Why do successful companies get themselves into debt difficulty?


Many successful companies borrow money, but at what point does this become a problem?

Why borrow?

Buying equipment, stock, vehicles, moving to new premises – these are all valid reasons for borrowing money. As long as a company is trading at profit and can afford the debt repayments, this is fine.


The difficulty is when borrowing becomes excessive and interest and debt repayments are a large percentage of the company’s profits. This could lead to a situation where the company can keep trading and is not at risk of failure, but there is not enough cash to allow for any growth. Research and development and marketing are ways to expand the company, but if there is no budget available for this, the company can become stagnant and not growing.

Economic downturn

The Bank of England in its recent Inflation Report said that because wages are not expected to rise in line with inflation, it expects people to consume less. This could negatively affect the turnover of many businesses. If yours is one of those businesses and also has excessive debts, then there could be serious cash flow problems.

Acceptable debt

Acceptable debt needs to be assessed to avoid debt difficulty. Many businesses calculate this as a debt ratio, the formula for which is:

Debt ratio = Total Liabilities / Total Assets

If the ratio is 0.5 or below, this is regarded as acceptable. This means that no more than 50% of a company’s assets should be financed through debt. Some financial analysts are more cautious and prefer a higher ratio – often somewhere around 0.7.

Companies with shareholders should use the debt-to-equity ratio, which is:

Debt-to-equity ratio = Total Liabilities / Stockholders’ Equity

These calculations are a rough guide to the amount of debt a company can ‘acceptably’ carry. They do not look at the interest rate or the company’s ability to pay off its debts. Some companies use the formula:

Interest Coverage Ratio = Operating Income / Interest Expense

In this case, a ratio of 3 or above is fine.

Whatever formula is used, companies need to calculate their level of acceptable debt and not borrow above this amount. In this way, cash flow is protected and any temporary downturn in business can be dealt with.

In order to focus on running the business rather than the day-to-day financial management, hire a management accounting service who will control cash flow and advise on acceptable debt levels.