Even highly profitable businesses can have debt on their books, and this can support operations and growth as long as it’s kept to a manageable level. Unlike equity financing, debt lets you maintain full ownership and control, and it can give businesses a tax benefit – as both principal and interest can sometimes be deducted as expenses.
However, business debt could impact your credit rating, and high interest and substantial repayments could constrain your cash flow and even the viability of your business. Ultimately, poorly managed debt can result in insolvency, voluntary administration or liquidation, and breaches of the directors’ insolvent trading duty.
Clearly, too much debt has severe consequences, so how can you tell if your business is close to incurring too much debt? These are five of the most common signs to watch out for.
1. Poor cash flow
Poor cash flow is a strong indicator of having too much business debt. Your accounts payable is increasing while your bank balance is on a downward trend, possibly because your payables fall due before your accounts receivables are paid by customers.
Potential driving factors of poor cash flow include big outlays spent purchasing equipment and supplies instead of incremental payments through leasing. Additional causes include not incentivising customers to pay earlier rather than later, no electronic options for payments, and not sending invoices out promptly.
Other reasons include failing to carry out customer credit checks, and poorly managed, stagnant inventory. Businesses that overlook the benefits of negotiating with suppliers for better pricing and other supply-cost-management strategies like buying cooperatives can also end up experiencing cash flow issues.
Finally, not exploring smart pricing increases can mean your business products and services are underpriced, leading to both low margins and poor cash flow.
2. Financial ratios aren’t healthy
Take a look at your basic financial ratios: your debt-to-asset ratio, debt-to-equity ratio, current ratio, quick ratio, and return on equity. For example, the higher your debt-to-equity ratio, the more debt you have relative to equity. Similarly, your debt-to-asset ratio tells you how much debt you have relative to assets, which might be funded by both debt and equity.
Your current ratio and quick ratio are two indicators of liquidity telling you how capable you are of fulfilling your short-term debt obligations. Your return on equity gives you an idea of how much net income is returned as a percentage of shareholders equity, and so it’s an estimation of your company’s profitability.
3. Inability to pay debts
One of the most explicit signs of too much owed by your business is the inability to pay debts as they fall due. This can manifest as debts growing faster than cash inflows, or it could emerge as your cash flow forecasts fail to match your debt repayments. Late repayments, constantly making payments outside trade terms, and having to negotiate formal payment plans are other ways this specific symptom can emerge.
Ensuring your business is always prepared for uncertainty can minimise the risk of this particular issue arising. All businesses operate in an environment of uncertainty because, although you can create fairly accurate financial projections, your knowledge about the future is always incomplete. From overheads and cash flow to sales and profit, your business finances are impacted by uncertainty thanks to fluctuating input costs, market conditions, regulatory changes, and much more. To survive, build resilience, focus on growth, and take other measures to stay prepared for disruptions and uncertainty.
4. Low profitability
Low profitability is another compelling sign of too much debt in your business. Look out for decreasing gross and net profit margins, increased operating costs, and declines in sales. For gross and net profit margins, you’ll want to review stock prices and expenses and make sure your business is passing on higher input and overhead costs to customers.
Similarly, your merchandising expense figures (cost of sale or cost of goods sold) can tell you a lot about your business’s profitability by revealing the cost of things like raw materials, manufacturing goods, and providing finished goods and services. Also, your operating charges or operating expenses cover ongoing items like office supplies, rent and utilities, and they can chip away at your profitability.
Additionally, excessive discounts for customers can erode your profit margins without consequential benefits for your business. And failing to identify effective strategies for growing sales with both repeat and new customers can be another driver of low profitability.
5. No access to finance
Suppliers refusing credit and no access to finance, or increasingly constrained access – such as further finance offered on the condition of personal guarantees, are also potential signs of excessive business debt. If it’s because lenders now see you as too risky a borrower, your lack of access to finance is likely a major warning sign on your business’s over-leveraged status. Similarly, if you’re denied finance because you’ve reached the limit of your borrowing capacity, your business likely has too much debt and you should take quick action to decrease your borrowing levels and avoid insolvent trading.
Another reason for a lack of access to finance could be leaving outstanding debts unpaid and accumulating more debt at the same time. You might have poor communication with your lender, and a strained relationship with them. Managing your relationships, open communication, and negotiating a manageable repayment plan could allow you to turn the relationship around and prevent it from further deteriorating.
Getting your business back on track
It’s possible for a heavily indebted business in financial distress to avoid processes like voluntary administration or liquidation, but acting quickly and early is crucial. Assess what’s happened to your business so you can take the right strategic measures to correct course. Restructuring, business turnaround, or other types of expert-guided plans could provide the remedies your business needs to get back on track.