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Debt or equity? Your cash flow already decided
Two numbers that size your debt before a lender does
Shaun Tiwari
October 15, 2026 • Estimated Reading Time: 3 minutes
An owner who wants to open a second facility. A sponsor funding growth at a company it already owns. A business coming off its best year with an expansion plan and a lender asking what it needs.
The first question is usually how much the business can borrow, or how much of the company it would take to raise the rest. Both skip a step.
A growth lender put it plainly in its newsletter recently: its underwriting comes down to one thing, "can this business service its debt from its own economics?"
The question underwriters actually start with
The lender described two very different borrowers that face the same test.
The asset-heavy company. Lots of receivables, inventory or equipment. This company cannot finance those assets through equity at any reasonable cost.
The company close to profitability. It could raise equity. It just has no reason to give up more ownership than it has to.
Different starting points, same underwriting test. The lender also made a point that gets blurred all the time: it does not lend against the expectation of new equity coming in later, or on the continued support of existing sponsors. The business itself has to carry the payments.
That is the right way to think about your own decision, too. If the business can carry the payments, debt deserves a hard look. If it cannot, no amount of structuring makes debt the right answer.
How to run the test on your own numbers
You do not need a lender to get a first read. You need two numbers, and the smaller answer wins.
Number 1: Coverage. Take the cash the business generates that is actually available to pay lenders, roughly EBITDA less capital spending, cash taxes and owner distributions. Divide it by the principal and interest you would owe each year. That ratio is your debt service coverage ratio, or DSCR. Many lenders want to see at least 1.25x, meaning $1.25 of available cash for every $1.00 of debt payments.
Number 2: Leverage. Divide total debt by EBITDA. Senior cash-flow lenders to lower-middle-market companies often stop somewhere around 2.5x to 3.5x, and subordinated lenders can stretch total debt further.
An illustrative example:
EBITDA: $4 million
Capital spending, cash taxes and owner distributions: $1 million
Cash available for debt service: about $3 million
Number 1, coverage at 1.25x: the business can carry about $2.4 million a year of principal and interest
Number 2, leverage at 3x: a ceiling of about $12 million of debt
Lenders look at both coverage and leverage, and often more, such as loan to value on an acquisition. The tightest one sets the loan, which is why two lenders can look at the same numbers and offer different amounts.
When the answer is yes
Debt is usually the cheaper capital, by a wide margin, because you pay it back. Equity you pay for forever.
A simple illustration:
Sell 20% of a business valued at $20 million to raise $4 million.
Grow it to $40 million over five years.
That 20% is now worth $8 million, and it is still not yours.
Borrow the same $4 million instead, and you repay the principal plus interest out of cash flow. When the loan is gone, 100% of the business is still yours.
Debt comes with real obligations: covenants, reporting, and in many cases a personal guarantee. Those deserve as much attention as the rate. But for a business that clears the coverage test with room to spare, the math usually favors debt.
When the answer is no, or not yet
Equity is the right instrument when the business cannot carry the payments. That usually looks like one of these:
1. The cash flow is not there yet. A turnaround, a business coming off a loss, or one that is profitable only in a forecast.
2. The cash flow swings too much. Heavy seasonality or lumpy contracts that would break a fixed payment schedule.
3. The money will not produce cash soon. A new facility, a new market or a hiring plan that takes years to pay back.
4. The business is already near its debt ceiling. More debt would push coverage below what lenders will accept.
In each case, taking on debt anyway means a payment schedule the business cannot reliably meet. That is how owners end up negotiating with a lender from a position of weakness.
The middle ground
Plenty of businesses land in between: enough cash flow for some debt but short of what the full raise would need. That is where blended structures earn their place.
Subordinated debt. Sits behind the senior lender and stretches total debt further, at a higher price.
SBIC capital. Many SBICs invest both debt and equity in the same company, often weighted toward debt.
Preferred equity. Equity with a priority return, which can cost less ownership than common equity for the same dollars.
The right mix depends on how much the coverage test leaves on the table and what the money is for. The one question still applies: the business's available cash has to cover the combined payments on all of it.
The Bottom Line
Before you go to lenders or investors, answer the one question: can the business carry the payments from its own cash flow?
If yes, start with debt and size it with both the coverage and leverage numbers.
If no, raise equity, and do not let anyone talk you into a payment schedule the business cannot meet.
If partly, blend the two.
We run deals across hundreds of lenders and capture their lending criteria every time, so we see how underwriters actually apply this test in practice.
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