What’s a Healthy Level of Business Debt?

What is business debt?

Business debt is money your business owes to others and is obligated to repay. It includes loan payments, business credit card payments, unpaid invoices and other monetary obligations owed by your company to another entity.

Debt isn’t uncommon — it’s often necessary for growth. Businesses use debt to improve cash flow, pay suppliers, run payroll and more. Taking loans or seeking financing can be part of a business growth mindset. However, business owners must understand debt, healthy loan practices and the difference between financing that can result in explosive growth and financing that can devastate your business. 

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Jeb Ory, co-founder and former CEO of social advocacy platform Phone2Action, agrees that financing is a crucial business growth ingredient that must be approached thoughtfully. “Access to capital,” Ory noted, “can be the difference between explosive growth, linear growth and the death of your business.”

Understanding your debt type is essential. There are two types: Consumer debt and business debt:

• Consumer debt: Consumer debt is money an individual owes for personal, familial or household purposes. This type of debt includes car loans, credit cards, mortgages and student loans. This debt is accrued for personal reasons.
• Business debt: Business debt, or nonconsumer debt, is any debt you take on for your business. 

There can be a gray area between consumer and business debt. For example, if you use your personal computer for work, that debt is considered consumer debt. Meanwhile, if you have business credit card debt from a company expense card, it is considered business debt.

Why healthy debt isn’t a defined amount

A healthy amount of business debt can vary widely by situation. However, it’s important to be aware of general debt ratios when analyzing money owed and forecasting your company’s finances. For instance, investors or other businesses interested in acquiring or merging with your company will want to see a debt ratio between 30 percent and 60 percent. If your debt ratio is higher than 60 percent, banks and other lenders may consider your company a risky borrower. 

In other words, it’s essential to acknowledge your company’s financial health and understand how others will perceive your business’s finances before amassing large amounts of debt. 

To identify a “healthy” — or “good” — debt amount for your organization, evaluate how that debt is tied to your business’s growth plans and strategies. Harj Taggar, a managing partner for Y Combinator and co-founder of Triplebyte, emphasized that a defined plan is crucial to handling business debt. “Good debt is tied to something solid with a clear plan for why it’s helpful,” Taggar explained. “Bad debt is money you spend without understanding how it impacts your business.”

Taggar and Triplebyte explored loan options but ended up raising funds through an equity round. This funding infusion was precisely what the business needed and Taggar had a realistic plan for building the business with the capital. 

Ory also weighed various financing options but secured funding through venture debt via a specialized bank that serves small software-as-a-service companies. “Technology has flattened barriers to entry and it’s easier than ever for new companies to enter a market,” Ory noted. “The ability to expand your business ahead of cash flow is critical to growth and can provide a competitive edge itself.”

Good vs. bad business debt examples

Taking on debt can be positive when accomplishing business goals, spurring your company forward or providing the necessary fuel to build your business. However, amassing debt without a plan can be costly — in more ways than one.

“Debt should be used to extend the runway and help businesses make purchases that they couldn’t normally make if it makes them more competitive,” Ory explained. “The type and amount of debt should be directly linked to the type of business.”

Examples of good business debt

Good business debt examples include the following: 

• Government-sponsored debt programs: The United States has numerous government loan programs that allow small businesses to borrow money at competitive interest rates. Additionally, the government will deduct the interest on the debt from corporate income taxes. If your business files for bankruptcy, the debt can sometimes be forgiven or reduced. 
• Financing for revenue-generating assets: When deciding between debt vs. equity financing, taking on debt to purchase equipment, technology or inventory that directly supports revenue generation or operational efficiency can be considered good debt. These investments often provide measurable returns that outweigh the cost of borrowing.
• Expansion financing: Borrowing money to open a new location, hire additional staff or increase production capacity — when supported by a solid growth strategy — can provide long-term business benefits.

Examples of bad business debt

Bad business debt examples include the following: 

• Debt you can’t repay: When you take on more debt than you can pay back, it’s a bad business debt. This practice can lead to financial strain and a loss of credibility with lenders and investors.
• Acquired bad debt: A business acquires bad debt when the money it’s owed becomes unrecoverable. If a customer can’t pay what they owe, the debt is deemed worthless to the creditor. While businesses can deduct bad debts in full or in part when filing taxable income, these situations still represent a financial loss.
• Loans to clients or employees: Providing loans to vendors, clients or employees can result in bad debt if repayment isn’t guaranteed. If a loan isn’t repaid, the business suffers financial loss. Businesses should only issue loans when repayment is fully secured, often with interest.

How to create a plan for taking on healthy debt

Creating the right plan to take on healthy debt for your business may involve hiring a certified public accountant or getting advice from another trusted financial professional. Working with an expert accounting and finance team can help you move in the right direction.

“Review [your] financials holistically with a financial professional at the end of each month,” Taggar advised. He emphasized that you shouldn’t only examine the numbers superficially. Instead, dive into fundamental business metrics to evaluate your business’s condition and develop a realistic financing plan.

If you don’t have access to a budget for financial professionals, do your best to assess your situation realistically, create a solid plan for the capital you secure and assess your growth properly. However, Taggar advised companies to be wary of situations where projected growth doesn’t align with the debt.

“If you took on a level of debt based on growth assumptions that proved to be optimistic [but] growth slows and you’re slow to react, you can be left in a fatal situation,” Taggar warned.

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How to get your business out of bad debt

If your business has taken on more debt than you can handle, here are some ways to dig yourself out of the situation:

• Take inventory: Examine your accrued debt and organize it based on interest rates and monthly payments. By organizing this data, you can prioritize which debt to tackle first.
• Increase your company’s sales: By increasing sales and making more profit, you can pay off your company’s debt. Consider building a customer loyalty program, starting a social media marketing campaign and raising prices.
• Refinance high-cost debt: Consider business debt consolidation or refinancing if you have strong credit. This will give you a lower fixed interest rate and decrease the number of payments. Additionally, combining your debt into a single payment could improve your business credit score. 
• Apply for a hardship plan: Many banks and other lenders have hardship plans when borrowers face tough times. Lenders may give you a temporary break from making payments, lower your monthly payment or lower your interest rate until you get back on your feet financially.
• Cut costs: Take the opportunity to cut business costs. Slashing expenses may mean layoffs, closing unprofitable locations, renegotiating vendor contracts, unloading excess inventory or downsizing your office. The extra money can be used to pay down debt.
• Renegotiate your debt repayment terms: If you borrowed money from an individual or owe money to vendors, contact the creditor and explain your situation. Ask for better loan repayment terms to avoid defaulting. 
• Improve your collections process: You may have customers behind on paying the money they owe you. If this is the case, step up your debt collection process or give them incentives to pay their bill in full immediately.
• Hire a debt restructuring firm: Debt restructuring companies can help you negotiate with creditors and pay off your debt, sometimes at a fraction of the original amount owed. While they charge a fee, it’s often a better alternative to bankruptcy.
• Stop spending money: If you’ve taken on debt you can’t pay, it’s important to act fast and stop spending money. By tightening your belt and getting financially sound, you can better your position and become less reliant on debt. “Start cutting costs immediately,” Taggar advised. “It’s a painful process, but the longer you delay it, the worse a position you’ll be in.”