When should I pay down my business debt?

At Brady CFO, we get this question a lot. The answer is that it depends. Some of our clients benefit from paying down their business debt, whereas it doesn’t make sense for others. 

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It’s super important to know when it’s beneficial and when it’s not because making the wrong decision could put your company at risk of cash flow issues, missed opportunities for growth, or even financial instability. Arriving at the appropriate conclusion requires careful evaluation. There are four key considerations to consider before you decide to pay down your debt.

How to determine whether to pay down your business debt

When deciding whether to pay down business debts, start the conversation by evaluating your current liquidity, upcoming spending, access to outside working capital, and long-term debt amount. Let’s dive into each of these to help you make an informed decision for your company. 

1. Evaluate your current liquidity

The best way to do this is to calculate your current ratio. Your current ratio is your current assets (cash, AR, inventory, etc.) divided by current liabilities (accounts payable, current amounts due on long-term debt, etc.). A general rule of thumb is that a current ratio of 1.5 is healthy. If your current ratio is well below this, I suggest building up your liquidity before paying down any debts. Any cash you produce from your business should be kept in your checking or savings accounts to build liquidity.

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Building up your liquidity is essential because if you are illiquid and face a serious business challenge in the next few months, it could bankrupt you. You could actually run out of funds to make payroll, pay vendor invoices, etc. You want to maintain healthy liquidity in your business to face short-term obstacles that could arise. So, if you aren't liquid, you aren't in a position to successfully pay down debt.

2. Evaluate your upcoming spending

Consider if you have any big spending that’s outside the norm. For example, you might have plans to upgrade your equipment, invest in new technology, expand your operations, or launch a major marketing campaign. These types of expenses can significantly impact your cash flow. It's best to reserve funds for that potential spend so that you aren't acquiring new debt to make that purchase, especially because new debt in this interest-rate environment is very expensive compared to debt procured in prior years. So, in this case, you wouldn’t spend money to pay down debts. 

3. Evaluate your access to outside working capital

Ultimately, this consideration boils down to asking yourself: “If I needed to get a working capital line to cover short-term cash flow deficits in my business right now, do I feel confident I can get it?” 

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This can be difficult to assess as capital markets can change with changes in economic conditions. A bank’s willingness to lend dries up if their customers default and can't make their payments. Banks aren't always as willing to lend new dollars in complex financial markets. So, if you doubt your ability to get a credit line if you need it quickly, it's best to keep sufficient cash reserves on hand and not focus on paying down business debt.

4. Evaluate your long-term debt amount

Finally, consider if you’re carrying too much long-term debt. A general rule of thumb is that you are too leveraged if your total debt makes up more than 50% of your total assets. However, you are not that leveraged if your total debt is only 10% of total assets. 

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If you carry too much long-term debt and are liquid, have appropriate cash reserves for upcoming purchases, and have easy access to outside working capital, you should pay down some long-term debt. If you encounter short-term issues in your business that eventually turn out to be long-term issues, having excess long-term debt can be crippling. It could result in you being unable to pay your long-term debt, which is why paying down debt at the right time can be a smart move.

So, should you pay down business debt?

If you …

• Are liquid
• Have cash reserves for any large, out-of-the-norm upcoming purchases
• Have ready access to outside working capital
• Don’t have any excess long-term debt

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… you are in a solid position to pay down additional business debt if you want to. But the question is, should you?

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The best choice for your business is whether you can get a better return on the money you have on hand vs. paying down the debt. For example, if you can place your spare cash in a savings account that earns 5% interest while your debt is only at 3.5% interest, it's a better deal to put your cash in a savings account and earn more interest than you’re paying on your debt.

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Or, if you can use your spare cash to hire new employees who will generate additional sales and net profits that exceed your debt's interest rate, it makes sense to invest in that growth. This way your investment yields a greater return than simply paying down debt.

When paying down business debt makes sense

As you can see, it's not a simple yes or no answer. Several factors must be considered when deciding whether to pay down business debt. 

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At Brady CFO, we recently helped a construction client determine it was in their best interest to pay off several high-interest equipment and vehicle loans before placing funds in a high-yield savings account. This was determined after ensuring the business had sufficient liquidity and an available credit line they weren't currently using. This meant this business was well prepared for any short-term concerns. Paying down the equipment debt enabled this construction company to be best prepared for any future negative economic swings that could arise. 

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Having a financial expert in your corner to help you make these decisions ensures all factors are carefully considered and that your business's unique needs are met. With professional guidance, you can confidently navigate the complexities of cash flow and debt management, making smart choices that benefit your company. This proactive approach not only safeguards your company’s long-term health but also sets the stage for continued growth and success.

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