Once you decide to take on debt to finance some aspect of your business, you’ll need to figure out exactly how much debt you need, and how much you can afford. Since this calculation is part art, part financial science, I called Larry Frank, a business coach and regional developer with Advicoach, in Richmond, Va., who’s got 25 years experience managing and advising companies, plus a down-to-earth attitude that’s invaluable for these kinds of questions.
According to Frank, the most important factor to consider when you’re thinking about taking on business debt is your goals. “Any business debt you take on needs to have a clear purpose,” he says. Yet therein lies the rub: A lot of small business owners are so focused on the short-term horizon, they’ve lost sight of their long-term goals. “Before you decide how much debt you’re going to take on, you need to know where you want your business to be in three to five years,” Frank explains. “Then you work backward from there. That is, if you want to be there in three to five years, where do you have to be in one year? Then where do you have to be in one quarter? It’s important to be proactive, to understand where you want to go, not just where you are now.”
He says it’s like when you’re out hiking. “When you’re in the thick of the woods, you can’t see how to get to the top of the mountain. But once you’re on top of the mountain, the path you took will be clear. We tell small businesspeople to imagine themselves at the peak and then figure out what the path was.”
Other factors to consider include your debt-to-equity ratio, which generally should be less than one (although it varies by industry), and the true cost of your debt. That is, your debt isn’t just comprised of the principal that you’re borrowing; it also includes the interest that you will be paying. As such, you need to be absolutely sure that you can afford the payments as long as you’ll be required to pay them. Never forget: Debt is risky. Depending on the terms of your loan, a default could mean you’ll lose your business, go bankrupt, even have your personal property seized.
Another key factor in figuring how much loan you can afford (and, no, you can’t just rely on what the lender says you can afford; sometimes they make mistakes) is the volatility of a) your industry, and b) your market. If you’re in construction, for instance, and home building activity in your area has been unstable in the past two years, you need to be sure that your forecast for your own business isn’t based more on wishful thinking than the unpleasant roller coaster nature of your market. On the other hand, if you run a small bakery, and your business has barely been touched during this recession (we always need pastries), you can probably be more confident about your sales over the next several years. General rule of thumb? The more volatile your industry the less debt you should take on, because you just can’t be sure what will happen next.