Financial: Debt as a Business Tool

By Mark E. Battersby / Published November 2014

 

One of the most daunting four-letter words for any pressure cleaning contractor, distributor, or manufacturer—particularly those with smaller businesses—is the word “debt.” Not too surprisingly, the tightening of credit, fewer sources for capital, and the general skittishness on the part of lenders has made avoiding debt easier for many small business owners. But, is operating and growing a debt-free business really practical?

Debt 101

Debt can best be compared to “leverage,” because borrowed funds help many pressure cleaning businesses grow their operations using someone else’s money. Debt is borrowing money from an outside source with the promise to repay the borrowed funds along with an agreed-upon amount of interest. Despite its negative connotation, even the healthiest of corporate balance sheets will include some level of debt.

In reality, a pressure cleaning business typically has two financial resources for growth—debt or equity. Raising equity requires the business to sell ownership interests, while debt allows the business to obtain the funds needed to grow and operate by borrowing it. In other words, debt can be extremely advantageous and a useful tool for any contractor, distributor, or manufacturer. The benefits of debt include:

• Maintaining Ownership: When funds are borrowed from a bank or another lender, the sole obligation is to make the agreed-upon payments on time. But that is the end of any obligation to the lender—the pressure cleaning business can be run as the owners, partners, or shareholders want without outside interference.
• Builds Credit: Businesses with good credit histories have an easier time of establishing credit with suppliers, eliminating upfront payments, and the personal liability of the operation’s owner.
• Tax Deductions: Because, in most cases, borrowed funds, or debt, result in a tax deduction, it is a huge attraction. In most cases, the interest portion of the loan repayments can be deducted on the operation’s tax returns.
• Lower Interest Rate: Tax deductions also have an impact on interest rates. If, for instance, a lender is charging 10 percent for a loan, and the government taxes the operation at a 30 percent rate, there is an advantage to tax deductible loans. Take the interest rate and multiply it by the tax rate, which in this case is a 10 percent interest rate multiplied by the 30 percent tax rate to equal seven percent. In other words, after tax deductions, the business is paying the equivalent of a seven percent interest rate.
• Cash Flow: Businesses generally incur debt, such as loans, to create cash flow. Businesses often use debt to create cash flow during seasonal or other slow periods. At times, there may be a gap between income coming into the business and bills coming due. Debt can be a useful tool in filling this gap. Obviously, there are also drawbacks to debt financing including:
• Repayment: As mentioned, the operation’s sole obligation to the lender is to make payments. Unfortunately even if the business fails, payments must still be made. And if the operation is forced into bankruptcy, the lenders will have a repayment claim before any equity investors.
• High Interest Rates: Even after calculating the discounted interest rate from tax deductions, the business may still be faced with a high interest rate—if they can find a borrower. Interest rates will vary due to economic conditions, the pressure cleaning business’s history with the lender, the operation’s credit rating, and the owner’s personal credit history.
• Credit Rating Impact: While  seemingly attractive, assuming debt when the business needs money, “leveraging up,” each loan will have an impact on the operation’s credit rating. Obviously, the more that is borrowed, the greater the lender’s risk and the higher the interest rate charged.
• Cash and Collateral: Even where  a loan is needed to acquire an important asset, the business must ensure that it will generate sufficient cash flows to repay the borrowed funds. And don’t forget the collateral often required to protect the lender should the pressure cleaning contractor, manufacturer, or distributor default on its payments.

Using Debt Financing

Lenders usually want installment payments shortly after funds are borrowed. Thus, in order to begin making those payments, the pressure cleaning business will need cash. Unfortunately, since even a thriving business may find itself short of cash, every borrower should ask:

• Are the borrowed funds to be used for fixed or variable assets? If the borrowed funds are to be invested in a fixed asset such as equipment, near-term cash is unlikely to be generated. If the funds are for a variable asset, such as inventory or materials for the operation’s products or services or costs associated with each new customer, then the debt should generate that needed cash flow.
• What are my customers like? Customers that consistently pay on time are critical to every pressure cleaning operation’s cash flow and its ability to repay debt. Learning the payment habits of customers and considering incentives such as discounts to get them to pay early are important. Also, checking with associations and competitors to ensure the operation’s payment terms are in line with industry standards is important.
• Where is the operation in its “lifecycle?” In the early stages of a business, debt financing can be dangerous. In all likelihood, the new operation will be losing money at first, thus hurting its ability to make payments. Also, since its net income will be low, the tax advantages of debt will be minimal. As the business grows and matures, debt becomes a stronger option. The tax advantage will be greater, cash flow will be more predictable, and the risk faced in bankruptcy decreases since the business has been operating longer.

Measuring It All

While it is true that borrowing enables a business to take actions or grow at a pace that might otherwise not be sustainable, it can also result in a less flexible business and one that takes on greater risk. After all, the more the business borrows, the more it must spend for debt payments and interest. But, how much debt is too much?

Lenders love to analyze ratios. It allows them to see how a business is doing and allows them to compare a business to other businesses they’ve loaned money to. Ratio analysis is also a useful tool for the owner of a pressure cleaning business.

How healthy is your business? Some basic ratio analysis may tell the story. Calculating the operation’s financial ratios will allow any owner or manager to check their business’s current temperature, diagnose potential problems, and see if the business is doing better or worse over time. Consider the so-called “Total Debt Ratio.”

The name of this ratio says it all; the Total Debt Ratio shows how much the business is in debt, making it an excellent way to check the operation’s long-term solvency. The formula is:

Total debt ratio = Total debt/Total assets

These numbers can be taken from the operation’s balance sheet and simply plugged in. To illustrate, a business with $22,375 in total assets and $25,000 in total debt would have a total debt ratio of $25,000/$22,375 = 1.11:1.

Thus, this business has $1.11 in debt for every dollar of assets. Obviously, the total debt ratio reveals this business is not in good health and may become really ill. For good health, the total debt ratio should be one or less.

The lower the debt ratio, the less total debt the business has in comparison to its asset base. On the other hand, businesses with high total debt ratios are in danger of becoming insolvent and/or going bankrupt.

Debt-Free

While a business owner or manager may find the prospect of becoming debt-free an intimidating prospect, the evidence shows that during economic downturns the less debt a business has, the greater the odds of that business surviving. And when the economy is looking brighter, the debt-free business is often in the strongest position to take advantage of opportunities.

Becoming a debt-free business, in-tentional or otherwise, can be a lengthy process. While there are no guarantees in life, it is certain that a small business owner will sleep better at night knowing that the pressure cleaning business is stronger and more secure in these uncertain times as a debt-free operation. Unfortunately, for the majority of businesses that choose to become debt-free, business growth tends to be slow. Quite simply, the more the business borrows, the more it spends toward debt payments and interest.

Bottom Line

Many businesses fail from lack of cash, probably more so than for any other reason. Simply put, most contractors, distributors, and manufacturers need capital. And today credit is an increasingly available resource—but it must be used wisely.

Business debt can be paid off when the business is ready to stop growing. Until then, the pressure cleaning operation should leverage all possible funding resources for investment in the operation. If debt is ignored as a business tool, it could hurt the operation’s growth.

Zimmerman Named General Manager

Rob Zimmerman was recently named Gen-eral Manager of Scaltrol, Inc., a manufacturer of hard-water scale control products located in Suwanee, GA. Zimmerman will be responsible for manufacturing, operations, and quality control functions, as well as overseeing the marketing efforts on all Scaltrol products.

Scaltrol, Inc. manufactures a proven solution for problems associated with hard-water scale designed for use with foodservice equipment, all steam applications, pressure washers, medical sterilization equipment, and residential whole house applications. More information is available at www.scaltrolinc.com or contact Zimmerman at rzimmerman@scaltrolinc.com.