A company is considered to be overleveraged when its debt profile is higher than its operating cash flow and equity. An overleveraged company has issues with paying its interest and principal payments and finds it challenging to afford its running costs due to its debt weight.
Typically, when this happens, most companies often continue to borrow to stay afloat, leading to more debts. This trend can often lead to companies needing to file for bankruptcy in order to get out of debt. Fortunately, debt solution companies offer another alternative for struggling businesses.
Let’s take a look at the potential consequences and what can happen to a company that has too much debt.
Good Debt vs. Bad Debt: What’s The Difference?
Debt can either be good or bad, depending on the purpose it was taken and how well it was managed. While there are many misconceptions about debt, some types of debt can actually help a business grow, improve its purchasing power, the medium of production, and other aspects of its operations. For example, having small amounts of debt to help your credibility in order to draw in more investors or customers.
Small amounts of debt can be a good source of capital when compared to other alternatives like issuing stocks. As long as a company can effectively manage its debt burden, debts can help a company become more successful. However, when a company is unable to manage its debt, it becomes a huge financial problem.
What Does Being Overleveraged Mean?
Overleveraging occurs when a company takes up more debt than it can pay. In other words, overleveraging is when a company’s debt level is too high and affects its ability to pay the interest, principal repayments, or efficiently pay for its running costs due to the debt burden. Businesses that borrow too much and become overleveraged may end up going bankrupt if their business experiences a market downturn.
As a business owner, taking more corporate debt is more likely to negatively affect your business revenue and operations in the long run. This is because the income that is supposed to service the debt may end up eating a large portion of your company’s revenue. Companies with less leverage are more likely to survive a market downturn because they have a lower debt impact on their realized cash flow.
How to Know if You Have Too Much Debt?
According to an article by US Today, the average small business has approximately $195,000 of debt. While getting business debt can be a source of capital or help you run your business effectively, it can sometimes crumble your business when not managed effectively.
It is quite difficult for most business owners, to draw a line between getting outside help for relieving debt and taking on more debts to salvage their present financial issues. So, the question is, when do you know that your company has too much debt?
While there is no set universal standard to determine how much debt is too much for a company to take on, there are however some industry metrics that can help.
- The first metric is looking at your company’s debt-to-EBITDA ratio. The term EBITDA stands for earnings before interest, taxes, depreciation, and amortization. You can find out your company’s level of financial trouble using this metric by calculating your total debt and dividing it by its EBITDA. While the normal debt level varies, any debt-to-EBITDA level above the 4-5 range is considered high.
- The second metric is to use your company interest coverage. This is the ratio of a company’s net income to the amount of interest it pays on its debt burden.
- Another helpful metric to monitor is the debt service coverage (DSC) ratio often used by banks. To calculate your DSC take your operating profit per month and divide it by your total monthly debt payment obligations. Try to aim to keep yours above 1.25.
- The last metric is to look at the company’s net debt and not just the figures reflected on the company’s balance sheet. For example, as of 2019, Tech giant Apple was $100 billion in debt but had a cash reserve of around $210 billion. If you were buying stock in Apple, it would be wrong to say Apple has a $100 billion debt. This is because Apple has enough money to settle its debt and more left in its reserve.
While none of these metrics can fully reveal a company’s debt burden, it can point you in the right direction when trying to determine your commercial debt level. Understanding these metrics can also be helpful when deciding to invest in a company’s stock.
What Happens When A Company Is Overleveraged?
There are several negative impacts on a company when it has too much debt. Most of these impacts may be gradual or as a result of poor management of the credit lines received but can result in you losing your business or having to sell it to someone else. Below are some of the things that can happen when a company has too much debt.
1. Constrained Growth
Businesses take loans for several reasons. For some, the purpose is to increase their production capacity, fund their operating costs, or purchase more sophisticated equipment to boost sales. In general, the goal is always to grow the company. However, every credit line or business loan comes with a specific repayment timeline.
Suppose a company receives a credit line with the expectation of increased revenue and production but hasn’t achieved these targets before the debt becomes due. In that case, they can find themselves in severe financial trouble. Having to pay back the loans without an increased income can negatively impact business growth and operations.
2. Loss of Assets
If a business is so much in debt it ends up becoming bankrupt, their loan agreement to the lender can be called into question. When this happens, the lender may end up having seniority on the company assets. This means that if a business cannot pay back its debt due to being overleveraged, the lender may be able to take over the business assets to pay off the outstanding debts. Essentially, a company may lose many if not all its assets when it has too much debt.
3. Limitations on Further Borrowings
Just like individuals, an overleveraged company may lose the ability to take on more debts. Before lending money, banks or lenders conduct an underwriting, which involves evaluating a borrowers’ credit report and debt-to-income ratio. So, if a company has too much debt, it will be difficult for lenders to offer them more loans. Lenders do not want to run at a loss. For lenders that may be willing to provide more loans, the interest rates would be typically higher.
4. Damage to Credibility
If you have too much debt you might start to miss payments which can hurt your credit score and credibility which businesses need to continue growing and expanding.
5. Failure to Gain More Investors
A company with a significant debt burden will find it difficult to attract new investors to buy its stocks or invest in them. The average investor wants a secured and promising investment with less financial risk. For the typical investor, investing in an overleveraged company is a poor or risky financial investment, unless they will receive a large equity stake within the company. However, giving up a large equity stake in any company is not a great idea as it loses control over its financial and operational decision-making process.
Finding Debt Relief For Your Business
Debts can be a tool for growth or a tool for destruction, depending on the purpose and management of the loan. However, a poorly managed loan can lead to several financial woes and bankruptcy for even the biggest company. Additionally, dealing with calls from lenders and the fear of their business shutting down due to debt can be a troubling time for any business owner.
Fortunately, if your business is dealing with debt or considering filing for bankruptcy there is hope. The first step to achieving financial independence and see your business thrive is to reach out to a debt solution company like Reorganization Management Group for assistance.
With a combined 50 years of industry experience, knowledge, and success, The Reorganization Management Group is the clear choice for all of your long and short-term financial needs. If your business is suffering our commercial debt management solutions can help save your company, pay off your debts, and establish a stronger long-term plan to help your business thrive.
Call us at 866-364-9161 and ask to speak to an advisor or you can fill out a no-cost/no-obligation form.
