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Q: My business can use an infusion of cash and I’m considering a business loan. I already have some outstanding debts, though. How do I strike a balance when borrowing for my business?
A: Borrowing money to fund an expansion or new venture can be a necessary part of running a business. But how much is too much? Here’s all you need to know about striking a balance when borrowing for your business:
What is debt capacity?
Debt capacity refers to the amount of money a business can reasonably borrow and pay back within a specified timeframe. A business can use its debt capacity to ascertain how much money it can actually afford to borrow.
To determine the debt capacity of your business, use the debt-to-EBITDA ratio. This commonly used metric measures the amount of income available for a business to pay down debt before covering costs. It compares the total sum of all long- and short-term debts of a business to the company’s earnings before interest, taxes, depreciation and amortization (EBITDA). Once you have both sums, divide total debt by the EBITDA to determine your ratio.
What is a good debt/EBITDA ratio?
There is no across-the-board rule for a responsible debt/EBITDA ratio. For some industries, a debt/EBITDA exceeding three or four can be problematic, while other industries can afford a debt/EBITDA as high as 10. Once you’ve determined yours, it’s best to compare it to other industries.
How much debt is healthy for my business?
You will likely not want to push your ratio to its limit, and you’ll need to make a choice about how much money you are comfortable borrowing for your business. Here, too, there is no one-size-fits-all answer. Your business is unique, and its capacity for new debt is unique as well. Harj Taggar, the co-founder and CEO of Triplebyte, says it’s more important for businesses to have a defined plan for debt than a definite number. Healthy debt for a business, he shares, is debt that will be used well.
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