What All Entrepreneurs Need to Know About Debt

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Yes, there are angel investors and venture capitalists; yes, there’s always bootstrapping; but the truth is, you probably can’t start your startup without accruing debt. You need capital to get your business up and running, and loans of one type or another are the fastest, most reliable way of acquiring money to fund your dreams — especially at the beginning of your entrepreneurial career, when you don’t have any small business credit to attract deep-pocketed investors.

But here’s the thing: Debt isn’t always bad — but it isn’t always good, either. Before you begin your startup, you should learn a thing or two about what debt is, what it isn’t, and what you should do about it.

First, a Discussion of Different Debt Definitions

Some of the most famous personal finance gurus make millions on messages that debt is the ultimate evil. They say that borrowing money should be a last resort, even if it is for large, necessary purchases like homes and businesses. As a result, most people experience terror at the idea of taking any kind of loan and feel anxiety and guilt at the prospect of maintaining debt.

However, borrowing money isn’t a complete definition of debt. Rather, according to the true accounting definition, you only have debt if you owe more than you own — if your liabilities are greater than your assets. Making loan payments doesn’t make you in debt; however, incurring liabilities when you lack sufficient assets does make you in debt.

Still, you should know the difference between consumptive and productive liabilities. Consumptive liabilities are those that do nothing to increase your wealth. Often, personal credit card debt falls into this category because goods purchased on credit are rarely put to profitable use. Conversely, productive liabilities help you build wealth. Some examples of typically positive, productive liabilities are: mortgages, education loans, small business loans, and business lines of credit. When you are building a business, you would do well to avoid the former while accruing a practical amount of the latter. Then, you should be able to stay out of debt while generating sufficient capital for your startup.

Next, an Explanation of Debt Monitoring Tactics

The security of your business depends on you maintaining productive liabilities and reducing (or eliminating) consumptive liabilities — but when you apply for loans or look for investors, all liabilities

Cash Ratio. This tells you how much cash you have available — and how much of your income is tied to liabilities. First, calculate the amount of cash you have on hand, which might also include cash equivalents like highly liquid investment securities. Next, add together your current liabilities. Then, divide your cash by your liabilities. The higher the number, the healthier your finances.

Debt Service Coverage Ratio. A debt service calculator will determine whether you are capable of producing enough cash to cover your debts. Most often, debt service is used to determine your ability to obtain more liabilities for your business. First, calculate your net operating income, which is your net income plus amortization and depreciation of assets plus interest expenses plus non-cash items. Next, calculate your debt service, which is your principal plus your interest payments plus any lease payments. Then, divide the first number by the second. Again, you should be looking for a large number, closer to one.

Debt-to-Asset Ratio. This calculates the percentage of your assets that were paid for with borrowed money. It can indicate financial leverage, measure solvency, and determine financial distress. First, add together your current liabilities and long-term debt; next, add together current assets and net fixed assets. Then, divide your liability total by your asset total to obtain the percentage. A large number isn’t necessarily bad, but it isn’t good, either. You should determine the optimal ratio for your business.

Debt-to-Equity Ratio. This tells you how much of your business you own, and how much belongs to others. First, add together your liabilities; next, calculate your equity, or how much money you have invested in your company. Then, divide your liabilities by your equity. If the number you produce is large, that means a large proportion of your business is owned by outside sources, like banks.



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