Debt isn’t necessarily a bad thing, even though we tend to see it as such. Having some debt can actually be quite healthy provided you are in control of your finances and are able to pay it back within a reasonable amount of time.
In fact, running into debt can sometimes be inevitable—especially when you need to expand your business or implement new strategies that require more funds than you can afford.
Whenever you borrow money from a bank, credit card company, or even a friend or relative, you take on a debt. If you are able to manage it wisely and pay back on time, it will improve your credit history, and you will be able to purchase and invest in other important things, such as a home, that you might not have been able to afford.
And more importantly, being able to take charge of your debts and paying back on time will give you rest of mind.
Things will be fine so long as you can keep your debts to the possible minimum and pay them back on time. But when you start facing difficulties with paying back and your business starts to submerge in a pool of debt, that’s disaster.
Most of the time, business owners don’t know that they are into serious trouble until their debts become so huge they can hardly overcome them. However, the earlier the problem is detected, the easier it becomes to get it solved once and for all.
So, whether your business will go bankrupt due to too much debt or survive the situation hinges largely on your ability to know when your business debts are starting to get out of hand.
How Much Business Debt is too Much for your Business?
There is no one-size-fits-all answer to this question because the answer will vary by business and industry. However, you can easily tell it when your business debt is getting too much by first figuring out how much debt you can afford to take on.
Once you know your limit, then anything that goes beyond that is “too much.” To figure out how much debt you can take on, you will need to calculate three important metrics:
1. Projected operating income/ interest expense
This is otherwise known as the interest-coverage ratio. It simply tells whether or not you can afford to cover your interest payments. If you can’t pay interest, the bank might be forced to either increase their reserves or write off the loan. Both are bad.
Operating income is revenue less all expenses except interest and taxes. If you can get your projections right, then an interest coverage ratio of 1.0 would be acceptable. But creditors want more cushion because they are usually skeptical. So, you can tilt towards 1.2 to 1.5.
Having a debt coverage ratio of 2 or more means your operating income could be reduced by half without causing the loans to go into default. But when you fall below 1, things may start to get difficult. In essence, your debt will be getting too much when you are dedicating a larger fraction of your operating income to interest payments than you can afford.
2. (Projected net income + Depreciation)/ Principal payment
Your interest coverage ratio will only reveal how much you can afford to pay in monthly interest. But this ratio will actually reveal your ability to pay back the principal.
Like the interest coverage ratio, target 1.2 to 1.5. If the ratio falls below 1.0 in the early months, banks may be willing to adjust your principal payment schedule, provide you business looks sound in other aspects. So, your business debt will be getting too much if this ratio falls below 1.
3. (Projected EBITDA + Lease payments)/ [Interest + Lease payments + (Principal/ (1-tax rate))]
No doubt this formula looks scary, but it is actually meant to provide comfort. It combines the two previously discussed ratios, but gives lessors (landlords and equipment-rental firms) an extra level of clarity and safety by highlighting the impact of all lease payments. (In the previous ratios, lease payments are pulled out of the numerators.)
EBITDA in this ratio stands for “earnings before interest, taxes, depreciation, and amortization. You should shoot for a ratio of 1.25 if your company is new. For an established company, a ratio of 1.1 is good.
Bottom line: The higher the ratios, the better. So, the lower the ratios, the more likely it becomes that your business will be unable to pay back its debt.