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Guide to debt management

18/06/2024 minute read Nadine Sutton

High interest rates and debt-servicing expenses have significantly raised borrowing costs. Coupled with subdued consumer confidence, these factors have left numerous businesses financially vulnerable. According to the Institute of International Finance (IIF), global debt reached a record of $307 trillion in 2023. Furthermore, the latest Red Flag Alert report for Q4 2023 by insolvency specialist Begbies Traynor Group PLC noted that 47,477 UK firms are in ‘critical’ financial distress, with 539,900 UK businesses likely experiencing ‘significant’ financial distress.

Given these challenging conditions, having a robust debt management framework is more crucial than ever. In this blog, we’ll delve into the definition of debt, the concepts of good and bad debt, the importance of effective debt management strategies for businesses, and the risks associated with neglecting this practice.

What is debt?

Debt essentially represents the money owed to a lender by an organisation or individual. Typically borrowed with an agreement to repay the principal amount plus accrued interest within a specified time frame. Companies often obtain loans or lines of credit from lenders such as banks, credit unions, or other financial institutions. It is a method that is favoured for financing operations and growth, particularly when there's an urgent requirement for substantial capital without compromising equity.

For example, a small manufacturing business might take a loan from a bank to purchase costly equipment that will accelerate their manufacturing process. By taking a loan, they can save their cash reserves for emergencies, investment opportunities, and daily operations, repaying the loan in smaller instalments as they generate revenue.

Good debt vs bad debt

Debt can facilitate growth, but it can also lead to significant financial challenges. So, with this in mind, what is good debt and bad debt?

When borrowed funds help to generate revenue, build wealth, and increase net worth, it is considered good debt. An example would be taking a low-interest loan to purchase a house that will eventually become a real-estate asset with growing value.

Bad debt is when the money borrowed is used for purchasing a rapidly depreciating asset or expenses that do not generate revenue or increase net worth. It typically carries high interest rates and can negatively impact finances going forward. An example would be using a credit card for non-essential business needs, accruing more and more debt over time.

What is debt management?

Debt management is the strategic process of tackling debt by overseeing and planning to effectively repay it on time, minimise the risks associated with it, and maintain good financial health within the company.

It involves understanding the nature of the debt, monitoring existing debts, budgeting and making informed borrowing decisions, planning for future borrowing, devising repayment strategies, negotiating with creditors, monitoring debt levels, and managing repayments effectively.

Why Is debt management important for businesses?

The need for effective debt management is evident with a high number of insolvencies reported in the UK. According to the UK Government's Company Insolvency Statistics, it reached 25,158 in 2023, the highest annual number since 1993. With a debt storm and financial distress among businesses, debt management offers a strategic approach to effectively counteract this issue. By aiming to reduce and eliminate the debt burden, this activity is integral for averting insolvencies and easing the financial strain on any given company.

In cases where organisations have multiple borrowings with varying terms and interest rates, keeping track of everything can be difficult. A debt management plan is a practical solution to this. It can consolidate debts into a single manageable monthly payment, helping to formulate strategies for negotiating lower interest rates and crafting a realistic repayment schedule tailored to the debtor's financial capabilities.

On top of this, debt management helps in planning for future needs, thereby preventing the accumulation of more debt further down the line.

Advantages of effective debt management

Effective debt management brings about numerous benefits that extend beyond its primary objective, such as:

1. Financial flexibility

Debt management strategies enable the restructuring of debt terms and obligations, such as extending loan duration or reducing monthly payment amounts. This offers businesses the flexibility to manage their finances in a way that is more aligned to their cash flow fluctuations.

This improved cash flow management ensures the availability of funds for daily operations and other essential expenses that are needed when running a business.

By lowering debt levels and maintaining financial health, debt management equips companies to better navigate economic turbulence, and industry disruptions, ultimately mitigating risks.

2. Enhanced creditworthiness

By facilitating consistent and timely payments, effective debt management helps build a positive credit score, thereby strengthening an organisation’s creditworthiness. A higher credit score enhances the probability of a business securing loans and trade credit, gaining the advantage to negotiate reduced interest rates. This prudent financial approach translates into long-term cost savings too.

3. Better investment opportunities

Adopting effective debt management practices and nurturing a solid credit score helps companies to earn trust among investors, creditors, and partners. This trust fosters improved relationships and opportunities, enabling easier access to capital for investments into market expansion, research, and acquisitions.

4. Strategic resource allocation

Reduced debt burdens and favourable repayment structures allow businesses to allocate resources more strategically, directing funds towards value-creating activities like innovation, asset allocation, and marketing efforts.

The risks of neglecting debt management

So, what are the consequences of not having a fully formed debt management strategy?

1. Operational inefficiency

Neglecting debt management can lead to cash flow issues, significantly impacting daily operations. Without a proper strategy, businesses facing unpredictable cash flow and cash shortages find it challenging to cover essential expenses like payroll, inventory, and utilities. This operational strain can lead to inefficiencies, reduced productivity, and the inability to seize new opportunities, ultimately hindering growth.

2. Damage to business credit

The absence of an effective debt management strategy may escalate to defaults and even bankruptcies, tarnishing the company's reputation. This reputational damage portrays the business as high-risk and unreliable, making it difficult to attract new clients, investors, and partners. Such negative perceptions can limit business opportunities and growth potential, further compounding financial difficulties.

3. Legal implications

Payment delinquencies and defaults will likely prompt creditors to take legal action. This could include lawsuits, asset seizures, and ultimately, bankruptcy proceedings. These events can severely threaten a business's longevity.

Strategies and tips for effective debt management

1. Open communication with creditors

Maintain financial transparency with creditors and pre-emptively reach out if repayment difficulties are anticipated. Honesty and willingness to pay can prevent relations from souring and open doors for negotiating an extended or paused payment period.

2. Team effort

An effective debt management strategy is not the responsibility of one person, it requires a collective effort. Having a diverse team with clearly assigned roles and responsibilities streamlines the process and brings the benefits of collaboration.

Involving leadership in the process is also essential. Their expertise is valuable in assessing the debt situation and executing the plan. Furthermore, it helps integrate debt management into the overall business strategy, rather than being treated as a financial problem to be dealt with by the finance team.

3. Prioritise debts

Have a thorough understanding of all the debts, including their terms and penalties for late payments. This can help to prioritise them, which is necessary to minimise their consequences. High-interest, time-sensitive, and secured debts need to have higher priority as they pose a greater risk.

4. Improve cashflow

Efficiently managing receivables, optimising inventory, and controlling expenses are essential strategies for improving financial health. Diversifying revenue streams provides another avenue for boosting cash inflows. This includes exploring new markets, introducing innovative products or services, forming strategic partnerships, and expanding customer segments to create multiple income sources.

5. Restructuring business debt

During financial adversity, exploring debt restructuring becomes necessary. It is important to evaluate options such as consolidating debts, converting debt to equity, or entering formal arrangements like Company Voluntary Arrangements (CVAs) with the guidance of financial advisors or insolvency experts.

6. Embracing technology

Technological solutions like automation and data analytics should be leveraged to optimise the debt management process. For example, tools can be employed to automatically track debt, schedule payments and reminders to avoid late payments.

Using Financials to streamline your debt management efforts

At OneAdvanced, our Cloud-based accounting software offers comprehensive functionality for financial management. Its fixed asset management module ensures finance teams have a clear overview of all assets and their values, which are crucial for informed decision-making.

Real-time dashboards and automated reports facilitate insightful financial analysis, and a clear understanding of trends, payment behaviour, and potential risks. Additionally, its budgeting, forecasting, and planning features enable businesses to create realistic financial models, so that they can allocate resources efficiently and reduce debt over time.

With Financials, you gain a valuable technology partner for your debt management strategy.