Continuing from our article on The Eight Levers to Increase Cash Flow, we move to debt. To be clear, in this situation we’re talking about bank debt, not trade debt (covered in this article on account payable).
Debt is a tricky issue for small businesses to address, because most owners approach business debt the way they approach their personal debt. This is a mistake, because there are some big differences between the two.
If you are debt averse, you may not want to have any business debt, but your industry may dictate otherwise. If you are in a capital intensive industry (e.g manufacturing), being debt free may not be a reasonable expectation.
Additionally there is a difference between short term debt (due within one year) and long term debt. Short term debt should only be used as working capital. This usually comes in the form of a bank line of credit, but also could include credit cards. Generally speaking, these facilities should have a zero balance at least once a year. If you never completely pay them off, chances are, this is not short term working capital, but long term debt that should be converted into a term loan and paid off.
In any case, the best thing to do is benchmark your numbers against your industry. This will give you a reasonable target to work towards.
There are two numbers to consider when evaluating debt, one is coverage and the other is leverage.
Coverage: Coverage is a measure of how much your cash flow is compared to your debt payments. Banks look at this number very closely, since that is how they expect to be repaid. Usually they require a coverage ratio in excess of 1.20, but could look for a higher number. That means that you have $1.20 in profit (cash flow) for every $1.00 in debt payments.
Leverage: Leverage is a measure of how much debt you have compared to equity in your business. This is a number that tells lenders how risky the loan is. Different industries have different acceptable leverage ratios, but anything less than 1 to 1 is considered risky. So for every $1.00 you have in debt, you have at least $1.00 in equity. That’s not to say banks won’t loan you money if you don’t meet those leverage ratios, but is a factor they look review closely.
Cushion: This may sound obvious, but make sure that your debt service is manageable. Build yourself a cushion, remember, you can always pay down debt faster AFTER you’ve made the profit. The old adage of a Banker is one that is happy to give you an umbrella when it’s not raining is 100% accurate. When you have a cash flow crunch is NOT when you want to negotiate with your lenders. Consider multiple lenders. Different banks have different lending criteria, so don’t be afraid to shop your bank.
Many non-bank alternatives have sprung up that are primarily based upon cash flow (e.g. merchant credit card lending). Usually, these are much more expensive alternatives to traditional bank financing, so make sure you understand the true costs.
Balance Sheet Matching: Essentially this is matching short term assets with short term loans, and long term assets with long term loans. So if the money is being used for working capital and is secured by accounts receivable and inventory, then it needs to be a revolving facility (line of credit).
Alternatively if the asset is a piece of equipment, it should be on a long term loan that has a term less than the expected life of the asset. This means not tying up your bank line of credit with equipment purchases. Real estate provides another opportunity to match up your debt with assets. Best thing is to work with your accountant, come up with a plan, and find banks to work with you.
Return on Capital: This is next level stuff, but if you really want to run a business the way it should be, you need to look at your return on capital. There are several different components of this and different ways to measure, but at it’s most basic, are you as the owner being compensated for the risk that you are incurring. I’m not talking about being compensated for your time (which should be reflected in your owner’s compensation), but as an owner, is the amount of money you have invested in the business returning an amount appropriate of the risk that you’re taking?
Most small businesses should be earning in excess of 20% on their investment in the business. Debt plays a part in this equation since the more debt to equity you have, the higher your returns, all things being equal. If you’re not making at least 20% on your money in your business, then you need to look at your debt structure AND your profitability. Otherwise, take your money and invest it in something else!
If you would like a FREE industry comparison for your business, schedule a no-obligation consultation. We promise, no pressure, just information to help increase your cash flow so that you can have a better business, and a less stressful life!