What is debt?
Debt is money borrowed from a lender, typically a bank. In exchange for receiving cash, borrowers will repay the loan with interest. Interest compensates the lender for risking his cash, and are the costs a borrower must pay to use someone else’s money.
Why is debt risky?
Debt is risky because lenders receive a first claim on the business. That means that lenders have the right to take away assets/or the business to recover their money. The borrower retains whatever is leftover after the lender has been fully repaid. The “first claim” structure gives lenders assurance they will get their money back, encouraging people with money to lend to those who don’t. Therefore, by taking on debt a business owner risks their business.
Debt amplifies outcomes – GOOD AND BAD
Here we have three businesses, with differing amounts of debt. Blue has no debt, while Red and Green have received half of their funding from debt. The other crucial point is that all businesses generate the same margin of Operating Income on their revenue, but the Red business’ Annual Income is negative.
The 100% equity funded business (Blue) generates $200 of Operating Income (or EBIT) which is the same as the profitable 50:50 funded (Green) business. Due to the debt, the Green business has interest expenses. Net Income is slightly lower at $140 for the Green business at vs $160 for the Blue.
Hold on… I just said debt amplifies good, and bad outcomes, but the Green’s Net Income is lower… That doesn’t make sense.
Bear with me! To see why debt amplifies outcomes, good or bad, look at the Owner’s ROI (Net income / Equity).We see Green’s Owner ROI is 28% vs the Blue’s 16%. The difference is due to the differing amount of equity invested.
The Green business owner takes out $500 of debt but only invests $500 of his own money– equity. The denominator in Green’s Owner ROI calculation is only $500 while the Blue business owner had to invest $1000 of his own money. By using debt, the Green business owner is able to generate more money relative to the amount he invested giving him a higher return. In essence, his investment is more productive.
Ok now you are excited. Isn’t this great? We just found a way to make more money faster.
Not so fast! Look at the Red business – also 50:50 debt equity funded, however they have hit a bad year. They negative $200 of Operating Income and must pay further interest expense. Look at the Owner ROI – its -36%. The loss is amplified by the leverage in the business meaning the owner is doubly punished. His Equity drops from $500 at the start of the year to $320. The figure is helped by a Tax Benefit of $40, however, the government only allows you to cash in that benefit when you become profitable again, so it is even worse on a cash basis! In periods of growth and stability, debt boosts the economic performance of companies, while magnifying poor outcomes in times of distress.
Now the mathematical reason why this is so important is because of how money compound. Say we lose 50% of our money, turning $1 into 50 cents. We need to double our money to get back to $1 – losses are much more impactful than gains. While all life involves risk, we need to be careful about when we choose to take risk and how much.
Debt: A High Stakes Balancing Act
For the vast majority of SMBs, I recommend a very simple 3-point debt policy:
- Low is good, none is better – you can’t go bankrupt if you don’t owe anyone anything.
- Keep some spare cash on hand in cash something goes wrong.
- Don’t rely on someone else’s kindness, a bank or a friend, to help you with money because you may get a nasty shock to find out that A) they don’t have any money to give or B) They aren’t very kind.
In the example above, we focused on Owner’s ROI. Not only does debt magnifying gains and losses, it also opens the door to potential bankruptcy. If the company is unable to repay their loan or interest on time, or fails to comply with loan terms, then the owner could lose their business.
Ray DeVoe, a late financial writer, wrote a phrase that perfectly captures the danger of debt:
“More money has been lost reaching for yield than at the point of a gun.” – Ray DeVoe
The quote points back to debt’s amplifying effect on outcomes. Allured by dreams to get rick quick, entrepreneurs take on debt and assume enormous amounts of risk. It is in the bad times where the mistakes of businessmen or women surface with unpleasant consequences. Many people, throughout the course of time have become, are, or will become extremely poor by using too much debt. Eventually the chickens come home to roost!
Of course, many people have and continue to use debt to make more money faster. The Private Equity industry has done this create vast sums of wealth. The big assumptions there, however, are that 1) you are making positive returns and 2) times are good. In bad times you may lose everything.
On my job, I have seen many unfortunate situations where owners have simply taken on too much debt without a viable pay it back – an unfortunate ending follows.
The final thing about debt is that the interest expense goes to the lender instead of being invested in your business. In one year, this is unlikely to make a difference, however over time interest expenses may starve your business of needed investment leading to long term decline.
Charlie Munger, Warren Buffett’s right-hand man, had a famous line: “All I want to know is where I am going to do and never go there”. And if you go bankrupt, that is effectively dying in the business world – a big fat zero. No matter what number you multiply by 0, whether its $1 million, $1 billion, or $1 trillion, you always end up with $0. I suggest you take Charlie’s advice.
Debt: Proceeding With Caution If You Must Use Debt
1. Keep moderate leverage levels relative to FCF | Net Debt at less than 1x FCF
Ensure you can easily pay off INTEREST AND PRINCIPAL payments. FCF is the amount of cash that your business is generating. If one can pay off all debt over the course of a normal year, you are unlikely to have many problems.
2. Have a safety cushion for your Worst-Case Scenario
Imagine, and forecast, what could happen to your business in your worst-case scenario. Maybe your two biggest customers leave in the same year, and there is a recession. What happens to your FCF? Your FCF may fall by half, which would effectively double the debt you have relative to your cash flow.
When building a bridge, engineers ensure the structure can hold much more weight than when the bridge is full of trucks, not just cars and people. Engineers build in a margin of safety to ensure the structure can easily withstand any weight it would need to carry.
Business owners would be smart to incorporate a margin of safety when sizing up appropriate debt levels in a company.
3. Short-term debt can quickly turn deadly
The thing about short-term debt is that is needs to be paid off in the short term. Sounds simple, but it is particularly dangerous.
Say you have $1,000 of debt due in 1 month, and you have nothing else but $2,000 of inventory to sell. Well, if you can’t sell your $1,000 of inventory in a month, and collect the cash, then you aren’t going to be able to repay the loan. Even though you are capable of paying off the loan if you were given more time, often that will fall in deaf ears to a lender.
In its early history, Nike nearly went bankrupt from this exact reason. Nike had plenty of inventory, but it couldn’t sell its inventory fast enough to repay a loan. Its assets were converting to cash too slowly to repay their debts on time. It looked like Nike was going into bankrupt until another lender stepped in help with the cash “hole”.
Make sure to give yourself more than enough time to repay the debt AND interest before the amounts come due.
4. Try not to tie debt to individual assets to the mothership
If possible, and the interest rate is reasonable, see if you can borrow using one of your assets e.g. a machine, building as collateral instead of your entire business. This will come at a higher interest expense. However, if you are unable to repay the loan, the asset being taken away will be the one machine/building vs your entire business.
5. Interest Rates Change
Unless you take out a fixed rate loan, the interest rate on your debt is likely to change. If it goes lower great. If it goes high, make sure you can afford to pay the higher interest expenses. Look at how quickly US Federal Reserve increased interest rates.
Many people got caught out by how much and how quickly interest rates increased. Those who took out debt had to pay much more interest than expected – undoubtedly this has caused some pain.
My default advice here is to generally use variable interest rates but plan give yourself room in case rates go higher. Fixed interest rates will likely be slightly higher over the longer term as borrowers get “certainty”. However, if interest rates are at historic lows (209-2016), then it’s a good idea to lock in a low rate.
6. Raise debt in anticipation of need rather versus out of need
Financiers are sharks. When they smell blood, they extract their pound of flesh. Good luck, if you come to the table from a position of weakness. Sadly, many people agree to very unfavorable terms this because they are desperate and have no other choice. An old boss told me: when you need money badly, you get money badly.
I saw this with a publicly traded company called Casa Systems. The company was highly leveraged with no way of paying off its debt clearly going bankrupt. Lenders put onerous interest rates, and restrictive covenants on the business that allowed the company enough cash to live but not get better.
The lesson of the story is to come to the negotiating table from a position of strength. See the document below for more info.
7. Leases can be seen as a form of debt
You may hear this and think I am crazy. How are leases debt? Well leases are the legal agreement where the lessee pays the lessor a fixed amount over the term of the agreement. Sounds a lot like a loan that needs to be repaid over a set period of time…
Leasing is a way to get access to equipment without making entire purchase price upfront. A leasing arrangement allows lessee to conserve cash. The flip side to the arrangement is that the company has a yearly, or monthly obligation to make payments to the lessor.
The consistent outflow of cash to make lease payments make the business more fragile if bad times were to arrive. Being aware that leases have debt-like characteristics involving obligations to make consistent payments.
Alternatives
If you need cash, and don’t have the means to invest more money yourself, and don’t want more debt to consider looking for an outside investor. Make sure you consult someone to ensure the terms of the investment are fair, but this provides a lower risk way to add more cash to your business.