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The average small business owner today has nearly $200,000 in debt. While financial leverage is often an essential way to grow a small or medium-sized business, you need to be careful about how much debt you take on.
As CEO of Wealth Stack, a company specializing in helping veteran business owners build an optimal capital structure and access the right kind of capital, I see CEOs and CFOs increasing their debt ratios without rhyme or reason.
As part of my one-on-one with select CEOs, I often outline a series of questions that can help business owners determine how much debt they should take on. Typically, this looks like asking yourself, “Do we have enough insight into our tax situation to be confident about the after-tax cost of debt? What are our strategic goals, and how might debt constrain our ability to achieve them? How much debt can we comfortably service without putting strain on our cash flow?”
By considering these factors, companies can create a debt ratio that is both sustainable and advantageous. However, there’s more nuance to taking on millions of dollars of debt than that. Here’s how you can determine how much debt and what kind of debt you should take out.
Related: 4 Scenarios When It Makes Good Sense to Take on Business Debt
The importance of financial leverage
In simple terms, financial leverage is the use of borrowed funds to increase returns on investment. The main advantage of financial leveraging is that it allows you to control more assets than you could otherwise afford, thus potentially earning higher returns. It can, however, amplify the effects of good investment decisions and weaken the effects of bad ones.
In worst-case scenarios, poor management of financial leverage leads to large amounts of debt that may become difficult or impossible to service. Thus, financial leveraging should only be used after careful consideration.
In this context, it’s important to carefully consider not only how much debt you should take out to grow your business but also what kind of debt makes the most sense. Before we dive into this, though, it’s important to ensure you understand what a debt ratio is.
Debt ratios for asset-intensive businesses
A debt ratio is a financial metric that calculates the relationship between a company’s total debt and its total assets. In general, the debt ratio for a medium-sized business should be below one, which indicates that the company has more assets than debt.
It is important to keep in mind that a high debt ratio can put a strain on cash flow and make it difficult to obtain new financing. As a result, companies with high debt ratios should carefully monitor their financial health and take steps to reduce their debt levels if necessary.
Related: 8 Things Entrepreneurs Should Look for When Getting a Business Loan
The coverage ratio of two times
Businesses should also have a debt threshold, which is the maximum amount of debt that they can comfortably carry. For many businesses, their debt threshold is reached at a coverage ratio of two times or higher. The coverage ratio is a measure of a company’s ability to make debt payments. It is calculated by dividing a company’s earnings before interest, taxes, depreciation and amortization (EBITDA) by its total debt payments (principal and interest). A company with a high coverage ratio is less likely to default on its debt payments than a company with a lower coverage ratio.
Factors to consider when determining debt threshold
When determining the debt threshold for your company, the most important factor is the company’s ability to service the debt. The company must have enough cash flow to make the required debt payments.
Additionally, the company should have a good track record of making debt payments on time. Another important factor to consider is the company’s creditworthiness. This includes both the credit score and the financial history of the company. Lenders will want to see that the company has a history of responsible financial management before they will extend credit.
Finally, it is also important to consider market conditions when determining the debt threshold for your company. If interest rates are high or economic conditions are weak, it may be best to limit debt levels to avoid financial difficulties. Aside from these basic factors, we urge all companies that work with Wealth Stack to consider these additional factors.
Related: The Most Common (and Preventable) Mistakes Small Businesses Make — and How to Avoid Them
What is your current cash flow?
When your business is growing, it can be tempting to take on more debt to finance expansion. However, it’s important to consider your current cash flow before making any decisions. If your cash flow is already stretched thin, taking on more debt could put you over your debt threshold and put your business at risk.
Instead, consider using other financing options like selling a portion of the business. These options can provide the capital you need without putting your business in a precarious financial position.
Organic growth
Organic growth is the internal growth of your company through factors such as sales and revenue. This is in contrast to growth that is achieved through outside means, such as acquiring another company or taking on new investments. When considering whether or not to take out more business debt, it’s important to consider your company’s organic growth.
Ask yourself the following question: Is growth inherent to the company or are we barely making it now? If your organic growth is strong, it likely means that your company is doing well and can handle additional debt. However, if organic growth is weak, taking on more debt may put your company at risk of defaulting on its loans.
M&A
Mergers and acquisitions can be a smart way to increase the scale and profitability of a business. Financing your business with debt in this way is a great way to turbocharge value creation in exchange for equity. This comes with the risks and requirements for discipline that debt necessitates. With synergies, sometimes one plus one does equal three. You can use that EBITDA to pay off the debt in two years.
Related: The 5 Cs to Consider When Applying for a Business Loan
Long-term goals
Project forward what your ability to repay this debt will look like over the life of the loan. Then, consider what are the patterns in your current cash flow and projected profits. What changes are you expecting to see based on your current cash flow patterns and business growth? For example, are you organically growing every year based on these patterns?
Look at amortization schedules
Some loans don’t need to be paid back until the end, but other loans require that you pay them back based on a business trigger (reaching a certain level of cash flow, for example).
Regardless of the amortization schedule, it’s best if your coverage ratio stays above two times.
In conclusion, while financial leverage can be a useful tool for small and medium-sized businesses to grow, it’s important to be mindful of the amount of debt taken on. Business owners should consider factors such as their tax situation, strategic goals and ability to service the debt without putting strain on their cash flow when determining the appropriate debt ratio.
Companies should also keep a debt threshold and consider factors such as their ability to service the debt, creditworthiness and market conditions when determining this threshold. By considering these factors, businesses can create a debt ratio that will last — and help you thrive.