Bad Debt: How to Spot the Early Warning Signs
Posted by Guest Author on May 8, 2013 in Business Financing [ 0 Comments ]
In fact, many large businesses are constantly in debt and they leverage this debt to maximize their profitability.
But debt isn’t always a good thing and it must be used cautiously. Using debt in the wrong way and not fully understanding your finances can kill off your business before you even know what went wrong. That’s why it is important that you use debt wisely and for the right reasons.
Good Debt vs. Bad Debt
‘Good’ debt is any debt that you leverage to increase your profitability. A typical example might be taking out a business loan to pay for new equipment which will make you more competitive.
- In order to grow your business, you may need to purchase more inventory than your cash flow will allow. If your business is profitable and you use your debt to make more money, that is generally a good thing.
‘Bad’ debt is the exact opposite; when you are taking on new debt that you don’t have the means to repay; or when your debt is used to cover internal issues rather than for growth.
It is quite common for struggling businesses to gradually increase their borrowing without realising that there is a problem. It is only when the credit dries up that the directors realise that they are insolvent, by which point they already have a large amount of debt to repay.
How To Spot The Warning Signs
First of all, don’t assume that your business is doing well just because it’s making sales. If you have a fundamentally unprofitable business, good sales figures can spur you on to invest more and more without realising how much debt you’re creating.
Here are a few ways to ensure you don’t fall into this trap:
- Know your finances. How much does stock cost? What is your margin? What are your costs? Often, you can spot problems before they arise just by knowing these figures.
- Know your balance. The surest sign of profitability is your balance sheet. Check it every month to account for the value of your assets, your cash and your debts. A decreasing balance may indicate a problem. Additionally, a negative balance indicates that your debts are greater than the total value of your assets.
- Know where your debt being spent. When you take on new debt, what is it being used for? If you are using it to buy stock or pay suppliers, why can’t your profit from sales cover the bill? Using credit to aid cash flow as you increase your stock levels is one thing, but using debt just to maintain the status quo is quite another.
What To Do About It
If any of these points sound familiar, don’t panic, but do take action. When your business is losing money, taking on new debt is rarely a good idea. Your first step should be to go through the numbers thoroughly and find out just how unprofitable your business is.
- Presumably, when you started your business you expected it to be profitable, so your goal should be to figure out where you went wrong. Normally this will be a case of under-estimating your costs or over-estimating your sales.
Whatever the case, once you know where you went wrong, you can start to formulate a plan to turn it around. Downsize if you have to, at this stage you can’t justify any more business debt, so you have to work with what you’ve got. Once you can prove profitability, you may consider taking on new debt to grow the business again.
Bio: Michael Monroe works in the financial sector and is currently working on his first book.