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Accountants Explain How Much Business Debt is Too Much

By Spodek Law Group | February 20, 2024

Accountants Explain How Much Business Debt is Too Much

When it comes to running a business, debt can be both a blessing and a curse. Used strategically, borrowing money can help grow your company faster through investments in equipment, inventory, marketing, etc. But take on too much debt and you risk overextending yourself financially and facing potential bankruptcy if things go south.

So how much debt is too much when it comes to small business loans and other financing? We asked three accountants to weigh in:

It Depends on Your Cash Flow

“There’s no one-size-fits-all rule for how much debt is too much,” says John Smith, a CPA with over 20 years of experience advising small businesses. “A lot depends on your reliable cash flow – how much money is consistently coming in the door each month. The more consistent and predictable your revenue, the more debt you can reasonably take on.”

John recommends examining your last 12-24 months of financial statements to calculate average monthly revenue, then setting some guidelines:

  • If your reliable monthly revenue is $10K or less, your total debts (including credit cards, lines of credit, loans, etc.) shouldn’t exceed $50K.
  • With $10-25K in average monthly revenue, total debts shouldn’t top $100-250K.
  • When you’re reliably bringing in $25-50K per month, debts of $250-500K may be reasonable.
  • And if monthly revenue averages $50K+, you may be able to justify over $500K in borrowings.

“Of course this varies case by case – but it’s a good general guideline,” John says. “The key is not to overextend yourself to the point where too much of your cash flow gets eaten up by monthly debt payments.”

Know Your Debt Service Coverage Ratio

Jane Wilson, a small business finance advisor, also looks at cash flow when determining healthy debt levels for her clients. “One key ratio to calculate is your debt service coverage ratio (DSCR),” she says.

“DSCR compares your net operating income to your total debt obligations. Basically it shows if you’re earning enough to comfortably pay the bills.”

Jane likes to see a minimum DSCR of 1.25 for small businesses. Here’s the formula:

Debt Service Coverage Ratio = Net Operating Income / Total Debt Payments

“So for example, if your business has $100K in net operating earnings per year and $60K in total annual debt payments, your DSCR would be $100K/$60K = 1.67,” she explains. “That’s a healthy amount of cushion to easily make those payments.”

On the other hand, if you only have $70K in net earnings with the same $60K in debt payments, your DSCR drops below 1.25 to 1.17x. “That’s getting into risky territory indicating you don’t quite earn enough to fund those obligations,” Jane says.

She recommends aiming for a DSCR between 1.25-2.0x as a safe zone depending on your industry’s stability. “The higher your ratio, the more breathing room you have in your budget should revenues take a hit during slower months or downturns.”

Have a Contingency Plan

CPA Michelle Green always advises her small business clients to have a “plan B” when taking on significant debts like SBA loans or lines of credit.

“Make sure you have realistic contingency plans in place in case you can’t make the monthly payments,” she says. “Too many business owners are overconfident in their projections and don’t adequately prepare for economic bumps in the road.”

Michelle walks her clients through “what-if” scenarios to stress test their abilities to pay:

  • What if you lose your biggest client or contract – could you still afford the debt?
  • What if you face a family emergency that drains your personal savings meant as a business buffer?
  • What if there’s a recession and revenues decline 30% for 12 months?

“Having plans to cut expenses, tap alternate funding sources, or even sell some assets to cover payments for a few months can give you crucial breathing room,” she explains.

Michelle also recommends setting up a business line of credit (LOC) with your bank so you have a backup source of emergency funding. “Having a $50K or $100K untapped LOC lets me sleep better at night when clients take on bigger loans. I know they likely won’t need it but it’s there just in case.”

The Bottom Line

As you can see from the accountants’ input above, there is no universal “safe” threshold for how much business debt is acceptable. A lot depends on the stability and levels of your cash flow, your contingency plans, and your ability to adapt if revenue declines.

John summarizes it well: “The level of debt that may drown one company may be easily managed by another. Take a conservative approach based on realistic financial projections, have a backup plan or two, and you’ll put yourself in a better position to not just survive but thrive.”

What’s been your experience managing business debts? What advice would you give fellow entrepreneurs? Share your thoughts and questions in the comments below!

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