How to Manage Short and Long Term Business Debt
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Virtually all business enterprises incur debt. Often, it is used as part of startup funding and forms part of the capital structure of a new business. The decision of what mix of debt and equity will be used to fund a new venture is essential and plays a significant role in a company’s future operations and the risk equity investors face.
Debt is also incurred during ongoing operations and takes many forms, including trade financing of accounts payable, capital and operating leases, bank business loans, and lines of credit, to mention just a few common types of debt.
A look at a firm’s balance sheet can provide much information about its use of debt. Essentially, the balance sheet shows the assets a company controls and who has a claim to them as of a given date. It also separates assets and liabilities into short-term and long-term categories, a helpful distinction when measuring a company’s short-term liquidity or ability to cover its debts in the near term.
Debt differs from equity in some significant ways:
- Debt usually carries an interest charge that must be paid to avoid default.
- A legal obligation exists to repay debts over time, determined by the terms of that debt. Equity funding usually carries no such legal obligation.
- Creditors may provide essential funding, but just as they do not lose claim to their financial outlays if a company suffers losses, they also do not participate in profits when they occur. This underlies the concept of financial leverage.
- Creditors do not share in the ownership of a firm, and funds obtained from them do not dilute the ownership interests of equity holders.
Disadvantages of Excessive Business Debt
While debt is desirable for many reasons, including some mentioned above, excessive or inappropriate use of debt can be dangerous to a company’s survival. Excessive debt can induce a downward spiraling effect as debt service damages profitability, lowering cash flow, reducing profitable investment, and increasing the cost of additional funding. It is easy to see the pattern and predict the outcome if corrective action is not taken.
Debt comes with a price. Part of this price is obvious – interest must be paid to the creditors over and above the amount advanced. Other costs associated with acquiring debt include:
- Diverting funds from profit-making activities to meet debt service payments.
- The need to comply with covenants or conditions, often imposed by lenders. These conditions are often related to key company financial ratios and performance indicators and must be fulfilled to prevent default. Some lenders require an independent accounting firm to audit the company’s financial statements. This can be very costly.
- Increased debt levels imply increased risk to subsequent lenders and investors, and the cost of raising additional funds can rise quickly as debt increases.
- Increasing debt can lead to an inability to acquire more funding when opportunities arise. This opportunity cost can be hard to measure but can severely restrict a company’s ability to grow and/or stay competitive.