The COVID-19 pandemic shone a new light on business debt, as the Canadian Federation of Independent Business reported that 65% of small businesses took on debt (to the tune of an average of $160,000) in order to sustain their enterprises during that period.
Debt and business go hand in hand. Let’s face it; debt and life seemingly go hand in hand. However not all debt is created equal – both in life and in business. There is good debt. There is bad debt. And there is bankruptcy-inducing debt.
What is Good Debt?
As a business owner, taking on debt of any sort may be seen as counterintuitive. However, if taken on responsibly, 'good' debt can actually help business owners to supercharge the growth of their business.
Simply put, good debt is debt that can generate a return and make the business money. This may include taking loans to buy capital assets - such as property or equipment for the business - that has the potential to streamline production and boost sales. Or making growth-minded investments in the business operations. When used wisely, debt can often be the key to unlock greater levels of success for the company – provided that the business can afford to service it properly, of course.
What is Bad Debt?
Whereas good debt will ideally help to drive business growth and increased profits, bad debt (or non-productive debt) does the opposite; it can drive a business into the ground. Bad debt involves spending beyond the businesses’ means or spending frivolously in a manner that does not make smart business sense. Such as buying a flashy $100,000 business vehicle when a $30,000 one will do (unless the business can easily afford it).
Particularly in these trying economic times with rising interest rates and increasing inflation, being mindful of taking on debt - and how it will impact operational cash flow - is critical for business owners.
Debt-Related Ratios to Consider
A good rule of thumb when considering whether to debt or not to debt is to look at some of your organizational financial ratios.
A current ratio is an important metric used to assess the overall financial health of a business. It looks at a company's current assets compared to its current liabilities, providing insight into the organization's ability to pay off debt in the near future.
Generally, anything over 1.0 means the business has enough cash and liquid assets to fully cover any near-term debts but ratios that are too high can signal problems too. The sweet spot for most companies is somewhere between 1.5 and 2, although every business is unique so it’s important to evaluate each situation individually.
Debt Service Coverage Ratio
The debt service coverage ratio is a key indicator of organizational financial health, and it’s essential for individuals to be familiar with it. The debt service coverage ratio measures the relationship between a company’s debts and its ability to effectively manage them through cash flow generated by their operations.
A debt service coverage ratio of 1.5 or higher is often seen as the optimal ratio for businesses. This is because it indicates that a company's operating income can easily support its debt obligations. Having too high of a ratio can be a sign of underutilization of available financing opportunities, while having to low of one might mean the business will struggle to repay its creditors. Assessing this ratio and how a loan would impact it is a must-do when considering incurring new debt.
The debt-to-equity ratio is calculated by dividing the total liabilities of a business by its total equity. It’s a way of determining how well a company is able to finance its expenses with both debt and equity. A lower ratio means that the company is using more equity than debt, making it less vulnerable to losses due to credit fluctuations. A higher ratio indicates that more debt rather than equity has been used in finance, which can lead to increased pressure on cash flow. Companies need to maintain a healthy balance between the two in order to ensure financial stability – ideally between 1.0 to 1.5
What is the Best Way to Accrue Debt?
So, your company’s debt service coverage ratio is 1.5. Current ratio is looking healthy at 1.8. Your debt-to-equity ratio is a nice 1.4. You have a potentially lucrative business growth opportunity at your disposal, one that could lead to tremendous savings within three – five years. All the debt accrual stars are aligned in your favour – what is the best course forward?
First and foremost, a discussion with your accountant is in order to involve them in the decision-making process. They will work with you to help establish the most financially healthy course of action.
The next step is to research what options will generate the lowest possible costs and give you the best repayment terms. Consider a loan from your own savings, or a business loan from traditional banks or alternative lenders. Good credit and a sound financial track record are typical requirements for most lenders.
In any case, engaging your accountant in the process will go a long way in making sure you get the best deal and negotiate the most favourable repayment terms that align with your unique cash flow situation.
Avoid Becoming a Debt Statistic
According to Statistics Canada, almost one quarter of Canadian businesses have reported higher debt levels in Q4 2022 than at the beginning of the COVID-19 pandemic.
While we have established that debt can indeed be good and drive operational growth, before even considering taking on new debt, it’s important to work with your accountant to understand the true financial implications. Developing a knowledgeable and informed approach to debt management is essential for all business owners seeking to maximize their potential for financial stability and growth.
A member of WealthCo’s Integrated Advisory community, Graham Thiessen is a Partner and Co-Founder with Summit Path LLP. Graham is passionate about educating his clients, enjoys being a sounding board for them, and is deliberate about asking the right questions to show them a different way to look at their business. Graham’s driving purpose is to leverage his client relationships to make a positive difference in the lives of others.
The Integrated Advisory community consists of a network of progressive CPA firms, along with best-in-class professional advisors, service, and product specialists, who work together to deliver an elevated and holistic client experience. One that optimizes both their personal and professional lives with an integrated financial strategy designed to help clients reach their goals.