How to Know If Borrowing is Right for Your Business

cash money bag debt public domainBig bank lending to small businesses is increasing. In addition to traditional loans, you may find yourself receiving unsolicited credit card offers from major banks.

While it’s nice to see a loosening of credit, the banks often – and the credit card companies always – loan money without truly assessing the credit worthiness of the small business borrower. Back in the day, a banker would do a detailed analysis of a business’ financials before issuing a loan.

Today, many will not take the time and the only thing credit card companies are looking at is your credit history. If you’ve managed to make your payments, despite running an unprofitable business, they will probably give you a new card anyway. All of this makes it incumbent on you to understand if and when you should be increasing your company’s debt position.

There are a variety of ratios that give you an indication of how much debt you can afford to carry, which I’ll briefly list below. However, before that you need to have a sense of how “steady” your industry is. If you’re in a business that is volatile, you need to approach any analysis from a very conservative point of view. If your income and growth are historically steady and predictable, you are probably in a position to handle more debt.

When discussing stocks, analysts will often mention the debt/equity ratio. This is the amount of debt a company has divided by its net assets (assets minus liabilities). This ratio tells you how much the company is leveraged. A high number – above 50, for example – means the company is highly leveraged. A highly leveraged small business in a volatile market could be in trouble. Debt/equity ratios vary wildly between industries as you can see in this chart.

Start with your debt/equity ratio. If it would go above 40 when you consider the amount of additional debt you want to take on, it could be too much. Here are other ratios to look at as you judge your ability to make interest and principal payments.

Projected operating income/interest expense. Your operating income is your revenue minus expenses with the exception of interest payments and taxes. Experts recommend a number between 1.2 and 1.5. Theoretically you would cover interest with a ratio of 1, but that is cutting it too close to the bone.

Projected net income plus depreciation/principal payment. This predicts your ability to pay back the principal on the loan. Anything lower than 1 spells trouble. Again, shoot for a number between 1.2 and 1.5.

Current assets minus inventory/current liabilities. This is the “acid test ratio” and gives you a yardstick by which to measure your ability to meet your short-term obligations. It’s a worst-case scenario snapshot that compares your liquidity to your liability. It must be greater than 1.

There are other ratios that serve to judge the credit worthiness of your company and give you an indication of how wise it would be to take on more debt. Ultimately, much of that analysis depends on how you would use the borrowed money. If you are using the cash to expand or get through a short-term cash flow shortfall, borrowing can make a lot of sense. If your cash flow problems are chronic, it’s a different story.

I’ve offered some introductory comments here that will provide you with an initial assessment of your situation, but this is a subject that requires sound advice from professionals. Talk to an experienced financial adviser as well as experts in your industry.

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