July 28, 2009

Practically every business must manage debt. For small- to mid-size companies, how much is too much? To find out, we tapped Eric Siegel, Wharton adjunct professor in management.

While there’s no hard and fast rule, there are certain common metrics lenders consider when deciding whether to make a loan, says Siegel, who is also president of Siegel Management, advisors to middle market growth companies. In other words, if you want to know if your company can handle its debt load, you may want to look at your operation the way a bank does.

“One of the metrics lenders use is a multiple of EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization),” says Siegel. “The multiples change, of course. Years ago, lenders were looking at four times EBITDA” as the amount they would be willing to lend to a business. “Today if you can get a bank involved at all, it would not be unusual for them to reduce that multiple by half. But this is not a hard and fast number,” Siegel cautions. “Some businesses are more ‘leverageable’ than others. But it gives you an idea.”

So, as a rule of thumb, a comfortable, workable debt load might be twice your business’s EBITDA. If your company’s debt is considerably higher than that, don’t panic! There are plenty of exceptions to this general rule. But you may want to run your numbers by your accountant or a trusted financial advisor just to make sure you qualify as one of those exceptions.

Siegel recommends finding ways to economize before going to a bank to ask for money. The strategies include the following:

1. Ask suppliers for extended terms. If you can pay an invoice in 60 or 90 days instead of 30, you can make better use of the cash before you must part with it.

2. Lease equipment rather than buying it. That could free up precious funds; you might find that you need to borrow less. Or, depending on the type of loan you’re seeking, you might also have more cash to use as equity.

3. Purchase the underlying real estate. “Buying can be a good idea,” says Siegel. “But be aware that if you buy the property you’ll be going into a second business. Do you want to be in the real estate business? Maybe it's a great idea, but it needs to be thought about. You need to go in with your eyes open.” Ask yourself about the risks and costs of owning the property. Write it all down so you can compare it to the cost of renting.

But there's no one-size-fits-all answer, says Siegel, noting that individual business owners have varying tolerances for risk. “People have different thicknesses of stomach lining,” he says. “Some have great tolerance for risk; others not so great.”