Learn how to use debt to grow your business without straining your finances.

Debt is a powerful tool for your small business, providing the necessary capital for growth and expansion. Knowing how to take on debt strategically and maintain a manageable level is crucial to the long-term success of your business.

Here’s what you need to know about taking on debt, the difference between “good” debt and “bad” debt, and how your Wells Fargo banker can help you manage debt to grow your business.

How to borrow strategically

1. Evaluate your debt needs

Before taking on any debt, assess how much is truly necessary. Make a list of exactly what you need capital for, and how it will contribute to your business. This will help you categorize your needs into “good debt,” used for investments that generate revenue or improve the business, and “bad debt,” which funds nonessential expenses. (More on good and bad debt in the next section.)

For example, using debt to purchase new equipment that increases production capacity or hiring staff to help you run the business are examples of good debt. On the other hand, taking out a loan for new office furniture might not be a priority for your business.

Tip: If you’re thinking about taking on debt, make an appointment with your Wells Fargo banker. Your banker can help you prioritize business needs and determine potential uses for the money.

2. Pay attention to your credit scores

Borrowing and managing debt builds your business credit profile, which is useful as your business grows and requires more capital. Your business and personal credit scores matter when you are applying for a business loan because lenders look at both to see how you have managed debt.

Tip: Keep regular tabs on your business and personal credit scores using Wells Fargo’s Mobile® app1. You can also check your scores across the major credit bureaus — Dun & Bradstreet, Equifax, Experian, and TransUnion. That way, you can ensure your score is in a good place when you’re considering applying for a loan.

3. Have a payback plan

The most important way to manage debt successfully is to have a plan for how you will pay back the money you borrow. Look at your projected cash flows and ensure you can meet all your obligations even if your business goes through a rough patch.

Tip: It’s good practice to ensure your business has enough cash on hand to weather potential downturns.

4. Compare financing options

Your borrowing options depend on how you will use the money, whether it is for short-term or long-term needs, and other factors.

Tip: Your banker can explain how different financing options work and help you pick the right one for your business goals. You can also use Wells Fargo’s Small Business Product Selector to choose the best option for your small business.

Differentiating between good and bad debt

Good debt. While there is no single definition of good debt, this term usually describes money borrowed to help grow your business. The U.S. Chamber of Commerce describes it as “taking out a loan on an asset that won’t depreciate, such as education [and] real estate.”

The characteristics of good debt: used to purchase assets that will not depreciate; should not carry high upfront fees; no rushed repayment period.

Bad debt. On the other hand, bad debt refers to money borrowed to purchase assets that decrease in value, such as office furniture and vehicles, or debt that comes with high fees. Payday loans, merchant cash advances, and similar financing options that seem too good to be true may appear beneficial in the short term, but can ultimately lead to financial strain for your business.

The characteristics of bad debt: used to purchase depreciating assets; carries high upfront fees; rushed prepayment period.

How much debt to take on for your business

1. Understand your debt capacity

There are methods to calculate how much debt your business can afford to carry. Here are two financial ratios you should know about:

a. Debt-to-equity ratio

This ratio measures how much debt your company has in relation to equity, which is how much money you and other investors have put into the business. Your debts may include things such as small business loans and a mortgage on an office space. A lower debt-to-equity (D/E) ratio generally means your business is managing debt well. To know where your company’s D/E ratio stands, you have to compare it to other businesses in your industry and also consider in what industry your business operates. Some, such as financial services, naturally tend to take on more debt.

A good debt-to-equity ratio is generally considered to be less than two.

b. Interest coverage ratio

This ratio indicates whether your business is earning enough to cover your obligations. A higher interest coverage ratio generally suggests that you can comfortably meet your interest obligations with current earnings. As with the D/E ratio, the definition of a ‘good’ interest coverage ratio varies by industry. Broadly speaking, an interest coverage ratio of two or higher is considered good.

A good interest coverage ratio should generally be two or higher.

Calculating key debt ratios: Debt divided by equity equals total liabilities divided by shareholder equity. For example, if you have $50,000 in total liabilities/debt and have invested $30,000, the business has $1.67 in debt for every dollar of equity. Interest divided by coverage equals earnings before interest and taxes (EBIT) or operating income divided by interest expense. For example, if you have $100,000 in annual operating income and an annual interest expense of $10,000, your interest coverage ratio is 10.

Calculating both these ratios can give you an idea of the health of your small business and how attractive it looks to investors and lenders. A conversation with your banker can help you understand what the ratios mean, what you can do to improve them, and how much debt your business can afford to take on.

2. Set realistic debt limits

When you’re figuring out how much to borrow, it’s important to establish a cap on the amount of debt your business can take on. This can vary with the size of your business, revenue, and industry standards for your line of business. Having a set debt limit helps prevent excessive borrowing and maintains financial stability for your business.

Tip: Your Wells Fargo small business banker can offer tailored advice and insights on a healthy level of debt for your business.

The bottom line

Debt management is a balancing act every small business owner needs to master. Your banker can help you prioritize business needs, understand financing options, and calculate how much debt your business can afford.

1Availability may be affected by your mobile carrier’s coverage area. Your mobile carrier’s message and data rates may apply.

Sources: U.S. Chamber of Commerce, Investopedia 1, Investopedia 2, Investopedia 3