What Happens When You Have Too Much Debt?

What happens when you have too much debt is that when a recession comes, you will have a very unpleasant experience. It may include losing everything you have.

We will discuss how much debt is to much elsewhere on this site. Here, let’s just concentrate on the consequences.

Recessions

Recessions come every 10-15 years.

A recession sends clear warning signs it is coming.
• Working capital starts rising. Your inventory takes a lot longer to sell and some customers stop paying your bills.
• Profit margins and revenues fall … and keep falling .

So far, the problem is survivable. You cut production and costs until you break even.

But even then, you need an operating loan. You still need to finance your inventory and receivables. If you have borrowed materially less than the bank will give you and you are well within your bank’s debt rules, no problem. You hunker down and wait the recession out.

But if you have too much debt, you will hit the limit of your credit quickly. When you ask for more money, the bank will refuse.

Banks & Recessions

When a recession hits, your bank has problems. It soon has a lot of customers who stop paying interest. The bankers who lent to them suddenly feel the wind blowing over their own necks.

In a recession, the banks realize they need to clean out the stables. They spend one or two years ridding their portfolio of bad loans. If you have too much debt, even if you have made your interest payments, you are a loan they want to get rid of.

They don’t encourage you to stay on by increasing your credit limit.

First You Run Out of Cash

You then start dragging out your payments to your suppliers. They start harassing you. At some point, they won’t send you anything unless you pay cash … which you don’t have.

Then You Lose Your Business

Then you miss an interest payment.

The nice banker is replaced by your new best friends – the collections group. Their only goal is to minimize their loss from the business.

It now becomes “the business” not “your business”. When the bank starts to move, they own the business. They allow you to run it for them but if they decide they can minimize their losses by closing the business and selling off the pieces, that’s what will happen.

Then You Lose Everything Else

You will likely give a personal guarantee of the bank loan for some years until the bank is satisfied they do not need it. If after selling off the pieces, you still owe the bank something, the next thing to go on the block is your house. This is when , if you are normal, your soul is destroyed.

Even Survival is Painful

At best, you will spend a few years fighting for your life, wasting time pleading with bankers and suppliers to buy time. Equally likely is that one day, the bank will put you into bankruptcy.

You do not want to be anywhere near this. Even if you come through it, you will have aged fifty years, you will be much poorer and your reputation will have suffered.

There is a simple way to avoid this: don’t borrow too much debt!

How to Read Your Statements: Important Ratios

When you design your financial statements, they should automatically generate some key ratios which you should track relentlessly. Included in these are a few financial ratios which tell you almost all of what you need to know about the financial health of your business.

The key finance ratios are those dealing with
• Leverage
• Coverage
• Operating Loan Margin and
• Profit Margin.

They are applied to the last 12 months performance i.e. a “rolling” year, as if every quarter was a year-end.

Banks Use These Ratios, So Should You

Banks use these as core ratios because they are smart. They give you the most reliable picture of your
• ability to withstand adversity such as a recession of a loss of some major accounts
• ability to pay your bills as they come due and
• profitability.

What is Profit?

There are two main definitions of profit:
• Net income after taxes and
• Earnings before interest, taxes and depreciation and amortization (“EBITDA”).

I think EBITDA is the most useful. More importantly so do the banks. EBITDA is the cash left after all operating costs have been paid. It is the cash available to service the debt you have borrowed, to pay your taxes and to fund the bare-bones capital expenditures needed to keep the lights on.

The Leverage Ratio …

… is the ratio of your debt to your EBITDA.

The higher the ratio, the greater the risk. You won’t be in doubt as to what your bank thinks is reasonable. The maximum will be written right into your loan agreement.

The maximum depends on your type of business. The banks want to keep the ratio inside the level that creates too much risk of trouble for a business like yours.

In your conservative forecast of the future, you never want your debt to more than 75% of the maximum the bank will allow.

The Coverage Ratio

… is the ratio of your EBITDA to the total of your
• interest,
• taxes,
• principal repayments and
• maintenance capital expenditures.

It measures the margin of comfort you have in not only paying your operating costs but all the other items you have to pay to stay in business.
• If it is less than 1:1, you are going out of business.
• If it is more than 1.5X you are building up cash nicely.
• If it is at least 1.2X you are comfortable.

Operating Loan / Loan Value

… is the ratio of your operating loan to the bank valuation of your inventory and receivables in your loan agreement. This value is usually the sum of:
• 25-50% of inventory and
• 50-75% of receivables.

This ratio measures the amount of debt capacity you have used up. Less is better.
• If it is more than 1: 1, you have run out of credit and can expect a call from your bank.
• If it is less than 75%, you have adequate room in your operating line to cover contingencies.

Profit Margin

… is the ratio of your EBITDA to your sales.

Whatever industry you are in, there is a range of profit margins from outstanding to poor. If your ratio is materially lower than these norms, you will have a tougher time getting loans or getting them on the best terms, than those with good margins.

How Much Debt is Safe to Borrow?

Debt helps you grow. You borrow money against the value of your business. You use the money to buy equipment and supplies to increase your sales and to pay bills while you wait for the extra cash to come in.

In finance, we call that “leverage”. You “lever” your business to get capital from the bank. This allows you to grow it faster than if you rely solely on the cash from your profits. Leverage is a key element of any intelligent financing plan.

We have dealt with how much the banks will lend you. How much it is safe to borrow?

The answer is simple: a lot less than the bank will allow you to borrow. If you respect this simple rule, you will never run into trouble.

Borrow Less than the Bank Will Lend – Part 1

Your operating loan will be a “revolver” which moves up and down as you need it. The maximum will be the lesser of
• a fixed amount you negotiate and
• a percentage of the value of your inventory and your receivables. As we have discussed, typically the maximum is 50-75% of your receivables plus 25-50% of your inventory.

Your operating loan should never be more than 75% of the maximum you are allowed. That 25% margin is what allows you to sleep at night, knowing the bank is unlikely to come knocking, asking for the keys.

If you start to eat into that margin, your business is under-performing or you need a bigger loan. Either way, it is a problem. Deal with it. Fix the business, get more shareholder capital or request an increase in your loan.

Borrow Less than the Bank Will Lend – Part 2

As you grow, you can borrow money to buy a new plant or some new equipment. You can even borrow to buy another business.

The market has rules as to the debt a company can borrow. The maximum debt is expressed as a multiple of your operating profit, typically 2-6X your cash flow, depending upon the nature of your business.
• Stable businesses like cable TV companies can support debt of as much as 6x operating profits.
• Small, more cyclical businesses will be restricted to 2-3x operating profits.

This rule is applied as long as your loan is outstanding, not just when you borrow it. As part of the loan, you will agree to keep the loan at an agreed multiple of operating profit at all times.

Your total debt at any time, now and in your conservative forecast, should never be more than 75% of the amount that the bank will allow you to have.

If it is, borrow less and face the fact you can’t do it all with debt. You need some shareholder capital.

If your loans subsequently creep over the 75% level, deal with it. Persuade the banks to change the maximum. If you can’t, get the debt down by selling something or bringing in more capital. Get ahead of the problem while you can because at some point, you won’t be able to.

Debt Part 2 – How to Deal With Bankers

Bankers – The People Every One Loves to Hate

In our age, bankers are portrayed as tiresome bureaucrats who
• won’t lend you the money you need,
• demand it back before you can repay it and
• overcharge you for services you don’t understand.

This is fairy-tale nonsense. Good bankers, and there are plenty of them, are hugely helpful in building a business.

Bankers Add Value

Long before the Internet, banks invented one of their own. Banks have moved money and information electronically for decades. They give us transaction information instantly and all the banking reports we could possibly need at least once a month.

Their debit and credit cards, ATM’s, telephone payment systems, pre-authorized payments, foreign exchange risk and cash management products are indispensable tools of a well-run business.

Banks are by far the cheapest source of capital in the market and they provide it to any reasonable risk. If the bank won’t lend you the money, you probably shouldn’t try to borrow it.

Believe it. Bankers add huge value. Running a business without all their services would be like heating a skyscraper with a wood stove.

How to Deal with a Banker 1: Tell the Truth

Bankers are the first to admit they don’t understand nearly as much about your business as you. It is easy to hide bad stuff from them … for a little while. Don’t.

They are your partners. They will find out about the bad stuff eventually. Once they do, they will never forgive you for hiding it.

Get ahead of bad news. It is part of life and experienced bankers deal with customer bad news all the time. Warn the banker it is coming and go in to explain it. If you are straight with your banker, they will trust you forever.

How to Deal with a Banker 2: Be Prepared

Even before you borrow, take a banker to Starbucks two or three times a year to find out about current lending practices. Later, when you walk in to ask for money, you will have crafted your request to respect these practices.

When you ask for a bank loan, give the banker the written information any intelligent person would need to respond:
• your bio,
• financial statements,
• a financial forecast with supporting analysis and
• a thorough written description of the business and assets, including its history.

Put it together so that the banker can cut and paste from your work into the presentation he or she has to make to their bank’s credit authorities. That way, you can almost write the internal bank credit application yourself.

Preparing all this will prepare you to defend your request. It will also show you the weaknesses in your case and cause you to amend it as necessary to be consistent with the market.

How to Deal with a Banker 3: Don’t Ask for the Impossible

Water cannot be made to flow upstream, snow cannot be made to fall in the Sahara and bankers cannot be made to lend outside their comfort zone. Find out what that is. Stay within it. If you need more money, you need an investor as well as a banker.

Also, find out what the lead times are. Respect them. Banks do not lend instantly. They need time. Plan accordingly.

Debt Part 1 – How Much Will Banks Lend You?

Why Good Businesses Need Financing

As you grow, you need financing. You need to purchase equipment. You need to pay the bills that come in before you generate the profit to cover them.

Strong growth makes things worse. The cash flow you receive today is always from your last 3-6 months operations. Assuming you are profitable, it is enough to pay the bills required for these operations.

But if you are growing fast, the cash flow may not be enough, even if you are profitable. You have to pay more bills for supplies, salaries and operating costs today than you did in the last 3-6 months because you are selling more. The cash flow you receive from yesterday’s operations may not be enough for today’s.

Growth is a nice problem to have but it is still a problem.

Banks – a Source of Inexpensive Capital

We will discuss raising money from investors in a future post. However, banks provide money much more cheaply (well under 10% vs. at least 15-20% for investors) and demand much less say in your business than investors. They also will provide valuable banking services you need, including the ability to “revolve” the loans up and down, depending upon your need.

How Much Will Banks Lend You Now?

Banks will lend as much as they believe will be repaid if things go wrong. In the start-up, this likely means zero – the banks will not led to an unproven business unless they have good security from outside the business e.g. the equity in your house.

Once you are past start-up, banks will lend an amount equal to a conservative value of the security you provide, typically
• 50-75% of your customer receivables
• plus
• 25-50% of your inventory
plus
• 25-50% of the value of your equipment
plus
• a percentage of the value of any security you provide from outside the business, depending upon the nature of the security.

You will move up the range of lending values as the bank becomes comfortable with you and your business.

Over and above this security, you will have to put up your personal guarantee until the banks are satisfied that if you get run over by a truck, your business can run without you and that it has a value to third parties.

These are timeless laws of finance. Don’t waste your breath trying to change them. It is like trying to make a compass point south.

How Much Will Banks Lend You Later?

As you prove yourself, banks will start to lend against a conservative value of your business as a whole.
• These values are 50-75% of the price at which they believe your business could be sold.
• This value is determined from the banks’ experience with the sales prices of similar businesses in the market.
• They calculate the average multiple of operating earnings reflected in these prices and apply that multiple to your operating earnings to estimate the value.

By then, you will know these multiples as well as the banks and will always be able to estimate the lending value of your business.

Next post …. What are reasonable banking terms?

Purpose of This Site

You are young and thinking about starting a business. Perhaps you are in the early stages of your business. To you, finance is both a mystery and a worry but your common sense tells you need to understand it … and you do. This site is intended as a start. It will lay out the tools and show you how to start using them.

Who I Am

My name is Ted Cape. I have spent almost thirty years lending to, investing in and raising money for businesses. (You can see my Bio elsewhere on this site.) In September 2006, I resigned my position as Chief Financial Officer at Black Press Ltd., one of Canada’s largest publishers of community newspapers to do something else. My last act in the finance business is to pass on what I have earned.

The Purpose of Finance

The purpose of finance is to

• generate the information you need to understand the health of your business and
• raise the money you need for your business on terms that won’t blow it up when (not if) bad times come.

Lousy finance is the poison that kills businesses when recessions push them to the edge. Good finance is part of the vaccine that protects them and helps them prosper.

This Site – All You What You Need to Know About Finance

Finance has many moving parts. But at root it is a discipline any intelligent businessperson can understand. It is also a discipline any person starting out in business, especially those who want to have their own business, must understand.

Over the next 11 weeks, I will explain the basics. I owe more than I can repay to the good humoured, honourable and competent colleagues and professionals who are best of the finance craft who taught me every day of my career. To help take the worry and mystery out of finance for those walking up to the start line of their own business is a way to honour that craft.

How to Read Your Statements Part 1 – Can You Pay Your Bills?

Your first job is to stay in business. To stay in business you have to pay your bills. If you don’t, you will waste a lot of time returning phone calls from your unpaid suppliers and the bank whose interest is overdue. If they don’t like what you say, they will stop supplying and lending. If you don’t satisfy them after this, they will put you into bankruptcy.

What is Liquidity?

Liquidity measures your ability to pay your bills. It can be very quickly calculated from your financial statements.

Plus
- Cash
- What your customers owe you
- Inventory (unsold products, unused supplies, services you have performed but haven’t yet sent a bill)

Minus
- Loans you must repay within 1 year
- What you owe your suppliers

Equals
- Your Liquidity.

If your liquidity is positive, you should be able to pay your bills. If it isn’t, you likely can’t. It is that simple.

In measuring your liquidity, you have to be careful of two things.

Are Your Receivables Good Receivables?

When you sell something or provide a service to a customer and they don’t pay by cash or credit card, you become their lender. Before you become their lender, you need to be comfortable they are good for the money. If you don’t know them personally or by reputation, get them to pay cash or by credit card. If you are selling them a service, get them to pay something up front. If they refuse, move on to the next customer.

If you have satisfied yourself that a potential customer is a good risk, set industry standards terms for how long they have to pay you after they have received your bill. 30 days is the norm. In practice, 45 days is a good target for your average bill to be paid.

Even good customers can have problems. These problems usually show up in slow payment of bills. Your accounting package will allow you to break your receivables down by how long they have been unpaid. Anything unpaid for more than 60 days is a flag, more than 90 days a problem, and more than 120 days a write-off. Customers who take more than four months to pay a bill usually won’t or can’t pay it.

To avoid inflating your liquidity, exclude all receivables over 90 days. Turn yourself into a bill collector for any more than 60 days old.

Is Your Inventory Good Inventory?

How long has a product been in inventory? If you haven’t sold it in a reasonable time, it may not be saleable. You need to set a shelf life for your products which represents a reasonable time for them to sell. Any goods you have on hand which are older than this need to be checked to make sure they are still saleable. If there is doubt, don’t fool yourself. Don’t consider them in your liquidity calculation.

Protect Your Liquidity

More potentially good young businesses die in the cradle because the owners don’t take care of liquidity. The bank gets nervous or the supplier stop supplying and suddenly your oxygen tank is empty. Don’t let this happen.

We will talk in a later post about how to raise the capital you need for your business.