When assessing the debt ratio of your business before a loan/finance application or as part of a formal review of your finances, you will need to take into consideration the financial health of your company and the implications this will have on your credit record. There are internal and external factors which will contribute towards your decision to increase or decrease liabilities, including your appetite for risk, growth and exit planning.
Your debt to asset ratio will help determine if increasing your liabilities is a wise step. If your business is largely dependent on borrowed funds to maintain daily operations over company cash flow, this raises an instant red flag. On the other hand, if your business can operate independently and with limited reliance on borrowed funds to meet essential payments, redirecting borrowed funds to facilitate company growth signals towards a business with a protected financial position. We will take you through some of the ways you can determine the ideal debt ratio for your business:
Operating structure – If you are operating through a limited company, you are protected by limited liability which limits your risk exposure. As your business is a separate legal entity, the liability will fall on the business to repay company debts and you will not be held personally liable. However, if you are operating as a sole trader, there is no legal distinction between yourself and your business, therefore exposing you to personal risk. The debt ratio your business embraces will depend on the level of risk your business is willing to embrace and the level of exposure you are personally comfortable with if you are not protected by limited liability.
Personal guarantee agreement – As a condition of taking out finance crucial to the success of your business, a personal guarantee agreement may be required which holds you personally liable for debt repayments in the event of default. If your business runs out cash and you have no means of making repayments, you will be held personally liable as this will be tied to the value of personal assets. The level of debt you agree to may be influenced by the finer details of the personal guarantee agreement and the risk you are personally willing to take.
Balance sheet and cash flow test – If your balance sheet shows that company liabilities are likely to overtake assets, this means that you are likely to overtake how much you can realistically afford. By keeping a close watch on company cash flow, you can ensure that you are borrowing within your means, in addition to striking the ideal balance of company debts. If your business no longer has the necessary funds to maintain operations and you require emergency borrowing to stay afloat, ensure that you calculate the long-term position of your business, steering away from overpromising.
Contingency planning – In the unfortunate event that you lose a key customer, cash flow dries up or you experience trading difficulties due to economic pressures, such as Covid-19, will you be able to keep up with repayments? Calculating cash earmarked for essential expenditure and the remaining value available for loan repayments will help you decide on the ideal balance. If mitigating factors, such as Brexit or the long-lasting impact of the coronavirus lockdown interferes with your repayment ability, you may need to explore a company restructuring route to lighten the burden on your business or company liquidation options if your business cannot be revived.
Taking a long term stance when determining how much your company can borrow is paramount as if you desire to exit from your business or sell shop to release returns from your investment, the sale value is likely to be influenced by your debt position. Although commercial borrowing reflects creditworthiness, stretching too far and overpromising could present you as high risk. Assess how this will impact your long-term plans for the business and research the market to find a competitively priced and cost-effective facility to suit your needs.