Managing Business Debt: When to Borrow, When to Pay Down

Debt Is a Tool, Not a Problem

Business debt is not inherently bad. A mortgage on a commercial building that appreciates in value while your business uses it daily is excellent debt. A high-interest merchant cash advance used to cover payroll because revenue is declining is terrible debt. The difference is not the debt itself but the purpose, the cost, and the return it generates.

The goal is to borrow strategically, at the lowest cost possible, for purposes that generate a return greater than the cost of borrowing.

When to Borrow

The ROI Test

Before taking on any debt, calculate the expected return on investment. If you borrow $50,000 at 8% interest ($4,000 per year in interest) to buy equipment that generates $30,000 in additional annual revenue with $20,000 in gross profit, the math works. You earn $20,000 against a $4,000 cost.

If the ROI is unclear or negative, do not borrow. "We need more cash" is not a sufficient reason. "We need $50,000 to purchase inventory for a confirmed $200,000 order" is.

The Cash Flow Test

Can you make the payments from existing cash flow without putting the business at risk? Calculate your debt service coverage ratio: divide your net operating income by your total annual debt payments. If the ratio is below 1.25, you are borrowing too much relative to your income.

The Timing Test

Is this the right time to borrow? Interest rates, your business cycle, and your competitive position all affect whether now is the right moment. Borrowing to expand during a strong market is different from borrowing to survive during a downturn.

The Debt Priority Framework

Not all debts are created equal. If you have multiple obligations, prioritize them in this order:

1. Payroll Taxes and Government Obligations

Never fall behind on payroll taxes. The IRS can pierce your corporate veil and hold you personally liable for unpaid payroll taxes, and the penalties compound rapidly. State tax obligations come right after.

2. Secured Debt With Collateral at Risk

If a lender can seize your equipment, vehicle, or building, keep those payments current. Losing critical business assets can shut you down.

3. High-Interest Debt

Merchant cash advances, high-rate online loans, and credit card balances with 20%+ interest should be attacked aggressively. The cost of carrying this debt compounds and can consume your profits.

4. Fixed-Rate Term Loans

Stable, predictable payments on reasonable terms. Make these payments on time but do not overpay if you have higher-interest debt to address first.

5. Low-Interest Lines of Credit

If you have a line of credit at prime plus 2%, this is your cheapest debt. Maintain it, use it when needed, but do not prioritize paying it off over higher-cost obligations.

When to Pay Down Debt Aggressively

Your Debt-to-Revenue Ratio Is Too High

If total debt exceeds 50% of annual revenue, you are overleveraged for most small businesses. Start directing excess cash flow to debt reduction until you bring the ratio below 40%.

Your Interest Costs Are Eating Your Margins

Add up every dollar you pay in interest annually. Divide that by your gross profit. If interest costs consume more than 10% to 15% of gross profit, debt is a drag on your business.

You Are Carrying High-Interest Debt

Any debt above 15% to 20% APR should be paid off as fast as possible. The compound cost of high-interest debt destroys small businesses more often than slow sales do.

You Are Planning to Sell or Refinance

Buyers and lenders both look at your debt load. Reducing debt before a sale increases your net proceeds. Reducing debt before seeking new financing improves your approval odds and terms.

When to Keep Debt and Invest Instead

Sometimes the best use of extra cash is not paying down debt. Consider investing instead when:

• Your debt interest rate is low (under 6% to 8%) and you have an investment opportunity with a higher return
• Paying down a loan early triggers a prepayment penalty that exceeds the interest savings
• You need to maintain cash reserves for seasonal fluctuations or upcoming expenses
• You have an opportunity to acquire a customer, a contract, or a piece of equipment that will generate immediate returns

The Debt Refinancing Decision

Refinancing means replacing existing debt with new debt on better terms. Consider refinancing when:

• Interest rates have dropped significantly since you borrowed
• Your credit score and business financials have improved, qualifying you for better terms
• You can consolidate multiple high-interest debts into a single lower-rate loan
• You need to extend the repayment term to reduce monthly payments (but be aware that longer terms mean more total interest)

How to Refinance

1. Pull together your current debt schedule: list every debt, the balance, interest rate, monthly payment, and remaining term
2. Contact your current lenders first. They may match or beat a competitor's offer to retain your business
3. Apply to 2 to 3 alternative lenders to compare offers
4. Calculate the total cost of the new loan (including any fees) versus the total remaining cost of the old loan
5. Only refinance if the savings are meaningful after accounting for fees

Building a Debt Management System

Track Everything in One Place

Create a simple debt schedule spreadsheet or use your accounting software's loan tracking feature. For each debt, track:

• Lender name and contact information
• Original loan amount and current balance
• Interest rate (fixed or variable)
• Monthly payment amount and due date
• Maturity date
• Collateral pledged
• Any covenants or special conditions

Set Up Automatic Payments

Late payments damage your credit, trigger fees, and can cause a loan to go into default. Automate every payment.

Review Monthly

At the end of each month, review your total debt position. Are balances going down? Are you staying within your debt-to-revenue ratio targets? Is any debt costing more than it should?

Build a Cash Reserve

The best defense against debt problems is a cash reserve. Aim for 3 to 6 months of operating expenses in a business savings account. This buffer prevents you from needing to borrow at bad terms when unexpected expenses arise.

The Bottom Line

Borrow when the return exceeds the cost, when cash flow supports the payments, and when the timing is right. Pay down debt when it is high-cost, when you are overleveraged, or when reducing debt improves your strategic position. And always know exactly what you owe, to whom, and on what terms. Debt is only dangerous when you stop paying attention to it.