When debt becomes overwhelming for a business, drastic measures sometimes need to be taken. Consider, for example, the recent news about Red Lobster considering filing for bankruptcy. With increases in labor costs and lengthy, expensive leases combining with slow sales in recent years, the chain’s cash flow has been significantly hindered. A bankruptcy filing would allow them to restructure their large debt, while continuing to operate and end those difficult leases, following the examples of WeWork and Rite Aid.
It’s a well-known adage in business that you have to spend money to make money. But is that always the best advice? How much debt is too much for a company to carry long-term?
Long-term debt is an inevitable part of doing business. Problems occur, however, when that debt isn’t managed properly. Unsustainable long-term debt has a negative effect on your cash flow, ability to repay debt on time and more. In the worst cases, a business can face bankruptcy if their long-term debt is managed incorrectly. In this article, we’ll discuss mistakes companies make when taking on long-term debt that make it unsustainable and open them up to significant cash flow and operational issues. Most importantly, though, we’ll focus on how to avoid making these mistakes.
Why do companies prefer long-term debt?
Depending on the strength of your credit profile, you may take on several different types of loans in addition to business grants and governmental support that some companies are entitled to. Short-term loans can cover short-term needs, such as emergency payroll or business expenses or other unexpected issues with cash flow.
If a debt’s repayment period is longer than a year, it’s considered long-term debt. This type of debt is inevitable with growing businesses of all sizes. Companies take on long-term debt to expand, such as into other regions or to secure larger portions of the market. A benefit of long-term debt is that the rates and repayment period is structured and stable.
How long-term debt affects cash flow
Larger businesses tend to carry more long-term debt. Not only do they require more capital as they work on a larger scale, they also have the assets and cash flow necessary to pay back their loans on a long-term scale.
Problems arise, however, when those larger businesses begin to struggle to make those payments on their long-term debt. In fact, a company’s DBT, or Days Beyond Terms, rising dramatically or fluctuating wildly is a key indicator of financial struggle within. Even if a business isn’t struggling as badly as Red Lobster or other companies facing bankruptcy, lenders and suppliers could start doubting your company’s financial strength if you have a high DBT or your DBT has spiked drastically multiple times over the last year. That, in turn, can cause further problems with cash flow and increase the debt.
“Taking on too much long-term debt can lead to overleveraging, where a company’s debt level becomes unsustainable relative to its earnings and assets,” explains Bill James, Director of Enterprise Sales & Strategy at Creditsafe. “This can negatively impact credit ratings, increase borrowing costs and hinder future borrowing capacity.”
Is long-term debt a liability?
All debts are considered liabilities for a business, because failing to repay them will have a negative impact on your company’s finances and overall creditworthiness However, long-term debt is widely accepted and common practice across most industries. If you understand the repayment terms of your long-term debts and can pay consistently and on time, simply holding a long-term debt won’t generally have a negative impact on your business.
Long-term debt should be looked at in a broader, ‘big picture’ sense rather than as a quick fix for an immediate problem. “Committing to long-term debt may limit a company’s ability to pursue other investment opportunities or respond to changing market conditions,” says James. “Funds tied up in debt repayment could be used for innovation, expansion or other strategic initiatives.”
6 mistakes that make long-term debt unsustainable for businesses
Failing to consider interest
One thing you shouldn’t forget is that all loans collect interest. So, you should be aware of the interest parameters of each loan you take on before signing any loan agreements. Lower interest rates are available in many cases, but this is usually influenced by how strong or weak your credit score and risk is. The worse off your business credit is, the more likely you are to pay higher interest rates. And this can increase your total cost of borrowing, which could cause other financial and liquidity issues down the line.
If your long-term debt carries a variable interest rate, it can also quickly become unsustainable. If the interest rate spikes unexpectedly, more of the company’s cash flow will need to be redirected towards paying the debt, which could hinder growth or cause the business to fall behind on paying other expenses.
“Long-term debt commitments can restrict a company’s financial flexibility,” explains James. “Fixed repayment schedules may strain cash flow, especially during economic downturns or periods of reduced profitability.”
Lack of emergency funds
It’s a rule of thumb that you should have three months’ worth of living expenses to fall back in in case of emergency, but how many companies can say they’ve done the same?
Generally, the same rule of thumb applies to businesses – they should aim to have several months of operating costs available in an emergency. But the bigger your business is, the more difficult that becomes. Between overhead costs for offices or locations, staff salaries, and other operational costs that could potentially be spread across the world, the cost to run a business for a month is exponentially greater for large businesses.
If your company is carrying long-term debt and runs into unexpected closures or another immediate, unexpected blocker to cash flow, chances are good that you won’t be able to pay off debt at the same rate you may have been previously. Priorities must shift, and paying employees takes priority over debt repayment.
Poor cash flow management
A company needs to pay constant attention to cash flow management. Every cent that comes in and out of your company should be looked at by your financial team. While that may seem unnecessary, being able to accurately forecast cash flow needs is crucial for the success of any business. Without proper cash flow management, a company may not understand how much money they need each month to continue paying a long-term debt.
A U.S. Bank study claims that 82% of business failures are due to poor cash flow management. A recent high-profile example of a business that held too much debt without the cash flow to sustain it is Bed Bath and Beyond, which filed for Chapter 11 bankruptcy in 2023. At the time of their filing, the company’s long-term debt had ballooned to $1.7 billion and they were unable to stock their shelves in the run-up to the 2022 holiday season.
Picking the wrong lender
The amount of long-term debt a company carries is an important factor in their potential success, but attention should also be paid to where that debt is coming from. If a company ties a large portion of its cash flow to a company that goes under or is unable to fulfil its obligations to the company, long-term debt can become unsustainable.
Before taking on a long-term debt, companies should carefully vet the lender and its associated businesses. Looking through a company’s business credit report is an excellent place to start with this. You’ll be able to gain a clearer picture of your lender’s financial condition, including their own payment habits, ownership structure, and credit score. With 36% of businesses not running credit checks before signing contracts, carefully inspecting a credit report is an excellent way to protect your business from risk when taking on long-term debt.
Getting behind on payments
The simple fact about any kind of debt is that if a company is behind on payments, it will have immediate negative consequences. Consistency is key when it comes to debt repayment and business credit scores. If a company makes a payment towards a long-term debt on average 3 days late each month, but continues to make the payments, they’ll generally be perceived as lower risk by lenders. If a company is inconsistent with its repayment schedule, or even begins to miss payments altogether, the consequences will be obvious – and they can topple even large enterprises if the issues aren’t addressed.
What’s more, paying month-to-month isn’t always the end of the story. “Long-term debt often comes with maturity dates, requiring repayment or refinancing at the end of the term,” James says. “If market conditions have changed unfavorably or the company’s financial health has deteriorated, refinancing may be difficult or expensive.”
Legal and regulatory pitfalls
Another reason businesses should carefully consider the ‘big picture’ when taking on long-term debt is the regulatory requirements that often arise with these types of loans. If a business misunderstands a complex legal term, for example, it could be an extremely costly mistake. The business could face expensive penalties or even find itself in court facing a legal dispute. These disputes can be lengthy and complicated, meaning even more of the company’s cash flow is forced to divert to legal fees, investigations, and fines.
In conclusion
While long-term debt is something nearly every major company carries, each long-term loan should be carefully considered. Understanding the loan terms and how the repayment schedule coincides with the company’s financial future is crucial. If used correctly and responsibly, long-term debt can help a company grow – but if used irresponsibly, they can have devastating consequences.
“It’s essential for businesses to carefully evaluate their financing needs, consider the risks associated with long-term debt and develop a sound debt management strategy to mitigate these risks effectively,” James concludes. “Consulting with financial advisors or experts can also provide valuable guidance in navigating the complexities of long-term commercial debt.”