Debtor, Beware

Question: How much debt is safe to get into when starting a business?

Answer: No more than you can handle without going broke. While many entrepreneurs launch businesses on their credit cards or by taking out home equity loans, it's risky to pile on too much debt before your company starts making a profit. If your business can't kick off enough cash to cover your monthly interest expenses, you risk defaulting on the loan and putting your home and business in jeopardy.

Once your company starts making a profit, you'll have many more options. One popular form of debt financing is a credit line secured by your company's accounts receivable. Unlike a loan that requires you to make fixed monthly payments of principal and interest, a credit line allows you to draw down only the money you need and to pay interest only on the amount you borrow.

No matter what kind of debt financing you use, the key is to keep your debt service at a manageable level. Justine DeVito Tenney, partner in the Private Business Group at accounting firm Weiser LLP in Lake Success, New York, advises as a rule of thumb that businesses maintain a debt service coverage ratio of at least 1.2 to 1--that means $1.20 of cash flow for every $1 of interest and debt payments.

DeVito Tenney also recommends that new businesses prepare detailed estimates of their monthly and annual cash flows to make sure they don't get caught short. "Even if total cash flows are sufficient to meet obligations as they come due, the timing of cash inflows may not match scheduled payment dates of liabilities," she says. In other words, when it comes to debt financing, it's better to go slow than to go for broke.

This article was originally published in the June 2006 print edition of Entrepreneur's StartUps with the headline: Debtor, Beware.