How To Decide How Much Debt Should Your Company Carry

During their life cycle, all companies take on debt at some point. In fact, even mega-corporations are more often than that servicing some form of debt. While debt is widely (mis)understood as something to be avoided, the fact is that borrowing money is an integral part of business.

 

In this post we are to take a look at the various reasons why a business  may need to obtain credit, borrow capital and take on debt and then we will examine how to assess how much debt your company can safely manage.

 

Why a Company May Need to Take on Business Debt

 

There are many different reasons why a business may need to take on debt but we can generally break them down into two categories: (1) borrowing to facilitate growth and (2) credit to help a company weather a difficult period.

 

For example, if a restaurant wished to lease the building next door, knock through and expand their seating capacity, they will probably need to borrow the money to do it. On the other hand, if that same restaurant is temporarily forced to cease trading like many were during COVID-19, it may find it needs to borrow cash in order to meet its’ (reduced but still significant) running costs.

 

Good Debt vs Bad Debt

 

While no business is ever exactly happy to owe out money, there is such a thing as good debt - but how exactly do we define what a good debt is?

 

Good debt is debt linked to a good type of credit facility such as a secured loan with a low interest rate, from a high street bank reputable lender. Next, a good debt is usually one borrowed for growth - it can be seen as an investment as the increased trade resulting from the growth will repay the loan. Finally, a good debt is one which a business can comfortably service.

 

Bad debt on the other hand is the opposite of all of the above. So, a bad debt is one tied to a lesser desirable line of credit such as a high interest, unsecured loan from an online (formerly ‘backstreet’) lender. Often bad loans are born from desperation in periods when a business is struggling to survive and the borrowing can represent sunken costs. Finally, a bad debt is on which the business is struggling to maintain and the results are increased fees and penalties, a deteriorating credit rating and possible legal action.

 

It is kind of possible to judge whether a debt is good or bad simply by looking at the debt ratio and we will explore what this means later in the post. However the ratio alone only shows part of the picture.

 

Debt Structure and Debt Capacity

 

The way in which a company structures its debt is vitally important in determining whether it remains as a good debt or turns into a bad one.

 

Debt capacity is the total amount of debt that a business can incur and repay. There are a number of different ways in which prospective creditors or investors assess how much business debt capacity a given company has. Let’s take look at them;

 

• Debt To Equity Ratio

 

The debt to equity ratio is the difference between how much debt a company owes, and how much equity is available to its shareholders or directors. Debt to equity ratios can provide creditors with an overview of a company’s capital structure although these ratios can be complicated.

 

• EBITDA

 

EBITDA, or Earnings Before Interest, Tax, Depreciation, and Amortization is the most common method used to evaluate a company's debt capacity. 

 

When calculated properly it can help creditors assess a company’s ability to pay off its debts and is also a good indication of the timescale in which it can do so.

 

• Cash Flow Metrics

 

Cash flow metrics look at how much cash flow comes into the business each month or quarter. These figures should include total debt-to-EBITDA, which can be broken down further to senior debt-to-EBITDA, cash interest coverage, and EBITDA-Capital Expenditures interest payments.

 

• Cash Interrupt Coverage

 

This key metric measures how many times over a company’s cash flow could service the interest  element on a debt.

 

The Key To Successfully Leveraging Debt

 

There are times when taking on debt can actually prove beneficial for a business; this is referred to as leveraging debt.  Businesses can leverage debt for growth or to keep them going through hard times. 

 

Of course leveraging debt can be risky as the new markets that it is borrowing money in order to target  may not materialise. Alternatively  the hard times which the company is borrowing to weather may last longer than anticipated and hoped. Therefore in order to successfully leverage debt, a business needs a clear plan. It means looking at the amount of return a business expects to generate versus the cost of servicing the debt.

 

For example, let's say a jewellery manufacturer notices that the price of raw stones is rising and they expect the price to rise further in the next financial year. One option available to them is to use their credit facilities to buy a bulk load of stones now, lock in the price and avoid having to pay the increased cost in a 6 - 12 months time, The business needs to work out how much it expects to save by doing this and then weigh it up against the interest that will accrue on the credit facility.  They also need to estimate whether they can sell their products fast enough in order to keep on servicing the debt.

 

Debt vs Equity Finance

 

An alternative to taking on debt is to consider equity financing. This is basically when a company “sells” off part of its equity (ie, shares or future profits) in exchange for capital. 

 

For example a business could offer an investor a 5% equity interest in exchange for a $100k loan. Equity value carries a lot of risk for an investor as their money is not really guaranteed in the event that the company fails. For this reason equity financiers usually seek very lucrative returns on their investment and for this reason, companies may not wish to pursue this option.

 

 

Final Thoughts

 

As you can see, business finance can be complicated. Whereas some company debt is normal and healthy, other business debts can be terminal. Ultimately though, the difference between good debt and bad debt comes down to whether the debt is being leveraged, and whether the debt structure is both appropriate and manageable.