It’s a known fact that every business can benefit from a certain amount of debt.
Using borrowed money helps to fuel the tide during lean months and can power some increases in profitability.
Sometimes too much of a good thing is not suitable for business. The key takeaway is that you must learn how to measure and manage your business debt for the best cash flow outcome.
How do you know when you’ve borrowed too much?
Before you were issued a loan, you carefully watched the numbers. Now, with the increased cash flow, do the math to determine if the business is over-leveraged. You can do this by looking at some simple financial measures of the company’s performance and reviewing daily and monthly cash flow.
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Do the company math
Take a look at some simple math formulas or financial ratios that are indicators.
Debt to Asset Ratio = (Total Debt/Total Assets)
The debt to asset ratio shows how much you’ve borrowed compared to how much you own. This ratio should be below 40% in most industries.
Debt to Income Ratio = (Annual Debt Payments/Total Income)
The debt to income ratio shows how much of your income is taken up by debt repayments and this ration should also be below 40%
The Acid Test Ratio = [(Current Assets – Inventory)/Current Liabilities]
The acid test ratio measures how easily you could pay off your current debts. Ideally, this should be one or more significant.
The target values are general suggestions. Your industry affects what is considered normal or healthy results. These, however, are all excellent baseline figures.
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The Company Has No Cash
Poor cash flow is a significant signal that the company is over-leveraged. If your income statement shows you have reasonable high profits, but you are always cash-strapped, then you may have too much debt.
To correct inadequate cash flow, look at several areas to begin to uncover some answers.
Don’t reduce debt. This concept may seem upside-down, but paying down the debt may make things worse. Instead, it may work better to pay the debt off more slowly to allow the cash flow to recover. This move would only be a temporary measure. Indeed, the goal is to get the deficit under control.
Reduce the number of staff. Usually, payroll is the most considerable expense on the income statement. It would mean that a critical team will take on more work. The danger with cuts is that it may impact customer service and work relationships.
Begin now to take the step to make your company more successful if you see signs that cash flow is an issue. It’s better to admit it now and take steps to stem the tide. Get the help you need to support your business. Many businesses fail by not taking steps early to give their business a fighting chance at survival for the long term.