Assessing Your Debt

Assessing Your Debt

by Karen Murphy, MostChoice.com

A surprising number of business owners are not aware of their debt situation and how to manage it. Just like personal debt, business debt is based on the money you borrow and the interest that you pay on that money. And, just like personal debt, the way to accurately assess your business debt is to first analyze your cash flow.

In fact, debt analysis for a business is inseparable from its cash flow. In other words, how can you know what you can afford to pay out without knowing first how much is coming in?

Do You Have a Cash Flow Problem?

If you find that you don't have enough money to pay your debts, you have what is known as a cash flow problem. And, a lack of cash to pay your trade creditors can be worse than a lack of profits. After all, it takes cash, not profit, to pay off debt.

Having an excess of cash is no guarantee your business can pay its debt, either. Your business can still go broke depending on when it has the cash and when the bills arrive.

Analyzing Your Cash Flow

By calculating your ability to make repayments, a cash flow analysis will help you decide how much debt your business can handle. It will also reveal how much debt your business needs in order to keep running.

Simply stated, a cash flow analysis tracks the flow of cash into and out of your business over a period of time. Your cash outflow includes checks written to pay salaries, suppliers and creditors. Inflows include money from customers, lenders and investors.

A positive cash flow means the cash coming in is more than the cash going out. A negative cash flow is the reverse situation in which you're left with not enough cash to operate your business or to pay your debts.

By breaking down your cash flow into three components: operating cash flow, investing cash flow and financing cash flow, you can help pinpoint the source of your problem.

Formulas for Assessing Debt

In addition to analyzing your cash flow, you can determine your ability to handle debt in the same way that a lender would.

Debt Coverage Ratio

net profit + non-cash expenses / debt
= debt coverage ratio

Use this formula to calculate how well your cash flow covers your debt and the capacity of the business to take on additional debt.

Debt-to-Equity Ratio:

debt / equity = debt-to-equity ratio

Your debt to equity analysis is the comparison of how much of the business was financed through debt and how much was financed through equity. The higher the ratio, the greater the risk you represent. Too much debt can put your business at risk and too little debt may may hurt your overall profitability. A good debt-to-equity ratio should fall into the range of 1:1 to 4:1.

Bad or Good Debt?

There are several factors to consider when deciding whether the debt you carry is good or bad debt.

Generally, good debt should eventually provide you with a long-term financial payoff. In other words, the eventual payback should outweigh the cost of the loan. Bad debt is considered short-term debt in which the loan lasts longer than the item you bought, and for which there is no financial payback. In addition, fringe banking of the type that includes title loans and payday loans with high interest rates are the very worst kind of debt.

Is the money you borrowed making or losing you money? Good debt will make you money in the long run. A good formula to use is one that determines the financial benefit of your debt:

debt / equity * (EOA - interest rate)
= financial benefit of debt

EOA stands for your earnings before interest and taxes (EBIT) on assets. It is the return you earn on the fraction of your business financed with equity. In general, if your EOA is above your interest rate, you're making money on your debt. If it is below your interest rate, you're losing money on your borrowed money.