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.
