The short answer. For every $1.00 of principal debt service, your business needs roughly $1.30 in pre-tax profit because taxes get paid on the profit before the principal comes out. That gross-up is invisible to the P&L. Interest is expensed. Principal is not. If your MMP does not include grossed-up principal, you are pricing against the wrong number.
The $1.30-Per-$1 Rule
Assume a business with a 25 to 30 percent effective tax rate at the marginal profit level. To generate $1.00 of after-tax cash for a principal payment, the business needs to earn roughly $1.30 pre-tax. The exact number depends on state, entity type, and marginal rate. Rough it at 1.30 and adjust for your specific situation.
That means $100,000 in annual principal debt service is not $100,000 in required profit. It is $130,000. That is a Layer 1 MMP sub-layer number, and it needs to sit alongside interest expense in Layer 2 Fixed Cost Capacity.
Most accountants report interest expense correctly on the P&L. Principal is reported on the cash flow statement under financing activities, if it is called out at all. Owners are not usually reading the cash flow statement line by line. Even when they do, the principal figure is not connected back to what next month's required profit needs to be.
Interest vs Principal on the P&L
Interest expense is a P&L expense. It reduces reported net income. Taxes are computed on the reduced number. Interest cost is fully visible.
Principal payment is not a P&L expense. It does not reduce reported net income. Taxes are computed on the unreduced number. The principal payment then comes out of after-tax cash. Principal cost is invisible.
This is the exact pattern in the machine shop field note. The P&L reported healthy profit. Cash kept dropping. The debt service was doing what debt service always does. It was invisible.
How To Restate MMP For Debt Service
Pull every debt on your books. Truck loans, equipment loans, credit lines, SBA loans, real estate loans, equipment leases, and any factor-rate financing.
For each, note the monthly principal payment separately from the monthly interest.
Sum the monthly principal payments. Multiply by 1.30. That is the pre-tax profit required this month for debt service.
That number goes into Layer 1 MMP as the Debt Service sub-layer.
It does not go into Layer 2 Fixed Cost Capacity, because Layer 2 is already picking up interest expense from the P&L. Do not double-count the interest.
Frequently Asked Questions
Does the $1.30 rule apply to variable-rate debt too?
Yes. The rate on the debt determines interest expense on the P&L. The principal payment schedule determines the debt service sub-layer of MMP. Both need to be restated every time the rate moves materially.
What about a business structured as an S-corp or LLC?
The gross-up factor changes with the owner's marginal rate rather than the corporate rate. An S-corp owner paying at the highest federal bracket plus state can be running closer to 1.40 or 1.45 per dollar. Compute the specific number for your situation.
Does the rule apply to merchant cash advances?
MCAs are more complex because factor rates and daily debits obscure the true cost. The rule of thumb is that an MCA at a 1.35 factor rate over 9 months has an effective annualized cost of roughly 60 to 80 percent. Gross that up for taxes and you need $1.60 to $2.10 of pre-tax profit for every dollar of MCA principal. See The Merchant Cash Advance Trap for the full math.
Should I pay off debt early to reduce the burden?
It depends on the cost of capital and the alternative use of the cash. Paying off high-cost debt (MCAs, credit cards, expensive lines) with retained earnings almost always makes sense. Paying off low-cost SBA debt when the cash could earn a better return elsewhere may not. Run the specific math with restated MMP before deciding.