Businesses and debt go hand in hand, particularly when they are new and need funds to get off the ground. The ubiquity of debt in business, though, can make it seem deceptively easy to handle when in fact it can be dangerous. Borrowers should have a plan for the money they take and fully understand the payment terms and the consequences for failure. Hoping to be able to pay it off later is not the same as knowing how it will happen. Debt should never be a long-term strategy; ideally, it should be a temporary bridge between cash out and cash in. For more on this continue reading the following article from TheStreet.
The debt clock is ticking up to over $16 trillion. Student loan debt (which has exceeded $1 trillion) now exceeds credit card debt (approximately $800 billion). Politicians are debating its impact and how to address it. But any way you look at things (right or left), debt is a major issue for us, whether it is the National debt, student loan debt, or debt needed to finance our businesses and homes. As our country (and the world) struggle to deal with debt, individual businesses need access to capital but face limited availability under tighter lending guidelines and markets.
I work with many entrepreneurs and major corporations that, regardless of their scale and assets, have one thing in common: the need to manage debt. For most organizations, debt is a necessary part of the growth equation, often used to smooth out the temporary fluctuations in cash flow. Cash can also be necessary during expansion to add jobs and purchase new equipment. Or, an unexpectedly large order may require additional parts and supplies. On the flipside, external factors might require borrowing to offset a temporary downturn in business due to external factors.
Regardless of why funds are needed, debt is about dealing with a timing difference in cash flows in and out of the organization.
Debt is not a solution or a fix for bad business practices, inefficient operations, or overly ambitious plans.
Neither "build it and they will come" and "Spend it and figure out how to repay it later" are sound business practices (or good behavior for anyone, really). Debt is not about borrowing as much as you can get. Instead, it’s about wisely borrowing an amount sufficient to meet a well-reasoned, planned, and temporary condition in your business.
One corporation that I’ve worked with has been carrying a multi-million dollar note for almost five years. They are just months away from the note coming due. In the normal course of business — and with most debt — whether payments are made monthly or as a single payment at the end of the loan, funds must be set aside to make the future payment. It’s impossible to ignore the fact that payments will eventually come due, especially because the final payment will include accumulated interest.
Let’s say you borrowed $5 million to develop a new technology and to put in place the manufacturing capability to produce the resulting products. Your generous lender gives you a five-year period during which no payments are due and a simple interest rate (amount borrowed x interest rate x periods). At the end of the five-year period, the company owes $9 million. Without making payments or accumulating the funds into a restricted account intended for repayment, the company will have to either come up with $9 million to make the payment, refinance (in this case with an alternative source because the note holder does not want to refinance) or default on the loan.
Companies in growth mode, with "plenty of time" before the debt is due, often put off dealing with the debt until it’s too late. Five years may seem a long time away, but time flies when your business is growing, especially if it has a huge appetite for cash. Tomorrow comes all too quickly, especially when your organization is under pressure to continue growth, maintain competitive position, and deal with economic pressures.
Carrying debt is usually necessary at some point in the life of a business. However, carrying debt and making payments on principal and interest means that you begin to have fewer options the larger the debt obligation becomes.
Debt must be a temporary tool, not a crutch or a long term "strategy."
If you consistently borrow money against credit cards, equity lines, and on vendor terms, juggle payments and scrape by to meet payroll, then you need to take a hard look at your business and determine what needs to change.
If you are debt dependent, then you need to understand why. If you don’t know why, you must acknowledge that your profitability is being reduced by the cost of borrowing funds.
One final point:
Growth is not always a good thing
Sacrilege, you say!. If you are growing your sales and operations, but your profitability is not increasing and you are not cash positive (i.e., have cash on hand to meet current demands), then you may need to take a breath and stop growing until you raise both profitability and cash flow. Growth in sales that does not include comparable growth in profitability and a move to positive cash flow does not generate adequate return on the investment being made.
This article was republished with permission from TheStreet.