Some people are risk takers and don’t mind going in to debt and some are totally debt averse. They don’t borrow at all.
But how much debt is too much?
The easy answer is don’t borrow more than you can afford to pay back or don’t borrow more than a lender is willing to loan you. They may not be the same amount. Do you want to use up all your borrowing power on this transaction or do you want to keep some in reserve? Here are some things to consider:
- Assume for the moment that you will use terms loans with monthly principal and interest payments for any borrowing need: working capital, equipment real estate or business acquisition.
- Each loan will probably have a different term. Working capital is 2-3 years, equipment is 3-5 years, real estate is 15-25 years and business acquisition up to 10 years.
- Calculate the total amount of your loan payments and make sure you have cash flow to cover those payments with a 25-30% cushion. 100,000 in payments requires $125,000-130,000 in cash flow.
- Cash flow is typically defined as EBITDA: earnings before interest, taxes, depreciation and amortization.
Remember the higher the cushion (50-100% vs 25-30%) the more wiggle room you have for owner’s distributions for taxes and or other personal expenses.
Here’s the tough part. Let’s pretend you’ve maxed out your borrowing capacity. All of a sudden there’s a great opportunity to buy out a competitor. You’re forced to either fund it yourself (if you even have the resources) or take on an investor. More often than not, the investor will seize the opportunity to take a bigger piece of your company than you want to give up. It may be a good idea to save some of your borrowing capacity for the future.
Another way to look at how much debt is too much is look at the leverage ratio or debt to equity ratio.
- Most lenders like to see the ratio of $3-4 of debt to every $1 of equity on the balance sheet.
- This is a 3 or 4 to 1 debt to equity ratio.
- Think of it this way. Your creditors have put up credit for 75-80% of your assets and you’ve put up 20-25% in equity.
- Beyond this level, most lenders feel they’re taking more than their share of the risk.
I hope these tips will be helpful the next time you think about borrowing. Now you'll know whether it's the right time to borrow.
Businesses that took out debt a year ago or even 3 years ago may find themselves in a situation where the cash flow used for the loan or the purpose of the loan has changed. Many businesses find themselves in a situation where a refinance makes sense because they either want to reduce their loan payments to use cash flow for growth or they may want to increase the loan amount because their business is expanding. Businesses are dynamic, but a loan repayment is usually static due to the fixed term of the loan. A floating rate loan is the exception.
Before you refinance your business loan, there are three things you must consider:
- Is there a prepayment penalty on your current loan and have you factored in the cost to your refinance? This is especially important if you have a fixed rate conventional loan or an SBA loan. Many SBA loans will have prepayment penalties for payment in full on a refinance. Depending on the type of loan and the length of the amortization, they can range from 3-10% in the first year and will burn off to 0 over a time period ranging from 3-10 years. If it's a large loan, like a commercial mortgage or business acquisition loan, then the prepayment penalty can be high. While it's not technically a prepayment penalty, there are many fixed rate loans offerred through a derivatives product called an interest rate swap (you and the bank swap rates, you want fixed and the bank wants floating). If you cancel the swap early, the intermediary is entitled to a make whole payment either to you or the bank depending on where interest rates are relative to the swap rate when the deal was consummated.
- Are your loans cross collateralized? If you only have 1 loan with your bank then disregard this point. But if you have a line of credit and a second loan (building mortgage or equipment loan) then check the fine print of your loan agreement. If your loans are cross collateralized then it's possible the bank will ask you to refinance both loans rather than just one. Sometimes there's a collateral shortfall that the bank handles by doing this. Other times this is just put in the small print of your loan agreement to make it hard for you to change banks. Before you look at refinancing your loan make sure this language is not in your loan agreement or note.
- You can't payoff an SBA loan with another SBA loan. Many business owners don't know the SBA guidelines when it comes to loan amortizations. SBA loans are made on the most favorable terms for bank financing in the marketplace (10 years for working capital and business acquisition or 25 years for real estate). Therefore, the SBA won't extend the term of a loan beyond it's original amortization. While there may be 1-2 exceptions, you would be paying off your SBA loan with a conventional bank loan and the payments and interest rate could be higher. As an alternative, you could take out a second SBA loan (limit is around $5 million aggregate). However, you would be making 2 payments where you would prefer to make one and it be a lower amount.
Before you jump in with both feet on a refinance, check out these three things to be sure you don't find a "gotcha" down the road that makes your refinance a no go.
Securing financing for your business can be challenging. Whether you're borrowing money for the first time to start your business or you're looking for a loan to grow, the lending criteria banks use can be rigorous. It's important to know what are the must haves that a bank is looking for to approve your loan. Here are the top 4:
- Financial statements that are timely and accurate. Some clients have one or the other, but you need both. Financial statements are the language that bankers speak to obtain credit. If you can't provide them within 30 days of month end or you can't produce them accurately then take a hard look at your people or process that is required to get you there.
- Cash flow sufficient to repay the loan with a cushion, usually 25-30% cushion. If you've heard bankers talk about debt coverage of 1.25 or 1.3-1, this is what they're talking about. Make sure you understand how they calculate it. Does it include or exclude owner distributions or taxes. On a line of credit, is it interest only or does the bank term out a principal portion of the line in their calculation? Since this is a ratio, make sure you understand both the numerator-cash flow and the denominator-loan payments.
- Collateral sufficent to cover the loan amount that is margined. What is an appropriate margin? For most real estate, equipment and accounts receivable, the margin is 20-25% meaning the lender can loan up to 75-80% of the value. However, if you want to borrow $500,000 and your only have $300,000 of margined collateral, then the lender will be looking for you to secure the difference.
- Good credit is a personal credit score above approximately 680. Since your credit score is based on a variety of factors, good credit excludes bankruptcy, liens, judgments, garnishments, and foreclosures.
When you go to the bank, these items will be what they're looking for to approve your loan. You can also read about 3 deal breakers for financing
If you're thinking about starting a business, you know you're going to need financing. Some banks like lending to start ups, some don't. You've heard of the 5 C's of credit:
- Cash flow
But most banks like to see a balance sheet that is:
But you may want to know what are the absolute deal breakers where the banks won't lend under any circumstances.
- Liquid (plenty of cash)
- Not leveraged (less than $3 of debt to every $1 of equity)
- And three years of profitable operations historically
As an aside, most start ups are financed through an SBA program (most often the 7a program). So, the SBA has specific guidelines which the bank combines with their own to make the loan.
1) Poor credit- About two thirds of your credit score is based on payment history of your credit obligations. So, if you've had a history of slow payments that could be a deal breaker. Also, if you've had a prior bankruptcy, liens, garnishments or judgments that will also affect your ability to borrow. Generally, banks are willing to loan to individuals with a credit score of 680 or above. Below that, it becomes increasingly unclear whether a bank will loan or not. If this is you, consider either a co signer or guarantor (with a good credit score) or talk to a professional about what you can do to improve your credit score.
2) Lack of collateral- A little know fact about the SBA 7a program is that the lender has to put forth best efforts to fully secured the loan with margined collateral. If the business doesn't have sufficient collateral to secure the loan, the bank is required to obtain additional collateral from the owner's personal assets. For example, if the loan amount is $500,000, then you need between $625,000 and $666,000 of assets with a 20-25% margin to get the loan. Each type of asset has a different margin requirement (SBA has their guidelines and so does each bank). Most banks will loan 75-80% on real estate, accounts receivable or equipment. In rare circumstances, banks do make loans that are slightly undersecured.
3) No business plan or 2 years of projections- About 80% of the businesses started fail in the first five years. The number one reason is that they are undercapitalized. So, a bank is looking for you to do a full business plan explaining the business, the market, the competition, the management team and two years of projections that are based on sound assumptions consistent with the industry performance and trends. Banks are not venture capitalists because they loan their depositors money, not their own. The business plan and projections along with the other factors involved need to show a high likelihood of business success with acceptable risk for the bank.
Lending to start ups is very risky because there is no historical performance of the company. This is not an exhaustive list of deal breakers, but these are three that bankers incur most often. Do your homework before you go see the banker to be sure your request doesn't have one of these.
If you have a line of credit with your bank, and you take out an equipment loan or mortgage on a building, the bank may cross collateralize your mortgage loan with the line of credit collateral and the line of credit may be cross collateralized with the real estate from the mortgage loan. The second cross is cross defaulted. That means if you have a default on your line of credit then you have a default on your mortgage loan and if you have a default on your mortgage, then you have a default on your line of credit. It doesn't matter if payments are current or not. This is referred to as a double cross.
Here are three things to watch out for:
1) Read the fine print of your commitment letters, loan agreements and promissory notes. Make sure there isn't language in there that provides for this.
2) if this language is in your documents and you want to move one loan or the other, you end up having to move both which creates additional hassle and costs for you. In the case of a mortgage loan, you pay for an appraisal, environment audit and attorney fees/closings again.
3) Watch out for loan covenants, for example a 30 day payout requirement on a line of credit, a cash flow covenant on a mortgage or a leverage covenant on either loan can trigger the cross default on both loans. Loan maturities give the lender the opportunity to insert this language into documents, especially if there's a problem.
I've had multiple clients that had a line of credit and a mortgage loan with the same bank. With this cross collateralized/cross defaulted language in the agreement, if they missed their 30 day payout on the line of credit or they missed their cash flow covenant on the line or mortgage loan, both loans would go into default. Even if payments on both are current. This also locks you in to the bank's terms for both loans which gives them significant leverage on rates and terms.
Many times you don't think to ask the right questions when you're at the loan closing table. Here are a couple to consider:
- Is there any prepayment penalty with this loan?
- Are there any covenants (financial or management)?
- Do I need to do all my banking with you?
- Are my two loans cross collateralized and/or cross defaulted?
Be sure to look for these to be sure the bank doesn't have you tied up without your knowledge.
If you assume the bank is going to renew your line of credit when it matures, you may be in for a rude awakening. Let me share with you a conversation I had with someone.
- The bank approved a line of credit
- The company had a loss.
- The bank reacted to the loss, by renewing the line for only 90 days and said that a new account officer would be assigned.
- They increased rates and fees for the renewal.
These are red flags for business owners to be aware of. The bank was not totally forthcoming about the state of the situation.
- Short renewals (90 days vs 1 year) and an increase in rate signal a change in the bank's point of view on the risk of this loan.
- A change in account officers can be (not always) another red flag.
- The bank renews the line to keep it off the past due list, but a short renewal means that something else is about to happen.
- The change in account officer could signal that the new account officer is in the workout department, (Special Assets) especially since the company lost money last year.
- The change in rate and fees signals a change in the perceived risk on the bank's part.
- It's conceivable that at the end of 90 days, the bank could declare a default at the maturity and enter in to a forbearance agreement rather than liquidate assets.
There are five things you should do prior to your line maturity:
1) Review your commitment letter and loan agreement to be sure you're in compliance with all the terms and conditions.
2) Don't assume the bank will automatically renew. Have a back up plan to repay the bank if they ask for it.
3) Did you have loan covenants? If you did, are you in compliance or can the bank declare a covenant default? (Cash flow and leverage covenants or change of ownership or management are common covenants.)
4) If you are in default, ask the bank to consider a covenant waiver. Yes, banks can waive covenant violations if you have a good reason.
5) If they won't waive a violation, can you offer additional collateral, agree to a lower line of credit amount or provide something of value in exchange for the bank's renewal?
We all know the danger of making assumptions, don't wait for the bank to react to your situation. Either be proactive yourself, or hire someone with the right expertise to help you understand your options.
During this series on Growing Your Business, we’ve talked about Getting the Right People, Getting the Right Strategy and Getting the Right Processes. Our final article is on Getting the Right Execution.
The standards for the right execution are efficiency (doing things right) and effectiveness (doing the right things). Your execution will begin to break down if you’re doing things poorly or doing the wrong things. The financial data that you look at monthly will be an indicator of how things are going.
- I have a client who wants to increase revenue. His revenues for the last 3 years have hovered around $8-9 million.
- He has changed his strategy and has changed his sales process, but his people have struggled to implement.
- Because the sales process has changed, their efficiency has suffered. This is because they’ve been doing it the same way for a long period of time and the old process yielded results.
- In the past, their close rate on business has been about 16%.
- To improve their close rate, their focus is on calling on the right clients with a high likelihood of doing business to increase their effectiveness.
Your execution can focus on any critical numbers on your balance sheet or income statement.
1) If want to have more cash in the bank, focus on being more profitable or collecting faster.
2) If you want to collect faster, focus on days in accounts receivable.
3) If you want to increase sales and profit, focus on revenue, gross or net profit.
4) If you want to reduce debt, focus on accounts or notes payable to banks or others.
All of the above strategies mentioned will require getting the right people involved, and could include process changes. However, the execution or lack of execution will be reflected in the critical numbers on your balance sheet or income statement.
We’ve talked in this series about Growing Your Business- Getting the Right People and Getting the Right Strategy. Today, we’re going to talk about Getting the Right Processes.
Growth always increases the complexity of your business. So, to get the right people, doing the right things right, you need processes in place to maximize your efficiency and effectiveness.
Here are three things you need to know about processes:
1) Process makes a business competitive. Companies with defined processes are better able to evaluate their strengths and weaknesses and identify opportunities for improvement.
2) Process enables growth. By leveraging defined processes, it become easier to deliver new products and services quickly and efficiently. Processes provide a blueprint for new employees and enable cross training to minimize business interruption.
3) Process drives profitability. A company with defined processes can find opportunities to improve efficiency without sacrificing quality and consistency. They can identify duplication of effort and spot areas that are being overlooked.
Here’s a story of how implementing new processes made a huge impact on my client’s profitability. This company was losing money in 2014. They had bootstrapped the company, but now had to borrow money from different sources just to fund payroll. They didn’t know where the losses were coming from.
- Process 1: They hadn’t taken the time to be sure there financial statements were accurate and that revenue and expenses were properly categorized. They established a month end close where part of their closing procedure was verifying that all revenue and expenses were properly categorized so their financials were timely and accurate.
- Process 2: They didn’t have a process to examine what portion of their payroll was converted to billable revenue. So, they didn’t really know how much of their payroll was unprofitable. They created an excel spreadsheet to show monthly payroll and how much of that could be allocated to their contracts.
- Process 3: This Company did not have a process to make sure their completion schedule of their projects matched their billing schedule. They didn’t know if they were over billed or under billed on any of their projects. So, they created a second excel spreadsheet to show what percentage they were complete on each project and then billed accordingly.
The process changes, in this case, yielded a huge change in the profitability and efficiency of the company. They had accurate and timely financial statements to make good business decisions and they cut payroll and increased billing based on the new excel spreadsheets, which in turn dramatically improved profitability.
What process changes have you made or need to make to enable your growth and increase profitability?
I heard a speaker at a conference say that many business owners feel that their most important assets are their clients. However, he disagreed. He stated that our most important assets are our people/employees. Our brand rises and falls on their efforts.
This is not intended to be written from a human resources perspective, but from a financial perspective. If we invest in people, how do we measure our return on dollars spent? Is there a formula for fixed vs variable compensation?
Here are a few things to think about:
1) Watch out for high dollar fixed expense. If you're hiring top talent, and alot of it, make sure, you are getting the proper return. For example, if you just hired a VP of Sales with a $100,000 and you have a 35% gross profit margin. You would have to see an increase of over $285,000 in revenue just to break even on their salary. Watch out that fixed compensation doesn't eat up your profits.
2) For sales people, when possible, implement an element of performance based compensation. Employees love for a large portion of their compensation to be fixed. A business owner would prefer for a large portion to be variable. Why? Because you can tie their compensation to actual performance, revenue or gross profit. The lower the fixed portion, the lower your overhead and the higher their variable piece if they're really good sales. If they're not, they won't last long.
3) Everyone has their own metrics or measurements on return on people investment. When possible, I really try to shoot for a 20-30% return (I call it return on spending)on compensation dollars spent. For example, if I hire a controller and pay them a salary of $50,000, I would hope there would be ways I could see a $60-65,000 improvement in business (efficiency, faster collections, taking discounts etc.)
I think one the biggest challenges most business owners have right now is finding the right people for their organization. Make sure you're doing things to attract top talent to your organization and continue to invest in their future.
Part 1- Cash Flow
Part 2- Establish Working Capital
"Growth always requires cash and increases complexity," says a popular business growth guru. Statistically, only about 4% of the companies make it above $10 million in annual sales in the US.
Doug Tatum, in his book, No Man's Land will tell you it's because of one of 5 M's.
- You have the wrong operating Model
- Your company is not properly aligned to the Market
- You've outgrown your Management
- You've outgrown your Money
- Your company has lost Momentum
Vern Harnisch, in his book, Scaling Up will tell you that there's a breakdown in one or several of the following areas:
His approach is that a business determines the strategic priorities for each month, quarter, year and then uses his/her data to keep score on the level of success. Getting your people engaged in the process using critical numbers or key performance indicators (KPI's) to create focus is key to gain alignment of thinking between shareholders and employees. The concept here is to determine the barriers you need to overcome to expand the business and either add people, create processes or improve execution.
What I've found is that both are true and both these points of view are necessary when evaluating your business.
Many times, companies need to add people in middle management to handle duties that correspond to changing complexity of the organization. Often, one person may be handling sales, operations and finance. Over time, many businesses have one person handling each of these three areas. A lack of any one person can cause the business to breakdown in the area that lacks management.
Due to a positive economic environment, many businesses are expanding geographically or increasing product lines, but they don't have a strategy, processes or execution in place to make those successful. Therefore, they may have added resources, but they're not getting a return on their investment (people, systems) which causes margin to decline or they become less profitable.
When you start your business it may merely require a good technician to complete the work. In later stages, management is needed to create processes and monitor performance. Finally, a mature company really needs entrpreneurial vision to understand the changing dynamics of the company and its market. This requires vision to create strategies to implement.
How do you grow you business? More often than not, most of us spend too much time working in the business instead of working on the business.
Are there ways for you to upgrade your people, improve processes and capitalize on new opportunities? These items are critical for you to overcome barriers to expansion and prepare your company for financial success.