Borrowing money is often a necessary part of running a business. It’s important to proceed with caution and understand business borrowing before taking on new debt.

Here’s all you need to know about striking a balance when borrowing for your business:

What is debt capacity?

Debt capacity refers to the amount of money a business can reasonably borrow and pay back within a specified timeframe. A business can use its debt capacity to ascertain how much money it can actually afford to borrow.

To determine the debt capacity of your business, use the debt-to-EBITDA ratio. This commonly used metric measures the amount of income that is available for a business to pay down debt before covering other costs. It compares the total sum of all long-term and short-term debts of a business to the company’s earnings before interest, taxes, depreciation, and amortization (EBITDA). All of these figures can be obtained from your company’s most recent income statement. Once you have both sums, divide the total debt by the EBITDA to determine your ratio.

Be sure to take any expected growth in revenue from new debts into account when determining the ratio of your company’s debt/EBITDA. You may need your accountant to help you with these calculations.

The debt/EBITDA ratio can serve as a guide when taking on new debt.

What is a good debt/EBITDA ratio for a business?

A high debt/EBITDA ratio can mean a business has taken on more debt than it can realistically afford. A low debt/EBITDA ratio means the business can afford to responsibly take on more debt.

Often, a creditor or lender will set a limit for a debt/EBITDA ratio, but sometimes, the business is on its own.

There is no across-the-board rule for a responsible debt/EBITDA ratio. For some industries, a debt/EBITDA exceeding three or four can be problematic, while other industries can afford a debt/EBITDA as high as 10.

Once you’ve determined your debt/EBITDA, it’s best to compare it to other industries. For example, a cyclic business will generally have a lower debt margin for an acceptable debt/EBITDA ratio than a business with a steady stream of revenue and a healthy cash flow throughout the year. Similarly, a business in an industry with minimal barriers to entry is always open to new competition, and consequently, has a low margin for an acceptable debt/EBITDA ratio. Also, a company’s existing debts can significantly limit its current debt capacity.

How much debt is healthy for my business?

Once you’ve determined an acceptable debt/EBITDA ratio, you’ll be faced with additional decisions. You will likely not want to push your ratio to its limits, and you’ll need to make a choice about how much money you are comfortable borrowing for your business.

Here, too, there is no one-size-fits-all answer. Your business is unique, and its capacity for new debt is unique as well. Harj Taggar, the co-founder and CEO of Triplebyte, a hiring platform geared toward software engineers and startups, says it’s more important for businesses to have a defined plan for debt than a definite number. Healthy debt for a business, he shares, is debt that will be used well.

“Good debt is tied to something solid with a clear plan for why it’s helpful,” he says. “Bad debt is money you spend without understanding how it impacts your business.”

Debt is a necessary part of the journey for most business owners, but finding the right amount to borrow can be tricky. Before taking on new debt, it’s important to look at the entire picture and to determine how much debt your business can actually afford.

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Businesses come to Directions seeking not just a lender, but a partner. With more than six decades of experience serving the business community of central and Northwest Ohio, and now, Southeast Michigan, Directions has a strong understanding of the region’s business needs.  Contact us or check out our business loan options.