You shouldn't borrow what you can't pay back--that's how we got into this whole economic mess in the first place. But figuring out how much debt you can take on--or, put another way, how much a lender is willing to extend (for they may not be the same thing)--is a bit tricky.
Obviously, you need cash to cover your principal and interest payments. But how much exactly?
First, estimate the amount of money you need by use (working capital, equipment, real estate, etc.). Assume for the moment that you will use "term" loans, with monthly payments of principal and interest over a certain time period, similar to the loan on your house.
Each asset has a different term. Working capital loans are usually repayable over three years (or five to seven, with a guarantee from the Small Business Administration); equipment loans usually stretch over three to five years, depending on the useful life of the equipment); and real estate leases run for 15 to 25 years, often with a large, one-time balloon payment at the end.
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Now it's spreadsheet time. Figure out your monthly payments and separate the amounts into principal and interest over the next year. At this point, you're ready to calculate three important metrics that will keep you honest about how much debt you can take on.
1. Projected operating income / Interest expense. Called the interest-coverage ratio, it tells lenders whether or not you can cover your interest payments. (They may have a little leeway on principal, at least in the early periods.) If you can't pay interest, the bank regulators can ask the bank to increase their reserves or write off the loan. Both are bad.
"Operating income" is revenue less all expenses except interest and taxes. If you could perfectly predict the future, an acceptable ratio would be 1.0. But lenders are skeptical and want some cushion. Assume the ratio should be more like 1.2 to 1.5. So, if your target ratio is 1.3, and your projected operating income for the next year is $130,000, your interest expense cannot exceed $100,000.
2. (Projected net income + Depreciation) / Principal payment. Maybe you can keep the game going by covering your interest payments, but not have a prayer of paying back the principal. This ratio will smoke you out. It uses in the numerator the free cash available to the enterprise, after all expenses. Like the interest-coverage ratio, target 1.2 to 1.5.
If this ratio is less than 1.0 in the early months, banks may be wiling to adjust your principal payment schedule, so long as the other aspects of your company look sound. Need capital to fund growth? Tough luck: Pull it out of equity.
3. (Projected EBITDA + Lease payments) / [Interest + Lease payments + (Principal / (1-tax rate))]. While it looks scary, this ratio is meant to provide comfort. It combines the above two ratios, but gives lessors (landlords and equipment-rental firms) an extra level of clarity and safety by explicitly highlighting the impact of all lease payments. (In the first two ratios, lease payments are pulled out of the numerators.)
In this ratio, EBITDA stands for "earnings before interest, taxes, depreciation and amortization"--the basic operating income of the company before non-cash expenses. Principal is adjusted to a pre-tax basis. New companies should shoot for a ratio of 1.25; established ones, 1.1.
Bottom line in this skittish environment: The higher these ratios, the better.
Dileep Rao is the author of Finance Any Business Intelligently®, and the president of InterFinance Corporation, which consults with governments, lenders and businesses on venture growth. He can be reached at drao@infinancing.com.
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