In the minds of the majority, being in debt means being in financial trouble. When launching a small business, however, it can be difficult to avoid taking on any debt.

While taking on debt to launch a small business might be beneficial, it’s crucial for all entrepreneurs to make sure their debt is helping them rather than holding them back. The goal, then, is to manage debt to contribute to rather than hinder business growth.

So, how much debt is OK for a small business? Let’s take a closer look.

Debt vs Equity

USA Today reports that the typical debt for small business owners is $195,000. However, if you take out a loan, a line of credit or a credit card for your business, you can ease the burden of financing and paying for your company’s expenses.

As with anything, there are benefits to using debt finance. One example is that you won’t have to give up any control over your company. It can also help you improve your credit score and high interest payments can be written off as a business expense.

However, the cost of borrowing money can be high. In addition, you’ll need to pay your debts on time, no matter the financial health of your small business.

As an alternative to debt, some entrepreneurs prefer to give an investor a stake in the company in exchange for financial backing. If your small business is truly a startup with no existing revenue or profits, equity may be the best option, as there is no risk and no debt to repay.

One drawback of equity financing is that once you bring on other investors (each of whom will want a piece of the pie), you no longer have complete control of your company. You will have to relinquish some strategic, creative and financial authority.

The Ideal Debt-to-Equity and Debt-to-Income Ratio

Often called the debt ratio, this indicator compares the total debt a small business takes on to keep operating to the amount of available capital.

To get the debt ratio, simply divide the amount of debt used to fund operations by the total capital the company has on hand. For instance, let’s say a business has $25 million in debt and $75 million in assets, giving it a total of $100 million in available capital. In this case, the debt ratio is 25% since $25 million divided by $100 million equals 0.25. A greater ratio indicates that a company depends more on debt to support operations.

However, finding the ideal debt ratio can be challenging. A debt-to-equity ratio below 1.0 is generally considered favorable. When the ratio is over 2.0, it is usually seen as risky.

On the other hand, the Debt-to-Income Ratio (DTI) indicates what portion of your company’s gross monthly income goes toward servicing debt. Lenders consider the DTI when evaluating whether to extend credit to your company.

If you want to get approved for a loan for your small business, your debt-to-income ratio needs to be under 50%. This suggests that you are spending less than half of your earnings on debt service. If you want to increase the likelihood that a lender will approve your loan application, your DTI ratio should be 36% or below.

A good rule of thumb is to keep your organization’s debt to less than 30% of its total capital. If your debt exceeds this, it could be a red flag to potential lenders that your business is not lucrative or is not managed responsibly.

Additionally, if business loans make up more than a third of your operational funds, it might harm your business credit score. Because of this, it is much more difficult to get financing and even harder to get a good interest rate.

Good Debt vs Bad Debt

To an extent, all debts are the same—we borrow money today and pay it back later. However, debts are often classified as either “good” or “bad,” given that they can have both positive and negative repercussions.

There is “good debt,” which is essential for growth when starting a business, and “bad debt,” which can have severe, long-term ramifications on your finances.

When business owners take on good debt, it’s usually to finance the purchase of necessary resources to help their ventures succeed. This could be to fund the introduction of a brand-new product or recruit additional staff.

In contrast, bad debt includes business loans to stakeholders you cannot recover or new obligations you must take on to pay off existing ones. If you don’t have a solid financial management system, your organization may be vulnerable to bad debt, which can slow its progress or even lead to its demise.

How To Avoid Bad Small Business Debt

If you want to keep your small business from encountering bad debt, consider the following:

Establishing a Process for Credit Application

Using a credit application before entering into a contract with a client or supplier is recommended. This can be done with a one-page form asking for basic customer information and permission to run a credit check. In the event of payment problems, a credit application can help your business create legally binding agreements with the customer.

Set Up a Collection System

Many startups fail to establish payment terms or late fees. Because of this, clients become complacent and eventually default on their payments. As an entrepreneur, you should promptly issue invoices when a transaction or shipment has been completed and ensure your customers understand your payment policies.

Strictly Enforce Your Payment Terms

Customers who are late with their payments should not be served, no matter how valuable or devoted they may be to your company. Even though you might lose money if you don’t serve these customers, you will be less likely to get in trouble with bad business debt.

Strategies for Resolving Business Debt

Here are some options to consider if your company has taken on more bad small business debt than it can properly handle:

Take a Close Look at Your Business Debt

Examine all your outstanding debts and categorize them by interest rate and payment due dates. Having this information in one place will allow you to decide which debts to pay off first.

Improve Your Business’s Income

Growing the company’s bottom line will allow you to repay its debts. Increasing product prices, launching a social media campaign or implementing a loyalty program are all options for this goal.

Lower Your Interest Rates by Refinancing

If your credit is good, you may want to look into consolidating or refinancing your business debt. You’ll get reduced fixed interest rates and fewer payments overall.

The Bottomline

For startups and struggling enterprises, debt can have both negative and positive consequences. On the one hand, it allows for increased profitability, expansion and management flexibility. On the other, it can cause a successful company to collapse if not properly handled. However, with the right debt management, you can get the funding you need to grow your business.