Avoid taking on more debt than you can bear, as it often results in the demise of the business. It really becomes a big problem if your business is over-leveraged, meaning you have more debt than the business can handle. The problem with leverage is that it acts as a fixed cost and, like any fixed cost, it does not fluctuate with the income activity of your business. Leverage typically comes as a fixed monthly payment consisting of principal and interest charges. Variable cost such as labor expense, employee load, material cost, on the other hand, closely follows the revenue activity of your business. Increased business activity translates into increased revenue, which in turn requires a larger workforce.

The same goes for a manufacturing business, the higher the demand for your product, the more material is needed to meet the demand. The lower the demand for your products and services, the lower the cost of labor and materials. However, the fixed cost, on the other hand, will remain constant, even if your income activity drops to zero, you are still committed to making the monthly payments. This, in turn, exacerbates the cash flow problems your business may face should you experience a drop in revenue-related activity.

Imagine accepting a personal home mortgage and financing agreement for a new personal vehicle, and the next month you lose your job. Regardless of whether you have a job or not, you’ll still need to make monthly payments on your mortgage and car loan. Depending on your cash reserves, it may take six months before the bank repossesses the house and vehicle, or it may take two months. The same would eventually happen to any business that is unable to pay its debt; the business eventually ends up being owned by the bank.

Companies typically go into debt to purchase equipment used to service a project with an unbreakable agreement that guarantees revenue for a specified period. A company can simply run a debt service coverage ratio to determine if it is capable of paying the debt. Basically, the formula is EBIDA (earnings before interest, depreciation, and amortization) / monthly loan payment (principal + interest expense). A ratio of one essentially means you’re generating enough cash flow to pay your monthly payments; banks typically require a debt coverage ratio of 1.2 to 1.5. The higher the index, the lower the risk of default on the debt.

As a business owner, you need to forecast your future cash flow the same number of years as your loan repayment terms. If the loan has a five-year repayment term, your cash flow forecast must also be for a five-year period. This exercise will be beneficial in helping you determine the amount of cash flow you can generate each year, as well as determining the amount of debt your business can support simply by applying and calculating the Debt Service Coverage Ratio.