Let’s be honest; talking about debt is never comfortable.
Personal debt can be deemed as shameful, but business debt can feel much worse because it often impacts more than one person. Depending on the size of the business that you own, getting into corporate debt can mean making employees redundant, letting down business partners and entering difficult conversations with investors, stakeholders and other financial lenders.
For this reason, getting advice about business debt is tricky. And while there are organisations you can access to receive confidential help — such as the Business Support Helpline in the UK, which you can access through the government’s website — this might not always be your preferred route.
In the early process of dealing with debt, it’s sometimes easier to conduct independent research and make decisions privately. This blog is designed to help business owners who are experiencing financial issues find out what their options are. We’ll also explain different ways a business can get into debt in the first place, in the interest of preventing current and potential business owners from making the same mistakes.
Six Ways Your Business Can Get into Debt
If you’re new to business, you might be thinking, how can a business even get into debt? Well, there are countless ways a business can be not so flush with cash — even though when it comes to running a company, profit is the name of the game.
In fact, we have a short disclaimer to make about business debt. Business debt isn’t always a bad thing, which makes corporate finance complex. This is why most business leaders will invest in the help of an accountant who can provide sound financial advice. Business debt, in small and manageable amounts, is positive.
But debt that compromises a business’s operations and makes paying essential overhead bills like employee wages impossible is obviously bad news. This is the sort of debt that we are talking about.
Here are the six most common ways businesses find themselves in a dangerous financial position:
- The business has failed to break even or has a flawed business plan — In some cases, professional business mentors might be able to spot a business that’s likely to get into debt before the company is even incorporated. This isn’t because experienced leaders have a sixth sense. No, this is because they are well versed in reading business plans. Your business plan should be fool-proof, and if it’s not, there’s a good chance that your startup will fail.
In fact, 30% of businesses fail within the first two years of their lives, and it could be argued that this is a result of poor planning.
Part of building a solid business plan is working out your company’s break-even point — a term used to pinpoint when a business is able to pay for all of its overheads but still makes no profit. In theory, if you’re at a break-even point in your business, your bank balance would be $0. When calculating your break-even point, it will become clear whether or not your proposed business has too many overheads or if the total number of customers you need to stay afloat is too ambitious.
To work this out, you’ll need to subtract your variable costs per unit from your sales cost per unit and then divide that figure by your fixed costs. This sounds complicated, but it’s actually a simple formula that you can do at home once you understand how to do it.
In other words, this quick calculation can be a warning sign that your business is unlikely to work.
- An industry has changed dramatically or a market has been disrupted — Those who have done their research and created a feasible business plan sometimes just get unlucky. In short, you may have had the right idea at the wrong time.
Part of building a business — and leading a successful business — is developing a future-proof strategy. If you build your business to work in the present and disregard anything that might happen in the next ten years, there’s a good chance you’ll struggle to retain customers.
This happens to the best of us — even global tech company Apple has fallen victim to market disruption. While Apple itself didn’t go bust, Apple’s iTunes service quickly became outdated when the music app Spotify was developed. In fact, it wasn’t just Apple that was impacted by Spotify’s music application. Some would say that Spotify disrupted the entire music industry, eliminating the need to buy CDs or purchase singular songs as digital files. Needless to say, this competitor wiped out much of its competition, and plenty of businesses that didn’t have a strong portfolio of products — unlike Apple — went bankrupt.
Examples like this show the importance of keeping up to speed with changes in your industry. Put simply, times change. To stay relevant and profitable, you should be thinking about cultural shifts that might affect your business as well as keeping a close eye on your competitors.
- A significant political, social or economic change has occurred — Spending habits are often affected by external influences. A sudden change in a country’s political sphere or economy can cause an entire nation to stop spending.
Take Brexit in the UK, for example. Brexit is a process that the UK is currently undergoing after voting to leave the European Union. When the news hit, people in the UK temporarily stopped spending. Why? With people uncertain about the strength of the pound and the future of their country, they are less likely to splash their cash on luxury items and big purchases like buying a home.
Brexit is an example of a political change that may have some economic consequences. But a clear-cut economic change — like the 2008 Great Recession — often means residents don’t have a choice; they simply don’t have as much money as they used to.
Both scenarios show how any change in a location’s Political, Economic, Social, Technological, Legal or Environmental (PESTLE) status ultimately has a detrimental impact on business. This route to crippling debt can happen almost overnight and is often unpredictable.
- The business is built on large transactions and is difficult to predict — Profit and financial projections can be difficult to predict in a business when the average transaction is a high value. Making a few transactions, in this case, is a cause for celebration, but on the flip side, failing to make one sale can have dire consequences.
Examples of these types of businesses include investment companies, high-profile law firms or service agencies, and construction-based businesses. Some industries are more high-risk than others, as shown on this business loans information page. To penetrate a market like real estate, a company will often require a hefty loan to get started. While risky, there could be a potentially huge payoff.
Unfortunately, when the clients don’t come rolling in or a client fails to pay, it can be difficult to recover the money.
- The business owns too many assets that it can’t afford to repay — Similar to the examples above, some businesses can only operate once they have invested in expensive assets. Engineering and construction are prime examples of this, as expert machinery and tools are required.
These types of businesses are faced with the same dilemma when setting up — to get into debt and be able to attract qualified leads, or to not get into debt but be unable to compete with competitors? A business owner who’s serious about getting their firm off the ground will likely pick the “get into debt” option with the best intentions of making the money back in the interim.
This is why it’s so important to draw up time-sensitive business contracts. Business contracts are legally binding agreements between two parties that usually cover project deliverables, terms and payment. Discussing payment terms is vital and ensures, especially for a startup, that your cash flow is protected. For example, an engineering firm may stipulate a 30-day payment clause to ensure that they have enough money per month to make repayments on their assets.
If you don’t have a healthy cash flow, it can be a slippery slide for your business and it’s easy to fall into debt with your initial lenders.
- A business has been sued for an amount that it cannot afford to repay — Businesses can be sued for a number of things. Obvious things like fraud and negligence can, and should, be easily avoided, but there’s also copyright to contend with, which is a much more grey area.
Copyright is a huge issue when it comes to design — an industry that can be incredibly subjective. Plenty of design copyright infringement cases show how thin the line is between being inspired by work and outright copying it. One such case is Shephard Fairey’s Hope poster of Barack Obama, which was modelled on a photograph shot by Mannie Garcia. The artist and photographer, in this case, came to a settlement to split the poster’s profits, but not every court case is settled so discreetly (and fairly).
A slightly more serious case, A&M Records vs Napster, had a deadly ending. The music company Napster was forced to shut down its site and pay out $26 million in damages.
Three Ways to Recover Your Business
As our six examples show, getting your business into debt isn’t always about a leader being careless. It’s easier than you might initially think and in some cases — like starting a business that relies on an initial investment — getting into debt is the only way to get your business off the ground.
That said, there are some ways to recover your business and slowly eliminate your “bad” debt.
- Take Legal Action — If you have fallen into debt because of clients failing to pay up, there are a few courses of legal action you can take. These range from sending a simple reminder to asking your local court for a County Court Judgement. To find out your legal options for business debt recovery, refer to Business Debtline’s literature on the topic. This page also gives business owners some insights into why a client might not be able to make a payment.
- Simplify Your Overhead Costs — If things are looking tight on the money front, the logical thing to do is to decrease your outgoing transactions. To do this, you’ll need to remove hefty overhead costs, and perhaps the easiest way to do so is transition from a physical company to a virtual company. This strategy eliminates the need to pay rental or commercial bills, which are often some of the most expensive overheads a company has to pay. Consider switching to a virtual landline number, which can be accessed via your mobile, and get a virtual address so that you can save money by working from home.
- Consider Signing a Company Merger — If you still have a relevant product, brand trust and willing customers, you could consider signing a company merger. What’s a merger? This is when two companies agree to mutually operate, and often, one business will acquire another. This does mean giving up some control, as you won’t be the sole owner of the company, but it’s worked for plenty of big name brands, including AOL, Vodafone and Time Warner.