Most business owners don’t get in trouble because they took on debt. They get in trouble because they took on debt without knowing what had to stay true for it to be safe.
I get asked some version of this all the time: “Can I afford the debt?”
And here’s the frustrating answer: there isn’t one clean, universal yes or no. The most common answer is “it depends” and that’s not at all satisfying. It depends on what has to stay true in your business for that payment to be safe.
Sometimes, business owners will go to banks and see if they can help. But the bank’s goal is different than yours.
Your goal is to keep the business stable, protect your cash, and sleep at night.
The bank’s goal is to get paid back on schedule.
Those goals overlap, but they are not the same, and you can’t outsource the decision to the bank. They’ll approve what their model can tolerate. You have to live with what your cash system can tolerate.
So before you sign anything, you need to understand: does this debt fit into YOUR model.
Today, I want to give you two numbers you can use to help your analysis and four stress tests to evaluate whether or not the debt makes sense.
WHAT YOU NEED (5 MINUTES)
- Your expected monthly debt payment (principal + interest)
- Your last 3 months average revenue and gross margin
- Your cash in the bank today
- Your accounts receivable (and how much is over 60 days)
- Your last 12 months Operating Cash Flow (from your cash flow statement)
- Your rough maintenance CapEx (what you must spend to keep the business running)
START WITH TRUE CASH FLOW (NOT PROFIT)
Profit is a theory. Debt payments are not.
Before you run any debt math, you need a normalized cash number.
I call it Steady-State Cash Flow.
Steady-State Cash Flow (SSCF) ≈
- Operating cash flow
- minus maintenance CapEx
- minus working capital needs
This is your real capacity to service debt.
If this number isn’t stable, or it’s hard to calculate, that’s already a warning sign. It usually means one of three things:
- your working capital is swinging all over the place
- you’re under-investing in maintenance (so the bill is coming later)
- your financials aren’t clean enough to trust
Here’s a quick example (round numbers):
- Operating cash flow: $650k
- Maintenance CapEx: $120k
- Working capital needs: $80k
- SSCF: $450k
That $450k is what the business can reliably throw off before distributions and growth bets. That is what the debt has to fit inside.
If you want the deeper breakdown on SSCF, read this: Start tracking this number today (Steady-State Cash Flow)
THE BASELINE TEST (THIS IS WHAT THE BANK CARES ABOUT)
Once you have a steady-state cash number, run the table-stakes metric.
Debt Service Coverage Ratio (DSCR) = Cash Available for Debt Service / Annual Debt Payments
A simple rule-of-thumb range:
- Healthy: 1.5x+
- Borderline: 1.2–1.5x
- Risky: < 1.2x
Example:
- Cash available: $500k
- Debt payments: $300k
- DSCR = 1.67 → likely fine
Banks do not care if you feel like the business can handle it. They care if DSCR says it can.
It’s also important to note: DSCR is baseline. It tells you if the loan works in a calm, average year. Most businesses don’t fail in a calm, average year.
This brings us to the stress test.
THE DEBT STRESS TEST (4 CHECKS)
Before signing a debt, we want to understand what the actual commitment we're making is. This isn't just the payments but this is the impact that the debt will have on your business and, frankly, your life.
Here’s the stress test I run before a client signs anything.
1) PAYMENT-TO-GROSS-PROFIT TEST (CAN THE BUSINESS CARRY IT?)
Debt doesn’t get paid from revenue. It gets paid from gross profit.
We want to make sure that our debt payments are not too much of a percentage of our gross profits. It's easy to underestimate the cost of our debt because we only see interest payments on the income statement. The actual principal pay downs come from the balance sheet.
There is no hard and fast rule with what percentage of your gross profits should be paid to debt but I think generally it's good to keep it less than 25%.
- Payment-to-GP % = Monthly debt payment ÷ Average monthly gross profit
If you’re over 25%, you're leaving very little room to pay other overhead expenses and make a profit. You’re betting your business on a perfect month.
We don't want to have to plan for the perfect month. We want to be able to plan for the hard months.
2) STRESS TEST DSCR (THIS IS WHERE MOST PEOPLE FAIL)
Now assume something goes wrong. Pick a few that match your real risks:
- Revenue drops 10–20%
- Margins compress
- Collections slow (AR stretches)
- One unexpected expense hits
Recalc DSCR under stress.
A simple way to do this is to run three scenarios:
SCENARIOWHAT YOU CHANGEPASS/FAILREVENUE SHOCK-15% revenue, same marginDSCR still > 1.2xMARGIN SHOCKSame revenue, margin -3 to -5 pointsDSCR still > 1.2xCOLLECTIONS SHOCKAR stretches, cash timing worse for 60 daysYou can still make payments
If your DSCR drops below 1.2x (or goes negative), you don’t actually “afford” the debt.
You’re just hoping nothing breaks.
3) THE TIMING TEST (WILL DEBT AMPLIFY A CASH GAP?)
Debt is a fixed payment, but your cash inflow is not.
When you have seasonality or uncertainty in your business, debt can become dangerous quickly.
Look for variability in your revenues and analyze how your profit and cash are impacted during these periods.
Ask if revenue is off by 20% in my lowest month, will I still be able to make this payment?
We're not making this payment once a year. We're likely making this payment monthly so you need to make sure that you can afford this payment every single month. Or if you can't, you have the cash flow from the good months to hold back to pay it during the bad months.
4) THE USE-OF-PROCEEDS TEST (WHAT IS THE MONEY ACTUALLY FOR?)
This is the most important one. I’ve seen too many business owners take on debt to dig out of a hole only to create a deeper one.
Good uses of debt (usually):
- A specific asset that produces cash (equipment, capacity, a proven marketing channel)
- Short-term working capital with a clear payback plan
- A refinance that lowers payments and buys time
Bad uses of debt (usually):
- Covering chronic margin problems
- Covering sloppy AR or weak billing cadence
- Funding a lifestyle
- “We’ll figure it out once we get the money”
Debt should fund a plan, not postpone a decision.
Truly reflect and evaluate: is this good debt or bad debt? If bad debt, follow up by asking: what hard decisions am I avoiding by exploring using debt?
WHAT TO DO IF THE LOAN FAILS THE STRESS TEST
You won't always pass the stress test but sometimes it can still make sense to get the debt. What do you do when you don't pass these tests? You have a few options at your disposal:
- Change the loan: longer term, smaller payment, interest-only period, or a better structure (SBA vs conventional, etc.). We want to make sure we’re not chasing bad debt here, but it can make sense to explore different banking partners to fully understand our options.
- Change the business first: ask what changes you can make inside the business to “fix” any stress test misses. Can you tighten AR and billing? Fix pricing or labor efficiency? Cut non-essential overhead?
- Change the timing: waiting is hard… but maybe we can wait? Sometimes you need to wait 60-90 days to make that purchase, especially if there is uncertainty today.
Debt is a powerful tool (and one we want to use when smart). But it can also be a trap.
The difference is whether the payment fits inside your real cash system.
Your next step in the next 24 hours:
- Calculate SSCF and DSCR for the last 12 months.
- Stress test DSCR using one revenue shock, one margin shock, and one collections shock.
If the numbers don’t hold, don’t sign.
Fix the system first.
