Like fire, the Internet, or the “reply all” option on your email, business debt can be either helpful or harmful, depending on how you use it. Debt used properly is a tool for business growth. When debt gets out of hand, however, it can hinder business growth, make it hard to find financing, and make any financing you do obtain more expensive.
How do you know when your business debt has become excessive? Here’s how to get a handle on your business debt before it gets out of hand.
“Poor cash flow is always the first sign that you’re overextended,” says David Worrell, whose company, Fuse Financial Partners, solves financial and operational problems for privately-owned companies. Without sufficient cash flow, “it can be hard to get the supplies and materials you need to serve your next client.” If vendors reduce you to COD terms or put you on a credit hold, delivering products or services in a timely fashion will become difficult. “If your delivery times are stretching out due to vendor constraints, perhaps the root problem is that you’ve borrowed too much,” says Worrell.
Ultimately, businesses with poor cash flow will have trouble paying basic expenses and making payroll. “That means you’re not going to be in business much longer if you don’t fix the problem.” Don’t let it get to this point. Long before you start struggling to make payments, you’ll see your accounts payable (A/P) increasing and your bank balance decreasing. “If you measure these two numbers on a weekly basis, you should have enough warning to find a solution before the house comes crumbling down,” Worrell says.
Do the Math
Calculating a couple of simple financial ratios will also help you keep an eye on your business debt and whether it’s getting out of hand. The Debt Service Coverage (DSC) ratio, used by banks to determine whether they’ll lend you money, is one you should monitor all the time, says Worrell. Your DSC is your operating profit per month divided by your total monthly debt payment obligations. Most banks require a minimum value of 1.25; try to keep yours well above this point.
You can also use a metric called the Acid Test, Worrell says. Simply take the current assets on your balance sheet and divide it by your current liabilities. “If this number is less than 1.0, you’re headed in the wrong direction,” he warns. “Try to keep it closer to 2.0.”
Pay particular attention to short-term debt — debt that must be repaid within 12 months. Categorized as current liabilities, these usually include your Accounts Payables. In particular, Worrell advises keeping a close eye on credit card debt and vendor credit: “It’s so easy to let them get out of control.” Long-term debt, which is typically secured by assets, should still be monitored, but not as urgently.
Make sure the financial statements you used to calculate your metrics are up-to-date and accurate. You also need to be hands-on. It’s common for business owners to ignore their balance sheets, often because they simply don’t know how to read one, says Worrell, author of The Entrepreneur’s Guide to Financial Statements. If that’s the case, he advises getting help from a CFO or analyst. “Don’t let your bookkeeper run these important numbers,” he cautions. If the bookkeeper has been making mistakes in data entry, you’ll be working with bad numbers.
That’s why Worrell recommends having a CFO or financial analyst review your business finances periodically. “Note that I did not say CPA or accountant,” he emphasizes. “Most accountants are too focused on tax issues to do a good job of communicating the management issues that can be discovered in your financial statements.”
Red Light, Green Light
Whichever metric you decide to use, Worrell says, “the important point is that you track it weekly and chart the trend so you can see problems coming.” He suggests plotting your ratios on a graph so you can see the trend line over time. If you use your accounting software’s dashboards to do this, be sure you look at the numbers — not just at visual indicators like red, yellow or green lights. “Knowing that the light is yellow doesn’t tell you which direction the number is trending or how [close to red] it is.”
How frequently should you review financial ratios? “It depends on how volatile the numbers are and how much control you want,” says Worrell. “For example, Dell Computer manages its inventory levels at least hourly because they build so many PCs each day.” For a small business that’s in good financial shape, monitoring key debt ratios and financial or operational key performance indicators (KPIs) once a month is enough.
If you see any of your metrics trending downward, Worrell cautions, start monitoring them weekly or more often. “More important, do something about it,” he says. “Too much debt will eventually put you out of business. Don’t let your borrowing lead you down that path. As soon as you see a trend line heading in the wrong direction, take action.”
Worrell, who helps businesses work out debt and cash flow problems, says too much debt is just a symptom of deeper problems.
This article is part one of a three-part series on lowering business debt.