Some people are risk takers and don’t mind going into debt. Some are totally debt averse and don’t borrow at all.
But how much debt is too much?
The easy answer is: don’t borrow more than you can afford to pay back or don’t borrow more than a lender is willing to loan you (and those may not be the same amount).
Do you want to use up all your borrowing power on this transaction or do you want to keep some in reserve? Here are some things to consider:
- Assume for the moment that you will use term loans with monthly principal and interest payments for any borrowing need: working capital, equipment, real estate or business acquisition.
- Each loan will probably have a different term. Working capital is 2-3 years, equipment is 3-5 years, real estate is 15-25 years, and business acquisition up to 10 years.
- Calculate the total amount of your loan payments and make sure you have cash flow to cover those payments with a 25-30% cushion. $100,000 in payments requires $125,000-$130,000 in cash flow.
- Cash flow is typically defined as EBITDA: earnings before interest, taxes, depreciation and amortization. Unfortunately, there’s not an easy place on the financials to find this, you must construct it. You take the net profit of an S corporation (pre-tax profit of a C corporation) and add interest, depreciation, and amortization.
Remember, the higher the cushion (50-100% vs. 25-30%) the more wiggle room you have for owner’s distributions for taxes and or other personal expenses.
Here’s the tough part. Let’s pretend you’ve maxed out your borrowing capacity. All of the sudden, there’s a great opportunity to buy out a competitor. You’re forced to either fund it yourself (if you even have the resources) or take on an investor. More often than not, the investor will seize the opportunity to take a bigger piece of your company than you want to give up. This is an example of why it may be a good idea to save some of your borrowing capacity for the future.
Another way to look at how much debt is too much is to think like a banker and look at the leverage ratio or debt to equity ratio.
- Most lenders like to see the ratio of $3 of debt to every $1 of equity on the balance sheet.
- This is a 3 to 1 debt to equity ratio. Think of it this way. Your creditors have put up credit for 75-80% of your assets and you’ve put up 20-25% in equity.
- Beyond this level, most lenders feel they’re taking more than their share of the risk.
So, if your creditors are funding 75% of your business, they will likely say you’ve reached your “debt limit” if you approach them for more money. At this point, again, you may be forced to fund things yourself or find an investor or different type of lender.
The best time to borrow money is before you need it. Having healthy cash flow and a line of credit as back-up can help you avoid taking on too much debt and allow you to grow the business of your dreams.