Borrowing

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Borrowing and Risk

Borrowing represents a real risk in that the borrower assumes an obligation that limits future possibilities. This is reflected in, and easiest to see, in the fact that the more you borrow, the less lenders are willing to lend. In other words, borrowing to finance purchase A today means your less able to borrow to finance purchase B tomorrow.

One wants to particularly look at their own ratio of debt to equity. The higher the ratio, the more risk you're carrying.

The question can be put as: if all cash flow dried up tomorrow, how long could you continue before your funds were depleted? The more loans your carrying, the less that number. I'm framing the question from an entrepreneurial perspective. It's a question that actually comes up a lot in my own business and in the business of many I know. I, for example, have often had to bridge myself between work opportunities. I know one guy who works for himself and his opportunities come in big chunks once or twice a year. The normal for him is to carry himself 6-12 months between pay days!

In that kind of situation, you have to think not only where you're at the beginning, but also at the end. If you have a 1 to 1 debt to equity ratio at the beginning of the period, are you 4 to 1 at the end? Is that sustainable? (Hint, probably not.)

Ideally, you want cash reserves to be able to carry you through any downturn such that at the end of the period you're still at an acceptable risk burden. For myself, I like to think of "what's the maximum amount of time I'm likely to have to bridge?" and then I double that.