Debt is often necessary and smart in planning and managing a business. Businesses need a line of credit to manage through lagging cash flow times. Businesses need debt to buy needed equipment and facilities. Debt can also overwhelm your business and cause it to fail. Managing debt is a balancing act, one that can make or break your company.
Before taking on debt, you have to analyze it. Take a good look at your balance sheet. How much debt do you have already? How does your total debt compare to your total equity? Total debt should be less than total equity. How much less depends on your industry and your banker’s guidelines. There are times, like during major expansion, when debt can exceed equity, but there should be a clear plan to reverse that situation in a limited period of time. Will the purchase generate enough cash flow to pay for itself and add to your profit? Prepare a budget comparing the cash flow you have before the debt and the cash flow after the debt. Will this investment improve your sales or lower your costs sufficiently to pay for itself even if times turn bad? It is not enough that your bank will lend you the money. The banker’s decision is not a test of whether it’s good for your business to take on this debt. You must do the analysis. Any new investment needs to be expected to turn a profit.
The term of the debt should correlate with the life of the asset being purchased. If you need a new piece of equipment, finance it with a longer term loan, not the line of credit. If the new piece of equipment will need replacing in 10 years, the term of the loan should not exceed 10 years.
Short-term credit such as credit cards and lines of credit should be used for short-term needs. Use the credit card to buy office supplies, pay off the credit card at the end of the month. Use the line of credit for cash while you are waiting for customer payments or to get through the slow season. Lines of credit should be paid off at some time during the year.
Treat leases the same as debt. Do the analysis of how much your sales will be increased or your costs decreased by leasing the asset. Read and understand the lease. Many leases are non-cancellable. If you go out of business, you are still on the hook to pay the lease. Understand the inherent interest rate in the lease. Equipment leases are most useful when the asset being leased will be outdated or worn out by the end of the lease. Computers and copiers are common examples. If however, you expect to continue to use that computer or copier after the term of the lease, you should buy it outright. Leased equipment is not yours at the end of the lease, it has to be purchased.
Pay off debt as quickly as possible. Pay off the highest interest rate debt first. When there’s extra cash, pay down some debt before taking a draw, paying bonuses or buying another piece of equipment. If your debt grows year after year without a growth in profit, your business is in trouble. Borrowing money is only wise when you can profit more from the use of that money than it costs to borrow it.
Robin Hayden, MBA, CPA, Certified Fraud Examiner, is a shareholder with Houck & Associates PC, a CPA firm specializing in small businesses and their owners. She can be reached at 360.892.4348 or Robin@Houck-CPAs.com.