Do you know what your business debt costs you?

What does your business debt cost you?

For business owners, debt can be a double-edged sword. On one hand, it provides much-needed capital to expand, invest, or smooth out cash flow gaps but, on the other, it comes at a cost (much of which isn’t immediately apparent).  In this blog, we break down the essential terms and concepts of business debt, as well as some of the costs we often don’t consider.  Important terms to understand Before we delve into the nitty-gritty of the cost of business debt, let’s start with some important terms you need to be familiar with:

• Principal: The initial amount you borrowed, which you’ll need to repay over time.
• Interest: The cost of borrowing money, typically expressed as an annual percentage rate.
• Loan term: The duration over which you’ll repay the debt.
• Collateral: An asset you pledge to secure the loan, which the lender can seize if you default.
• Unsecured loan: A loan not backed by collateral, often with a higher interest rate.
• Amortisation: The process of repaying a loan through regular, fixed payments.

Loan amortisation Critical to understand is loan amortisation because it refers to how a loan is paid off through regular, fixed payments that cover both interest and principal. As you make payments, the balance between interest and principal changes, with more of your payment going toward reducing the principal over time. This means that early on, you’re paying more in interest and as you near the end of the loan term, you’re paying more toward the principal. Annualised percentage rate  The annualised percentage rate (APR) is a comprehensive measure of the cost of borrowing money. It includes not only the interest rate but also any fees or other costs associated with the loan. Understanding the APR is important because it gives you a clear picture of how much the loan will cost you over time, enabling you to compare different financing options effectively. Total cost of capital (TCC) TCC is a broader concept that considers all costs associated with raising capital for your business, not just the interest on debt. It includes the cost of equity, debt, and any other financial instruments you may use. When evaluating the cost of business financing, it’s essential to take the TCC into account to make informed decisions about which financing sources to use. Monthly interest payments When you make monthly payments on a loan, a portion goes towards the interest and the rest is used to reduce the principal. As time passes, the balance shifts from more of your repayment going to the principal and less to the interest portion of the loan. Understanding this split is important because it affects your cash flow and how long it will take to pay off the loan. While debt is often a necessary means to fund growth, cover operational expenses, or invest in new opportunities, have you stopped to consider what it’s truly costing you? Beyond the obvious financial interest, other costs can significantly impact your company’s bottom line and long-term success:

• Interest payments: Interest rates can turn a seemingly affordable loan into a significant financial burden.
• Reduced cash flow: Regular debt payments can limit the amount of money available for day-to-day operations, payroll, and growth opportunities. 
• Opportunity cost: When a significant portion of your revenue goes to servicing debt, you might miss out on valuable opportunities. 
• Stress and mental health: Constant financial stress can affect your well-being, leading to burnout and strained relationships. It can also impair your decision-making ability, potentially harming your business in the long run.
• Credit score: Your business’s credit score is directly impacted by how you manage your debt. A lower credit score can limit your ability to secure favourable loan terms in the future, impacting your ability to invest or grow.
• Loss of control: Debt often comes with covenants and conditions that can limit your operational flexibility. Defaulting on loans can result in the loss of control over your business, including potential foreclosure or a change in ownership.
• Reputation: Suppliers, customers, and investors may view heavy debt negatively, impacting your relationships and future business prospects.
• Cost of raising capital: If your business has too much debt, it can be challenging to attract equity investors or secure additional financing at reasonable terms. 
• Legal costs: In some cases, struggling with debt can lead to legal disputes, bankruptcy, or other legal issues. These costs can be substantial, both in terms of money and time.

So, what can you do to mitigate these costs? Manage debt carefully. Ensure you’re not taking on more than your business can handle, and find opportunities to refinance at lower interest rates or consolidate high-interest debt. Additionally, focus on improving cash flow, reducing expenses, and generating more revenue to free up money for debt repayment and future growth. Create a solid business plan that outlines your debt management strategy. Debt isn’t inherently bad for your business. It can be a valuable tool when used wisely. However, understanding the true costs of debt and taking proactive steps to manage it effectively can make all the difference in ensuring your company’s long-term success and financial well-being.