than necessary or pays too much for new equipment that will depreciate in a few months is making an unwise financial move. Smart and savvy business owners only purchase necessities within budget. This helps to avoid incurring bad debt.
How Much Good Debt Can Your Business Afford?
Even when taking on good debt, it’s important to keep it at a manageable level. You should be able to make monthly payments without difficulty and have a cushion left over if business emergencies or unexpected costs arise.
Debt Service Coverage Ratio
The Debt Service Coverage Ratio (DSCR) measures how comfortably your business can cover its monthly loan payments. It compares your business’ net operating income to total debt payments. In general, it is calculated using the below formula:
DSCR = Monthly Business Net Operating Income/Monthly Business Debt Payments
For example, let’s say your business’ monthly net income (profit earned after expenses are paid) is $10,000 and that the monthly debt payments are $6,000. That gives you a DSCR of 1.67. Ideally, the DSCR should be 1.25 or higher, so the business has enough income to comfortably make debt payments and cover other expenses.
When calculating your monthly debt payments, be sure to count principal payments, interest payments, and loan fees. In addition, you should include existing business debt as well as the loan you’re applying for.
A DSCR less than 1 means that your debt payments exceed your income. In this case, you should focus on paying off the debt you have already incurred before borrowing more money.
There is a lot to consider when taking on a business loan, but once you have done your research and understand the differences between good and bad debt, you’ll greatly increase your chances of success.
Priyanka Prakash is a member of the DailyWorth Connect program. Read more about the program here.