Key Takeaways
- Extra cash can be used to reduce debt, build reserves, reinvest in the business, or make owner distributions.
- Before paying down debt, consider the interest rate, loan terms, monthly payment, and how the payment would affect available cash.
- Determine how much cash the business needs for operating expenses, upcoming investments, and periods of less predictable revenue.
- Compare the financial impact of paying down debt with other uses of the money, such as buying equipment or hiring employees.
- Revisit the decision as interest rates, expenses, cash flow, and business plans change.
When a business accumulates more cash than it needs for its immediate expenses, owners have several choices. They can pay down debt, keep the money available for future needs, reinvest it in the business, or make a distribution to the owners.
The right decision depends on more than the amount sitting in the bank. The cost and terms of existing debt, upcoming expenses, cash flow predictability, and your plans for the next year or two play into that decision as well.
Look at the Debt First
Start with what the debt is costing you. Review the interest rate, remaining term, monthly payment, and any prepayment penalties.
High-interest debt is often the first place to focus, particularly when paying it down would meaningfully reduce monthly expenses. Lower-rate debt with manageable payments may be less pressing, especially if the business has other uses for the cash.
Also consider whether paying down a loan will affect your access to capital. Once cash has been used to reduce debt, getting it back may require applying for new financing, potentially at a different interest rate and on different terms.
Before making a large payment, make sure the business will still have enough cash to cover its operating needs and upcoming expenses.
Determine How Much Cash You Actually Need
A large bank balance doesn’t necessarily mean all of that money is available to spend. Look at expected cash needs over the next several months, including payroll, taxes, insurance, inventory, bonuses, and other significant expenses. Then consider how predictable revenue and collections are. A business with seasonal sales or uneven receivables will generally need a larger reserve than one with steady recurring revenue.
Look at your upcoming plans as well. If you’re expecting to hire, buy equipment, upgrade technology, expand into new space, or make another significant investment, some of today’s cash may already have a future purpose.
The goal is to identify how much cash the business reasonably needs before deciding what to do with the remainder. Paying down a loan can save interest, but that benefit is reduced if the business has to borrow again six months later to cover an expense it could have anticipated.
Compare Debt Reduction With Other Uses of the Money
Once you’ve determined that cash is truly available, consider what else the business could do with it.
- Pay down debt. How much would you save in interest, and how much would reducing the monthly payment improve cash flow?
- Buy equipment. If you’re considering a $75,000 purchase, what will it allow the business to produce or save, and how quickly will you see that return?
- Hire another employee. What additional capacity or revenue do you expect that person to create, and how long will it take before the new position pays for itself?
- Make an owner distribution. How much can you take out while still leaving the business with sufficient working capital for upcoming expenses and planned investments?
Looking at each option this way makes it easier to compare what the money can accomplish rather than defaulting to whichever choice feels safest.
Review the Decision as the Business Changes
Interest rates move, loans mature, large expenses arise, and growth plans evolve. Reviewing debt and cash together periodically can help owners make those decisions based on the company’s current position rather than an approach that made sense several years ago.
If your business has accumulated cash and you’re deciding whether to reduce debt, reinvest, or hold onto it, we can help you review the numbers and evaluate the financial impact of each option.