Which business debt should I pay down first?
This is my personal opinion that I developed through years in accounting and mentoring.
While working with clients I often get asked,
“Which business debt should I pay down first?”
Depending on who the question in asked to, it could be anything from paying down the one with the highest interest rate first or maybe the largest balance first. Needless to say there are a bunch of different answers out there, just depends on who you ask.
In my opinion, the short answer is debt that you can re access at a later date. These would include revolving debts such as credit cards or lines of credit.
The reason for paying down revolving lines of credit first over any other types of debts such as auto loans, long term loans, equipment loans, etc; because you are able to re access that money at any point in time as long as you have not exhausted the limit available.
The COVID crisis is a great example of being able to pull money from a line of credit to float the business or pay expenses via credit card while keeping your cash in the bank a little longer.
Through my experience, training and opinion, there are several factors to look at before an educated guess can be made.
Lets run through an example that I come across often and we will use an imaginary client called “Sunny’s Landscaping”
Sunny is having a great year so far and has an extra $25,000 in cash to use to pay down some of his debts.
We review his balance sheet and notate what he has:
His credit card balance is at $5,000
Line of Credit $20,000
Auto Loan $34,500
Long term bank loan $25,000
Sunny’s first inclination is to either pay down his Auto loan and/or Long term bank loan.
First question that is asked, “Do you have enough set aside for savings in case an emergency happens?”
If no, then you should think about setting up a separate bank account and store excess funds there in case you need to get out of a tough spot.
The general rule for business savings is three to six months. That should be able to cover general operating expenses.
If yes, then how much do you have stored away and does the balance meet the general rule of three to six months?
Lets say Sunny has enough savings to last him 4 months should something happen.
So Sunny has enough squirreled away in savings and he still thinks that it would be best to pay down in long term loans. Saving him interest by paying off a loan and not having to come out of pocket for the monthly payment sounds great. It is the goal to get loans paid down as fast as possible.
The issue with paying down debt like that is the cash is gone and the only way to get cash back out is to sell the asset or take another loan out against it. $25,000 in debt paid down and the cash is gone.
Now if we look at paying down his revolving debt, the credit card and line of credit. Sunny pays both balances to zero and now has access to $25,000 in credit that he is able to use again if he needs to.
Having that extra $25,000 in credit could allow Sunny to survive a couple months in tough times before he even needs to touch his business savings.
There is no perfect scenario and the purpose of this post is to provide an opinion. Ultimately, the client will choose to pay what they feel is best and it is my goal to provide my clients some additional insight and opinions so that they can make the best possible decision.