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Accountants Explain How Much Business Debt is Too Much

When it comes to running a business, debt can be both a useful tool and a dangerous burden. As an accountant, I often get asked by small business owners – how much debt is too much? Unfortunately there’s no one-size-fits-all answer. Every business has different cash flow needs and abilities to take on debt. But there are some general guidelines accountants use to assess if a business’s debt load is getting out of hand.

How Do Accountants Evaluate Business Debt?

As a business owner, you don’t want to wait until you’re drowning in debt to realize there’s a problem. Savvy business owners periodically review their debt levels and meet with their accountant to get an objective assessment.

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Accountants look at a few key ratios and metrics to gauge the health of a business’s debt position:

  • Debt-to-Income Ratio – This compares your monthly debt payments to your business’s monthly gross income. As a very general rule of thumb, this ratio should stay under 30%. A ratio approaching 50% is a warning sign that debts are becoming unmanageable.
  • Debt Service Coverage Ratio – This metric compares your net operating income to debt obligations coming due in a year. A ratio of less than 1 means you don’t have enough income to cover your debt payments.
  • Interest Coverage Ratio – This ratio compares your operating income to just the interest expenses you need to pay in a year. A lower ratio means you’re spending an increasing amount on financing costs rather than business operations.

Accounting software like QuickBooks can help calculate these ratios automatically. Your accountant can also review your finances and provide these metrics.

Warning Signs It’s Time to Rein in Business Debt

While the above ratios provide more precise guidance, there are a few general warning signs that business debts are reaching risky levels:

  • You’re frequently late making payments or missing payments entirely
  • Your business relies entirely on credit lines or high-interest financing to make ends meet
  • You’ve maxed out all your available credit and financing options
  • More than 30-50% of your operating income goes towards debt repayment rather than core business operations
  • You have to take on new debt just to service existing debts

If one or more of those describe your current situation, it’s definitely time to speak with an accountant and banker about restructuring debts before it gets worse.

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Setting a Debt Limit Based on Cash Flow

Rather than focus just on arbitrary ratios, a smarter approach is for each business to set a customized debt limit based on predictable cash flows. Here’s a simple process:

  1. Project your monthly net income – Your reliable sources of income after basic expenses.
  2. Establish a reserve – Set aside 20-50% of net income to build reserves/savings.
  3. Set maximum debt payments – Your monthly debt payments should not exceed 50-80% of the remaining net income.

For example:

  • Net Income: $10,000/month
  • Reserve: $2,000/month (20%)
  • Remaining for Operations & Debt: $8,000/month
  • Maximum for Debt Payments: $4,000 – $6,400/month (50-80% of $8k)

This customized approach prevents your business from taking on more debt than your reliable cash flow can handle.

Other Considerations in Managing Business Debt

Setting a maximum debt level is a start, but business owners should also:

  • Lower interest rates – Renegotiate with lenders to reduce interest costs, allowing you to pay down principal faster.
  • Consolidate higher interest debts – Combine multiple high-rate debts into a single, lower-rate loan.
  • Only borrow when necessary – Don’t take on debt for non-essential purposes.
  • Have an operating reserve – Maintain a cash buffer to continue paying some debt through slower months.
  • Focus on higher ROI spending – Cut expenses that aren’t driving growth.

Signs Your Business May Need Debt Consolidation

If your current debts are spread across multiple credit cards, loans and lines of credit – with high variable rates that keep growing – it may be time to consolidate.

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Signs your business could benefit from consolidating debts include:

  • Monthly payments to multiple creditors that are difficult to manage
  • High balances on multiple credit cards charging 15-30% interest
  • Multiple near-maxed out loans and lines of credit
  • Frequently late or missed payments leading to penalties
  • Overall high interest costs every month

By consolidating multiple debts into one single loan or line of credit, you can:

  • Lower your monthly payment
  • Lock in a fixed interest rate
  • Pay off debts faster
  • Simplify payments to just one lender
  • Potentially improve your credit score

Just be sure the consolidation loan has clearly better repayment terms. If not, it may not solve the issues with existing debts.

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When to Seek Emergency Business Financing

What if your business is already so saddled with debt that basic monthly expenses exceed reliable cash flow? At some point debts can snowball to the point business failure is imminent unless emergency action is taken.

Signs you need emergency financing to save the business:

  • Debt interest/payments are 50%+ of net monthly income
  • Payroll and other expenses can’t be met without new financing
  • Major business-critical investments can’t be made as cash reserves are fully depleted
  • Creditors refuse to lend you more money under current debt levels

In this type of near-crisis scenario, you’ll need emergency financing merely to keep the business afloat, make payroll, cover basic operating costs and avoid bankruptcy. At this stage, it’s best to speak to both an accountant and a business financing advisor to weigh your strategic options:

  • Seek emergency SBA loans/grants
  • Pursue emergency lines of credit or merchant cash advances
  • Offer equity to investors in return for capital
  • Consider selling business assets to raise cash
  • File Chapter 11 bankruptcy reorganization

No matter what, don’t let debts spiral out of control to the point of facing bankruptcy without at least seeking professional advice on business survival options.

Key Takeaways on Managing Business Debt

To summarize, key lessons on avoiding excess business debt:

  • Monitor standard debt ratios, but also set a customized debt limit based on reliable monthly cash flow
  • Keep debt payments at or below 50% of net operating income
  • Reduce interest costs whenever possible
  • Only borrow money when absolutely necessary
  • Build operating reserves and work on improving cash flow
  • Consolidate high-interest debts into a manageable loan
  • Seek emergency financing if debts begin spiraling out of control

Running a small business is tough enough even when debts are under control. Hopefully this gives you a better idea of how accountants evaluate business debt capacity and signs that debt is becoming dangerous. Don’t hesitate to consult an accountant or financial advisor if you have concerns. It’s much better to tackle debts proactively rather than waiting until problems spiral.


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