When Debt Makes Sense vs. Doesn't

Key Takeaways

• Debt isn't good or bad by default. The question is whether the money you borrow will earn more than it costs. That's the only test worth running.
• Your debt service coverage ratio (DSCR) is the number that tells you and your lender whether your business generates enough to cover the loan payments. Most banks want to see 1.25 or higher. The SBA accepts 1.15.
• A DSCR below 1.0 means the business isn't generating enough to cover the payments yet. That's a signal to wait, not borrow.
• Borrowing to fund growth or an asset that pays for itself can be smart. Borrowing to cover ongoing losses rarely is.
• In California, lenders making financing offers of $500,000 or less must now disclose the APR and total cost before you sign (SB 1235), so you can compare offers honestly.

It's easy to react to debt instead of evaluating it. Some owners avoid it on principle, even when borrowing would help the business grow. Others lean on it freely, borrowing up to whatever a lender will approve.

Both approaches skip a useful question: will the borrowed money earn more than it costs?

If you borrow at roughly 10% and the loan helps you generate a 25% return, the math works in your favor. If you borrow at 10% to cover expenses that aren't producing anything, the debt tends to make a cash flow problem more expensive instead of solving it. Here's how to run that test on your own numbers before you talk to a lender.

Start with the cost of the money

You can't judge a return without knowing what the money costs. As of June 2026, the prime rate is 6.75%, the base most business loans are priced from (GoSBA Loans). Most SBA 7(a) loans, the most common government-backed business loan, currently run about 9% to 11.5% APR, with SBA 504 loans for real estate and equipment closer to 5% to 7% (NerdWallet). Conventional bank and online loans range widely above that.

Whatever your rate, that's the bar to clear. The borrowed money should earn more than it costs to be worth taking on the debt.

The number every lender looks at

Debt service coverage ratio tells you, and your lender, whether your business produces enough cash to cover its loan payments. The formula:

DSCR = Net Operating Income / Total Debt Service

Net operating income is your income after operating expenses. You can find it on your profit and loss statement as total revenue minus all operating costs. Total debt service is the full annual cost of your debt, principal plus interest. This shows up on your loan statements or in the liabilities section of your balance sheet.

Read the result like this:

• Below 1.0 means the business isn't generating enough income to cover the loan payments. This is typically a sign to wait, not apply.
• At 1.0, every dollar of income is committed to debt, leaving no cushion for a slow month or an unexpected cost. Most lenders won't approve at this level for that reason.
• At 1.25, you earn 25% more than your debt requires. This is what most banks want to see.
• At 2.0, you earn twice what you owe. You're in a strong position to take on more if needed.

Here is the math with round numbers. Say your business produces $200,000 in net operating income and your total annual loan payments come to $150,000. Your DSCR is 200,000 / 150,000 = 1.33. That clears the typical bank minimum of 1.25 and the SBA's 1.15, so debt service would not be the thing holding back your application (SBA 7(a) Loans).

The SBA accepts a DSCR as low as 1.15 because its guarantee lowers the lender's risk. Many banks hold out for 1.25, and some want more from newer businesses (Chase Business; Bankrate).

Two more numbers worth a look

DSCR tells you whether you can afford a loan right now. These two tell you how much debt your business is carrying overall.

The Consumer Financial Protection Bureau treats a DTI of 36% or lower as a sign that your income-to-debt load is manageable. If you're planning to apply for financing, keep it under 50%. Lenders use this as a signal of how stretched your income already is (CFPB, via Beancount).

For debt-to-equity, a range of roughly 0.5 to 1.5 is reasonable for most businesses, but it swings hard by industry (Towerpoint Wealth; Eqvista). Capital-heavy businesses like construction or manufacturing carry more. Service and software businesses carry far less. Compare yourself to your own industry, not to a single number.

The action number is DSCR. The structural numbers, DTI and debt-to-equity, tell you whether you have room to take on more.

When debt makes sense, and when it doesn't

Good reasons to borrow share one feature: the money creates a return larger than its cost. For example:

• Equipment that increases capacity or cuts labor cost
• Inventory for orders you already have in hand
• Expansion into a location or product line with proven demand
• Bridging a known, temporary cash gap, like a seasonal slowdown or a large receivable you will collect

Borrowing tends to backfire when:

• You are covering ongoing operating losses instead of fixing what's causing them
• The expected return is a hope rather than something the numbers support
• The new payment would push your DSCR below 1.25 with no cushion if revenue dips
• You're turning to a high-cost product, like a merchant cash advance, to patch a problem that cheaper financing would solve

Before you sign, ask: will the borrowed money produce a return higher than the interest rate? If the answer is no, or if most of the situations above apply, it may be worth holding off and closing those gaps first.

California: read the disclosure before you sign

California was the first state to require consumer-style cost disclosures on business financing. Under SB 1235, a lender making a commercial financing offer of $500,000 or less must give you, before you sign, the total funding amount, the total dollar cost, the term, the payment amount and frequency, prepayment terms, and an annualized rate (California Department of Financial Protection and Innovation).

This matters most with non-bank and online financing. A merchant cash advance quoted as a "1.4 factor rate" can work out to an APR above 200% on a short term (Debtura). The disclosure forces that real number into the open, so you can compare it against a bank or SBA loan on equal footing.

Two gaps to know. Banks (depository institutions) are exempt from this disclosure rule, and so are loans secured by real estate (California DFPI). So you may need to ask a bank directly for the APR. Either way, it helps to compare every offer on APR, rather than the rate or factor rate that gets quoted first.

Why it helps to have a CPA before you apply

The math here runs off two documents you already have: your profit and loss statement and your balance sheet. A CPA can pull your DSCR from those documents and tell you what a lender will see before you sit down with them. That conversation removes the guesswork. It means you're not learning where you stand from the institution trying to sell you a loan.

Internal - Sources

• Prime rate and SBA 7(a) rate context (June 2026): GoSBA Loans; NerdWallet.
• DSCR definition, thresholds, and worked example: Bankrate; Chase Business; SBA 7(a) Loans; SBA Express Loans.
• Debt-to-income benchmark: CFPB (via Beancount).
• Debt-to-equity ranges: Towerpoint Wealth; Eqvista.
• California SB 1235 commercial financing disclosures: California DFPI; factor-rate context via Debtura.