How much debt is too much for your company?

Q: I need to apply for a line of credit for cash-flow purposes. At what point is there too much debt? Revenue is 20 percent of debt to date, but I'm in my first year of business and have naturally acquired more debt than expected going forward.

A: To resolve the amount of debt you can afford, you need to perform a two-step process.

First, start with the cash flow of the business to establish the maximum payment that can be afforded.

Second, use that maximum payment to determine the maximum amount of debt for which you can ask.

Free cash flow (FCF) represents the maximum amount of cash flow left over after covering operating costs, equipment purchases and working capital needs.

FCF for the month equals your current net income (or loss) plus depreciation expense claimed (if any), minus any equipment or hard assets you need to buy that month, as well as any net working capital you need (such as out-of-pocket inventory replacements).

If your book keeper did not include your personal salary in the calculation of net income or loss, then subtract that amount at this time.

I would recommend not using all of this amount for debt, but leaving yourself a little cushion in case of an emergency.

Step two is to estimate the maximum credit limit. Roughly, take the amount derived in step one and multiply that by the number of months required by your credit arrangement. If your FCF is $500 for the month and your loan requires a 10-month payoff, the maximum loan amount is $5,000.

David Vang is a professor of finance at the University of St. Thomas Opus College of Business.