A lot of people see debt as a really bad thing for a business. However, the truth still remains that it does not necessarily have to be so. Having some debt can be quite healthy as long as you are in control of your finances and you are able to pay it back within a reasonable amount of time. As a matter fact, getting into debt can be inevitable especially if you want to expand your business or startup a new project that requires more funds than you have at hand at the moment.
Whenever you borrow money from the bank, Credit Card Company or even a friend or a relative, you will take on debt. If you are able to manage the debt wisely and pay back on time, it will help to improve your credit history. More importantly, keeping your debt status in mind and being able to repay them back on time will give you rest of mind.
As long as you are able to keep your debts to the barest minimum and pay them back on time, your business will do just fine. But when you start facing difficulties in paying them off on time, it will lead to your business being submerged in a pool of debt that will definitely be disastrous for you and your business. Most of the time, a lot of business owners do not even realize that they are in serious trouble until the debt becomes so huge that they can hardly repay them. According to a poll that was conducted in 2014, 46 percent of business owners are currently having a lot of debt that may just be too much for them to handle. However, the earlier the problem is detected, the earlier it will be solved.
Therefore, whether your business will go bankrupt due to too much debt or will survive the situation depends largely on your ability to detect when your business debt is about to get out of hand.
How much debt is too much debt for your business?
The truth is that there is really no one-size-fits-all answer to this question because the answer will vary depending on the business or the industry involved. However, you can easily tell when your business debt is getting too much by first figuring out and carefully delineating how much debt that your business is capable of taking on. Once you have determined your limit, then you can safely say that anything that goes beyond that limit is too much debt for your business. To figure out the amount of debt that your business can take on, here are a few tips and parameters to take note of.
- Interest expense: this is otherwise known as the interest coverage ratio. It simply tells whether or not you will be able to cover your interest payments. This ratio is able to tell how soon a business will be able to clear its outstanding debts. It seeks to uncover how many times a business will pay its current interest payments using its available earnings. Basically, the interest coverage ratio is calculated by dividing the business’ earnings before interest and taxes (EBIT) during a specified period of time by the interest expense within the same period of time.
Ideally a company has to make sure that its interest payments are above murky waters so as to stay afloat. If a business finds out that it is struggling with this, it will have to borrow or dip its hands into its cash reserve which should have been reserved for emergencies or further investments.
The higher a business interest coverage ratio is the better for the business and the lower the interest coverage ratio, the more its debt expenses burden on the business.
2. Determine your debt to equity ratio: debt to equity ratio simply refers to the amount of money that you owe people as opposed to the amount of equity you have in the business. It is calculated by dividing the businesses total liabilities by its shareholders equity or the total debt divided by the total assets. Therefore, it measure the financial leverage of the business. A high debt to equity ratio tends to indicate that a business has been over dependent on financing its growth with debts.
3. Analyze cash flows: a business that has a high profit but does not have much cash at hand may still be considered as having too much debt. This is because when principal payments are made on loans, it is considered as a transfer between accounts therefore when it is paid back it does not reflect on the profits figure. To reverse the trend of sluggish cash flow, it is advisable to pay off the debt slowly so as to free up the available cash.