FINDING THE BALANCE: Optimal Debt Levels for Your Small-To-Medium Business.

BY: DOUG VERLEY

Executive Summary

Debt can be a powerful tool for driving growth in small-to-medium businesses (SMBs), but it must be managed with precision to avoid negative consequences. In this article I delve into the question of whether there is an optimal level of debt for SMBs. I explore the components of an optimal capital structure, the pros and cons of using debt for business growth, and how to think about free cash flow in the context of funding and risk management. We also discuss key measurables, initiatives, and alternative funding options to help SMB leaders make informed decisions.

Introduction.

The decision to use debt as a financing tool for SMBs is a critical one. An optimal level of debt in your capital structure can drive growth and enhance shareholder value, but it must be carefully considered and managed to avoid undue risks. This article explores the nuances of determining the ideal level of debt and offers recommendations for SMB leaders.

What Comprises an Optimal Capital Structure and Healthy Debt Level?

An optimal capital structure balances equity and debt financing. Key considerations include:

1. Debt Capacity: Assess the capacity of your business to service debt by evaluating cash flow, profitability, and collateral.
2. Risk Tolerance: Consider your risk appetite and the industry-specific risks your business faces.
3. Cost of Debt: Evaluate the cost of debt financing compared to the return on investment (ROI).

When is Debt Positive and When is it Negative?

Debt can be positive when:

• Used to fund strategic growth initiatives with a clear ROI.
• Capitalised at a lower interest rate (Cost of debt/money) than the return on investment (ROI).

Debt can be negative when:

• The interest costs outweigh the return on investment.
• Over-leverage results in financial distress or insolvency.

Pros and Cons of Funding Business Growth with Debt.

Pros:

• Allows for rapid expansion and investment in growth opportunities.
• Tax benefits, as interest payments are often tax-deductible.

Cons:

• Increases financial risk and interest expense.
• Can lead to reduced flexibility and pressure to meet debt obligations.

How to Think About Free Cash Flow in the Context of Funding Growth and Managing Risk?

Free cash flow is a critical metric for decision-making. SMB leaders should assess whether free cash flow is sufficient to cover debt service, support growth initiatives, and maintain a financial cushion.

Key Measurables and Initiatives.

Measurables include debt-to-equity ratios, interest coverage ratios, and return on assets (ROA). Initiatives to achieve the desired outcomes may involve optimising working capital, improving operational efficiency, and diversifying funding sources.

Recommendations.

1. Carefully assess your debt capacity and risk tolerance.
2. Use debt strategically for value-enhancing initiatives.
3. Continuously monitor key financial metrics and adapt your capital structure as needed.
4. Diversify funding sources to reduce risk and maintain control.
5. Seek professional guidance when necessary.

Conclusion.

The question of an optimal debt level in SMBs has no one-size-fits-all answer. It depends on various factors, including your business's financial health, risk appetite, and growth plans. To make informed decisions about debt, evaluate your capacity, consider the pros and cons, and prioritise free cash flow. To explore your specific financing needs or for assistance in optimising your capital structure, please don't hesitate to contact me, Doug Verley, at 0405 122 345. I'm here to help you find the right balance between debt and equity financing to drive growth while managing risk effectively.

Call or email me.

If you’re a Small-to-Medium Business Leader, or a Bold & Innovative Start-Up / Early-Stage Entrepreneur, and you are genuinely committed to achieving your desired work-life goals, and significant breakthroughs, then I invite you to please contact me - Introductory phone and/or email communication is FREE with no obligation.

DOUG VERLEY

Business & Life Coach, Business Advisor & Strategist

[email protected]

0405 122 345

Remember – “Good fortune & happiness favours the well-informed”.

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