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Toting the right debt load
By Jenny
C. McCune • Bankrate.com
Too much debt can swamp a small
business or make it impossible for a company to get a loan. Too
little can keep a company from growing. When is debt too heavy a
load? It all depends on who you ask and what industry your company
is in.
Bankers use formulas to figure out when a company
has taken on too much debt. These formulas compare cash flow (money
coming in) to debt service (how much your company has to pay in
loans and other lending obligations). Most bankers' want to see
cash flow that's 1.25 times its debt service, says Wes Sturges,
president of First
Commerce Bank, Charlotte, N.C.
That ratio ensures that a small business still has
enough cash to honor its debt obligations. Some lenders may even
want a higher figure, perhaps 1.5 times more cash flow to debt owed.
Another rule of lending that financial institutions
use is the debt-to-equity
ratio, says Mike Gould, director of business evaluation and
consulting at Mintz
Rosenfeld in Fairfield, N.J. Generally, lenders don't want to
see companies with more than a 3-to-1 debt-to-equity ratio. "The
max they want to see is one dollar coming in for every three dollars
owed," Gould says.
Comparative debt loads
The amount of debt that a business can comfortably sustain
also depends on industry norms. For example, real estate companies
generally have higher debt loads than a professional service firm.
"Real estate companies have big mortgage debt," Gould
explains.
The type of debt that your company has taken on can
also play a role. "The guiding line is to make sure it is 'good
debt,' which means money spent directly for income-producing activities
or assets and not 'bad debt,' which may be money spent to pay off
old debt or to provide the owner's take-home pay or to develop a
new logo," says Judith
E. Dacey, a CPA based in Orlando, Fla.
Of course, lending institutions also look at a host
of other factors, particularly if they are familiar with your company,
says Florence Brown, vice president of operations for Forum
Credit Union in Fishers, Ind. A history of profitability, collateral
for loans and good credit record can all make a loan to your company
look more reasonable even if your company's ratios don't hit the
numbers. "Even if your debt is a little high, if you have a
good game plan, lenders will try to find a way to work with you,"
Brown says.
That said, you might not want to hit up your local
credit union for a loan just yet. That's because credit unions generally
have to follow stricter lending guidelines, those of the National
Credit Association, than regular banks. However, if you make a good
faith effort to turn around a bad financial situation, bankers,
particularly those that know you, will be more likely to give you
a loan, Sturges says.
Dealing with excess debt
If your company's debt load is judged too high, there are
steps you can take to make your company more fiscally fit.
Restructure your debt: Forum's
Brown and First Commerce's Sturges say their lending institutions
do this all the time. They help small businesses change debt from
short-term, such as a revolving credit line, to long-term, say
a 10-year loan. Restructuring your debt can help improve your
company's balance sheet and make it a better loan candidate.
Switch to leasing:
Leasing
capital equipment costs more than buying it outright, but
it has one big advantage, CPA Dacey says. "Items leased don't
appear as debt on the balance sheet, unlike installment loans."
Put more money in or take
less out: Increase equity by plowing more money back into
the business, says Mintz Rosenfeld's Gould.
Reduce credit lines or
otherwise rein in debt: Probably easier said than done. And
if you're in the market for an additional loan, chances are it's
because you don't have cash on hand. Without cash on hand, how
will you reduce your credit line spending? Check out these ways
to slash operating costs that can help reduce your cash flow
problems and ease the need to take on more debt.
The key when you owe is to realize that your company
will never be debt-free, but you can make its debt load lighter.
Jenny C. McCune is a contributing
editor based in Montana.
-- Posted: Sept. 20, 2002
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