Like any large successful businesses in the world, small businesses too rely on borrowings to achieve their growth objectives and expand their reach. Entrepreneurs consider business loans as an effective tool to fuel organizational growth. However, it is to be noted that there is always a narrow gap between leveraging debt for success and falling into financial trap.
Business organizations who are able to efficiently handle their debt obligations can sustain for a longer period and achieve long term growth. Read further to understand the risks of overleveraging in business financing along with ways to avoid them.
Overleveraged in Business – What does it mean?
A business is said to be overleveraged where the business entity has over borrowed excessive funds from lenders in contrast to their assets and business cash flows indicating a high level of debt. Excessive borrowing can be detrimental for both borrower business as well as lenders since it increases the likelihood that the latter would default on its debts and go bankrupt.
Large amounts of debt payments consume a sizable portion of borrower’s business revenue. Thus, overleveraged businesses find it challenging to repay principal amounts as well as interest payment while managing operating expenses often leading to financial decline of the business. Making matters worse, it compels the borrower business to take out further loans in order to continue operating and fulfilling its debt obligations. Usually, this cycle comes to an end only when a business files for insolvency or debt restructuring. A less leveraged business therefore has better abilities to cope with sales declines simply because it doesn’t have significant debt-related strain on its cash flows.
Causes of Overleveraged Business
Some common causes of overleveraged businesses may include:
Aggressive Expansion-
Borrowing extensively can be beneficial for a business to grow swiftly. Although, businesses shall account for possible losses to ensure that expansion is managed efficiently allowing business to recover swiftly in case things do not work out positively.
Economic changes-
Businesses typically experience slump growth during economic shifts making it difficult to fulfil debt commitments. It may result in excessive business leverage specially for businesses heavily relied on borrowed funds.
Excessive Borrowing
How to Know When a Business is Overleveraged?
Since the volume of business debt indicated as ‘too much’ might vary from business to business and may even shift over time based on the growth phase the entity is undergoing, it is impossible to establish a precise figure.
Nevertheless, there are some caution factors to look out that could indicate excessive business leverage-
- Difficulty to repay debt liabilities- Difficulty to repay debt liabilities mostly interest payments suggest higher leverage.
- Declining Creditworthiness: Lenders’ increased interest rates or low credit scores are signs of financial instability.
- Operational Dependency on Debt-Unbalanced finances are evident when daily operations, salaries, or stocks are substantially reliant on borrowing.
- Inadequate or lack of access to fresh capital- Businesses who are unable to access fresh funds though either investments or borrowings indicate overleverage in business.
- Sensitivity to economic shifts- Businesses with excessive leverage may face challenges such as revenue fluctuations putting them at risk of committing loan defaults.
Apart from this, there are certain key financial metrics to be considered to find out whether a business is overleveraged. These are explained in the following section.
Financial Metrics that Point Towards Being Overleveraged
Debt to Equity Ratio-
The debt-to-equity ratio of a business entity examines the comparative proportion of the overall business debt to the investor’s ownership percentage in the business for the purpose of raising business capital.
Debt/Equity= Total Liabilities/Total Shareholder Equity
It is also commonly referred to as the risk ratio, leverage ratio, and gearing ratio making it closely associated with leverage in business. Business organizations with higher debt to equity ratio (higher than 1) usually place considerable dependency on borrowings making the business more exposed to economic recessions.
Debt to Asset Ratio-
The Debt-to-Asset Ratio examines the total debt availed by a business organization in contrast with the value of assets owned by it.
Debt/Assets = Total Funded Debt/Total Assets
Therefore, a Debt to Asset ratio (ranging from 0.6 or above) indicates a substantial portion of the total business assets funded through debt indicating a greater possible risk.
Debt Service Coverage Ratio-
The Debt Service Coverage Ratio (DSCR) evaluates an organization’s ability to manage its overall debt obligations (including interest payments) within the specified time frame.
DSCR = Net Operating Income/Annual Debt Service
Businesses holding a low debt service coverage ratio (less than 1) suggests its inability to fulfil its debt commitment ensuing in financial difficulties or even bankruptcy.
Cash flow to Debt Ratio-
Cash Flow to Debt Ratio defines the sum of revenues earned by the business in comparison to the overall business debt availed by the business.
Cash flow/Debt= Cash flow from Operations/Total Debt
Businesses holding a low cash flow to debt ratio (less than 1) face difficulty to generate adequate revenues to fulfil its debt obligations.
Risks of Overleveraging in Business
Constrained Growth
Businesses seek external funds for certain reasons such as expansion of their product lines or achieving sales growth. Most loans have a pre-agreed upon term for interest and principal repayments provided businesses have the ability to repay loans without having to increase cash flows, limiting activities and growth.
If a business organization borrows funds with the objective of generating more sales but cannot do so until the loan is repaid, they may find themselves in a tight spot. Repaying business loans without improving cash flow might be detrimental to the business’s capacity to fund operations and fuel growth.
Loss of Assets
Overleveraged businesses have higher chances to end up in bankruptcy and contractual obligations to its lender will arise. Most loan agreements give power to lenders to take back the ownership of the business assets to be sold off out of which the remaining debt liability is paid off to settle outstanding debt. Thus, there are higher chances for overleveraged businesses to lose several of assets if not all of them.
Reduced Cash Flows
High interest obligations resulting from high levels of business debt might limit the amount of funds available for overseeing operational needs, fulfilling growth and reinvesting funds into the business. When an organization incurs too much debt, a substantial portion of cash flows could go for repayment of debt principal and interest. In extreme situations, it may leave no funds for operational costs or even the business to default on its loan repayments.
Loss of Control
Over-leveraged businesses may be compelled to cede control of their operations to their creditors. This can be an uphill battle for entrepreneurs who have invested years establishing their business.
Difficulty Getting New Investors
Attracting new investors will be practically impossible for a company that is overleveraged. Without a substantial ownership stake and a recovery strategy in place, investors who offer business capital in exchange for a major chunk of ownership stake will regard it as a ‘bad investment’. However, giving up a substantial stake of ownership could also be a difficult choice as the business organization loses control over the decision-making process.
Limitations on Future Borrowing-
An overleveraged business may find it challenging to secure fresh credit or funding from banks and other lenders as they carefully assess creditworthiness of the loan applicant. Lenders perform extensive credit checks to assess the debt repayment ability of a business prior to offering a loan. Hence, the possibility of a bank extending funds to an overleveraged business is extremely lower.
Normally, financial institutions are cautious to assume the risk of potential losses. And even if they agree to take on such additional risk, they are likely to offer funds at substantially higher interest rates making borrowing a less optimal choice for an already struggling business.
Higher financial risk
Overleverage in business makes a company extremely susceptible to shifts in the market and sector. Any economic recession or industry transition can have adverse impact on the cash flow of a business, rendering it challenging to pay off loans.
Covenant Breaches
If a loan agreement’s terms and conditions, known as debt covenants, are violated, the lender may demand that the entire sum be returned right away.
Reduced profits and returns for shareholders-
Excessive interest payments reduced net income, which affects the general profitability thereby rendering it more challenging to achieve returns for stockholders.
Damage to Business’s Reputation
Financial concerns can tarnish a company’s reputation, which renders it more challenging to bring new clients, investors, and employees.
Tips to Manage an Overleveraged Business
Understand Business Debt
Whenever businesses intend to manage their overleveraged business, they should start by comprehending the full scope of their debt liabilities. Start by building a list of all debt obligations comprising details such as lender name, principal remaining, applicable interest, terms of repayment and due dates. It will help the business to manage debt and to prioritize and maneuver their debt repayment schedule.
Create a Repayment Plan
- Once the entrepreneur gains sufficient understanding of all of its debt obligations, the next step should be to build an organized repayment strategy.
- Build a priority list for debt repayment on the basis of applicable interest rates and repayment terms. Accordingly, start by paying off high interest debt to reduce interest amount payment to be paid in the long term.
- High-interest debts should be paid off first to reduce the amount of interest paid over time. The repayment strategy should be practical that takes into consideration the company’s cash flows while ensuring all debt repayments are made without hurting budgets.
Negotiate Terms with Creditors
Business organizations who feel that the existing debt terms are harsh, they could consider negotiating debt terms with their creditors. Many creditors are eager to collaborate with borrowers to establish more affordable repayment conditions. It could entail extended the repayment period, cutting down interest rate, or reworking the debt structure. Effective interaction and an apparent dedication to repaying business loans often end in beneficial terms.
Consolidate or Refinance Debts
Debt consolidation could be a critical instrument to manage different loans with varying interest rates and different repayment terms. Consolidating multiple loans into one may allow businesses to lower down their interest expenses for the organization through a single low interest debt.
Nonetheless, it is imperative to carefully examine all aspects of the merged debt to ensure that it offers a financial benefit over existing business liabilities.
Minimize unnecessary Costs
Businesses should research, identify and implement effective cost-cutting strategies which may help to free up funds for debt repayment purposes. To identify possible areas for minimizing business costs without forgoing quality or efficiency, businesses should conduct a thorough assessment of their business expenses. It may include areas such as reducing administrative costs, simplifying processes and negotiating contract terms with vendors, etc.
Look for Alternative funding sources
Other than this, businesses could effectively reduce the likelihood of overleveraging in business by seeking business capital though alternative funding sources such as angel investors, venture capital, and seeking funds through crowdfunding.
Cash flow planning and effective cash flow management
- Businesses who wish to keep themselves on top of their financial obligations must manage their cash flow effectively. Businesses ought to have a consistent stream of revenue to meet their debt obligations. Moreover, businesses with excellent cash flow possess the financial freedom to manage debt effectively.
- Creating newer sources of revenue, minimizing business expenses and streamlining invoice processes to advance receivables, etc. are some common means to achieve efficient cash flow management.
- Cash flow planning can also aid businesses in restricting unnecessary expenses and prioritizing principal repayments.
- Businesses can identify measures to enhance financial inflows and decrease cash outflows. Furthermore, if an organization entity plans to pay off its debt in advance before fulfillment of its term, it would be a good idea to find out any penalties that might be imposed for refinancing or loan prepayment.
Improve Credit Management
Businesses can also reduce the likelihood of bad debt and guarantee on-time customer payments by putting in place a strong credit management system. Some common steps should include defining explicit credit standards and terms for customers, run credit checks before extending credit, keep a careful watch on and manage accounts receivables, etc.
Leverage Technology to Monitor Debt
- Businesses could leverage technology for effective debt management with BankKeeping
- Automated payment systems can prevent late penalties and assure timely repayments.
- Advanced debt management tools could help to monitor business incomes, cash flows, operational costs and gross profit margins. It could also be used to raise alarms whenever the business reaches its financial thresholds suggesting possible risks.
- Similarly, it could identify extra funds available with the organizations which could be used to pay off debts.
BankKeeping is the only Fintech company in India that helps SMEs manage their debt at one place effectively. It is a loan management software designed for the borrowers. We manage essential filing of reports, timely reminders, creating crucial reports like CMA data, etc. all at one place.
Conclusion
Therefore, Business loans serve an important purpose of supporting business growth and expansion, encouraging venturing into new prospects and surviving turbulent times. Whereas, businesses who are heavily dependent on borrowings are exposed to a number of threats including uneven cash flows, higher risk of business failure, lesser growth prospects and even bankruptcy.
Moreover, if businesses resort to measures such as an efficient debt repayment plan, reducing expenditure, renegotiating terms with lenders as well as business suppliers and looking for alternative sources of business capital, etc. could help to avoid overleveraging.
Maintaining a real-time understanding of a business’s financial situation, and achieving a balance between debt reduction and sustained investment in business growth are all critical components of good debt management. Adopting such measures could ensure businesses to benefit from business debt without risking its financial health and stability.