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 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?