Leverage Limbo: How much is too much business debt?
Sometimes we indulge in too much of a good thing. We’ve all been there… too much wine when celebrating with friends, too much dessert at our favorite restaurant. And for many entrepreneurs, too much business debt in an attempt to survive the pandemic or grow the company.
Leveraging your business by using cash from debt or loans to grow can be a fantastic thing.
However, going too deep into business debt can cause big problems. Unlike the next day’s headache from the wine and dessert, the effects of too much debt linger for months or years and can be much more harmful.
Consider the EIDL loans from the SBA.
Not too long ago, I had a conversation with a client who felt that taking a second draw from the SBA’s Economic Injury and Disaster Loan (EIDL) program was a no-brainer because the business would never be able to get another loan cheaper or easier.
While I do think a lot of good came from these loans (you can hear more of my thoughts on this in my recent post, “How to be sure your SBA EIDL Loan helps you do more than survive”), I also want you as a business owner to be careful of the slippery slope you walk when choosing to take out a loan for your business.
The problem with accepting one of these low-interest, easy-to-qualify-for EIDL loans (or loans in general) is that if you have too much debt, it will weigh down your business's cash flow. If too much of the money you’re bringing in goes straight to debt payments each month, you will end up with much less cash available to cover payroll, utilities, rent, and owner’s pay. It will also slow down your ability to invest in future growth of the company.
The overall value of the business will also be reduced when the amount of your debt is high compared to your assets and the equity or net worth of your business. Before saying yes to adding debt to your balance sheet, its important to look at the overall financial picture to determine if its the right move for your business.
So, how much business debt is okay?
Leverage is the ability to use cash from outside the business (ie, a bank, or in this case the SBA) to fund growth in the business. The right amount of leverage is a balance between having enough funds to invest in growth; without owing so much that the debt payments slow your growth or sink your business in the process because they restrict your cash flow.
It’s all a balancing act!
Banks, investors and other savvy business owners look at a few key numbers on financial reports to determine whether a company has a healthy amount of leverage and is able to easily make required loan payments. In this post I’ll crack the code for you on two useful financial ratios related to leverage.
A Financial Ratio compares 2 or more pieces of information from your company’s financial statements to determine the relationship between different elements of your business and to understand the health of the company.
First: Compare Debt to Equity
The first component of leverage is a simple comparison of how much debt your company carries compared with how much equity has been accumulated or invested in the company. Basically the Debt to Equity ratio shows how much a company uses debt to finance assets and operations compared to how much equity is being used.
How to calculate Debt to Equity
The formula for the Debt:Equity rato is Total Liability/Total Equity.
Look on your balance sheet for the Total Liabilities
Look at the Total Equity showing on your balance sheet
Divide Total Liabilities by Total Equity.
Understanding and using Debt to Equity (aka Debt: Equity)
Debt:Equity ratio of 1 means the company has equal amounts of debt and equity. This would be a very stable and solvent company, that could possibly take on additional debt without creating too much risk or drag on cash (depending on the terms of the loan, of course).
A Debt:Equity ratio between 1 and 2 would indicate that your company has already secured a reasonable amount of debt, which should help to increase the value of the company as long as the company’s use of debt is leading to increased revenue and profitability which are more than the interest costs of the loans. (If your loan costs are high, your business could already be in a dangerous position.)
A Debt:Equity ratio greater than 2, could mean that the company is over-leveraged and has too much debt. (Exceptions are businesses that carry lots of assets such as a manufacturing business). If your Debt: Equity is 2 or above It’s probably time to evaluate your costs of capital and a start campaign to pay down your loans.
A negative Debt: Equity ratio means the company has suffered losses and has a negative equity position and a large amount of liabilities. The company may be at risk of bankruptcy or closure and would be considered high risk for lending. A company in this position must focus on building profit to increase the equity side of the balance sheet. If you have friends and family with deep pockets, you may be able to bring in outside capital to boost equity or substitute friendly debt for higher-cost debt.
Pro tip: If you are concerned about the level of debt in your company, check out my post on the best way to reduce business debt: Snowball Your Way Out of Debt in Six Simple Steps.
Second: Compare your Debt Service (or payments) to Operating Income
The second element to consider with your debt is how well your business can afford the payments of both principal and interest.
The Debt Service Coverage Ratio calculates what percentage of your operating income (or profit) is required to pay (cover) the loan payments.
How to calculate Debt Service Coverage
The Formula for the Debt Service Coverage Ratio is Operating Income divided by Total Debt Service
Look on your Profit and Loss statement to find your monthly operating income or operating profit. (Operating Profit can also be called EBITDA or Earnings before Interest, Taxes, Depreciation, and Amortization).
Add the total monthly interest expense on all of your loans plus the total monthly principal payments on all of your loans - this is your Total Debt Service cost.
Divide monthly operating profit by total monthly debt service.
Understanding and using Debt Service Coverage ratio
A Debt Service Coverage Ratio of less than 1 means that your business is not creating enough profit to cover all of your debts.
Debt Service Coverage at or close to 1 means that your business is only creating enough profit to cover your debts, you will not have cash profit available to grow the company.
Debt Service Coverage of 2 or more means the company probably has enough cash to cover debt service, and taxes, and still has some cash profit remaining.
On this metric, the higher the number the better the company’s cash position will be. In fact, I would recommend looking at the overall net profit of the company alongside its debt service coverage to truly understand how healthy the business is.
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