Managing Business Debt: A Practical Guide for Owners
Almost every business borrows at some point, whether to buy equipment, fund inventory, smooth out seasonal cash flow or expand. Debt is not a problem in itself. Problems start when payments outgrow the cash the business generates, or when the terms are expensive or risky in ways the owner didn’t fully understand.
Key takeaways
- Used well, debt helps a business grow. Used poorly, it drains cash flow and puts the owner's personal assets at risk.
- Know the main ratios lenders watch, especially debt service coverage (DSCR) and debt-to-equity.
- Read personal guarantees carefully, and treat merchant cash advances with extreme caution.
- The earlier you spot cash flow trouble, the more options you have.
Business debt at a glance
Common types of business debt
| Type | What it's for | Things to watch |
|---|---|---|
| Term loan | Large one-time purchases, expansion | Fixed payments regardless of how sales are going |
| SBA loan (7(a), 504) | Working capital, real estate, equipment | Longer terms and good rates, but more paperwork and usually a personal guarantee |
| Line of credit | Short-term cash flow gaps | Variable rates, annual renewals, can be reduced or frozen |
| Equipment financing | Vehicles, machinery, technology | The equipment is collateral |
| Commercial mortgage | Buying property | Balloon payments and refinancing risk |
| Business credit cards | Everyday expenses | High interest if balances are carried |
| Merchant cash advance | Fast cash against future sales | Very high effective cost, daily or weekly withdrawals |
| Invoice factoring | Turning unpaid invoices into cash | Fees reduce margins, customers may be contacted |
The ratios that matter
Lenders, investors and buyers judge your debt using a few key ratios. Knowing them helps you borrow on better terms and spot trouble early.
Debt service coverage ratio (DSCR)
net operating income divided by total annual debt payments. A DSCR of 1.25 means the business earns $1.25 for every $1.00 of debt payments. Many lenders look for at least 1.20 to 1.25. Try our DSCR Calculator.
Debt-to-equity ratio
Total liabilities divided by owners' equity. It shows how much the business relies on borrowed money versus the owners' investment.
Current ratio
Current assets divided by current liabilities. A result below 1.0 can signal difficulty paying short-term bills.
Interest coverage ratio
Earnings before interest and taxes (EBIT) divided by interest expense.
Personal guarantees: read before you sign
Most small business loans require the owner to personally guarantee the debt. If the business can’t pay, the lender can come after your personal assets, such as savings, investments and sometimes your home, even if the business is an LLC or corporation. Before signing:
- Ask whether the guarantee can be limited to a fixed amount or a percentage of the loan.
- Ask whether it can be released once the loan balance falls or the business hits certain targets.
- Understand whether your spouse is being asked to sign, and what that means.
A word about merchant cash advances
Merchant cash advances (MCAs) are marketed as fast, easy funding. Instead of a loan, the provider buys a share of your future sales at a discount and takes daily or weekly payments from your bank account. Because they are often structured as purchases rather than loans, they may not be subject to usury limits, and effective annual costs can be extremely high. Stacking several MCAs is one of the most common reasons small businesses end up in a debt crisis. If you already have MCAs, get professional advice before taking on another one.
Warning signs your business debt is becoming a problem
- You use new debt to make payments on existing debt.
- You regularly pay suppliers or taxes late to meet loan payments.
- Your line of credit is always fully drawn.
- Your DSCR is close to or below 1.0.
- A lender has issued a covenant violation notice.
- You are behind on payroll taxes. These carry personal liability for owners and should be treated as an emergency.
Steps to get business debt under control
Build a 13-week cash flow forecast
So you can see shortfalls coming.
List every debt
With its balance, rate, payment, maturity date, collateral and personal guarantee.
Cut costs, collect faster
Cut costs and speed up collections from customers.
Talk to lenders early
Lenders have far more flexibility before you default than after.
Consider refinancing
Expensive short-term debt into longer-term, lower-cost debt.
Get professional advice
If payments still don't fit.
Get an expert view of your business finances
Foxboro Consulting Group provides financial consulting, forecasting and valuation services to privately held businesses.
