It got crazy in the mid-80s, the days of the very highly leveraged buyouts. It settled down some, although it has come back a bit.

Adding leverage by using more bank debt rather than equity can help you improve your return on equity in an acquisition. And you’re putting less of your own equity or other investor’s equity up into the acquisition. However, like many things in life too much of a good thing is not a good thing. With a lot of bank debt and a transaction, there’s more risk, more money is going out to interest expense, cash flow has to be allocated towards paying down the debt that leaves less cash generating that can go towards operating the business.

If things fall short of the mark, it can turn out to be very precarious. In the worst case, it could mean that the company could go under. And no matter what the leverage when the company goes down, the return on equity is a multiplier times zero.

So how much is too much? Take a look at the cash flows that you expect to generate from the acquisition each year. Then compare that against what you have to use for debt service whether it be principle or interest. Look at how much cushion you have over that cash flow. Ideally, it should be at least two to one.

Another way to look at it would be to do a simulation on your financial forecast and see how much results could fall down before you start to have trouble making the bank payments.

Another factor to consider with the leverage taken on in an acquisition are the bank covenants. What other kind of restrictions is the bank going to put on you? How much breathing room do you have over the covenants that would be proposed such as maintaining a minimum, tangible net worth balance?

I joined a pharmaceutical firm as CFO after a highly leverage acquisition done the year before. The company had not performed well and with the high leverage there was no breathing room. The company was nearly bankrupt. Fortunately, we were able to put a plan in place and rebound. It doesn’t always work out that way. It could very easily had gone under.

Like a lot of things in life, it can be a matter of balance. Make sure in the acquisition you’re looking at you’re not over doing it on the bank debt side. Use some of the tests that we mentioned to be your gauge. Have a balance capital structure between equity and debt left in line with what you can handle and you’re more likely to have a company that you’ll be able to get your hands on for many years to some.