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The Business Pitfalls of Leveraging

Avoid taking on more debt than you can endure, it often results in the demise of the business. It really turns into a big issue if your business is over-leveraged, meaning that you have more debt than the business can handle. The issue with leveraging is that it acts like a fixed cost, and like any fixed cost it does not fluctuate with your business revenue activity. Leveraging normally comes as a fixed monthly payment consisting of principal and interest expense. Variable cost such as labor expense, employee burden, material cost does on the other hand closely follow your business revenue activity. Higher business activity translates into higher revenue, which in turn requires a higher labor force.

The same goes with a manufacturing business, the higher the demand for your product, the higher the material required to meet demand. The lower the demand for your products and services, the lower the labor and material cost likely to be. However, fixed cost on the other hand will remain constant, even if your revenue activity goes down to zero, you are still committed to making the monthly payments. This in turn exacerbates cash flow issues that you business can face in the event that your business experiences a downturn in revenue related activity.

Imaging taking on a personal home mortgage, and a financing deal for a personal brand new vehicle, and the following month you loose your job. Regardless whether you have a job or not, you will still be required to honor the monthly payments for your mortgage and vehicle loan. Depending on your cash reserves it may take six months before the bank reposes the house and vehicle, or it may take two months. The same would eventually happen to any business that is incapable of servicing their debt; the business eventually ends up being owned by the bank.

Businesses normally take out debt to purchase equipment that is used to service a project with an ironclad agreement that ensures revenue for a specified period. A business can simply conduct a debt services coverage ratio to determine if it is capable of servicing the debt. The formula is basically is taking you EBIDA (Earnings Before Interest, Depreciation & Amortization) / Monthly Loan Payment (Principal + Interest Expense). A ratio of one essentially means that you are generating enough cash flows to pay the monthly payments; banks typically require a debt coverage ratio of 1.2 to 1.5. The higher the ratio, the lower the risk of defaulting on debt.

As a business owner you should forecast your cash flow into the future the same amount of years as the repayment terms on the loan. If the loan has a repayment term of fiver years, your cash flow forecast should also be for a five-year period. This exercise will be beneficial in helping you determine the amount of cash flows you can generate each year, as well as determine the amount of debt your business can endure by simply applying and calculating the debt service coverage ratio.


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