Balancing Debt
Small business owners should be prepared for the “necessary evil” of borrowing money.

By Bruce Morgan

For many small businesses, debt is a continuing fact of life. And most companies, at one time or another, find that borrowing is a necessary evil.
A business, regardless of size, cannot operate for long without equity capital, working capital, profitability or a positive cash flow.

There are no easy answers to the question of how much debt is appropriate for a small business. Each situation is unique, and the answer for each company depends on a number of factors, including the type of business, sales, growth prospects, taxes, risk aversion of the owner, interest rates and cash flow.

Debt financing is the “cheapest” form of capital in a business’s overall capital structure, because the interest is deductible (assuming the business is profitable). However, the more debt to total assets increases the financial risk of the business—the risk of default and failure.

Every industry has “typical” ratios of debt to equity (e.g., RMA Annual Statement Studies), but the critical factors to consider are within the business itself and the owner’s aversion to risk and desire to retain control of the business.

The Trade-Offs in Financing
There are trade-offs in seeking equity financing vs. debt financing. In seeking equity financing, you generally are taking on partners who usually want a higher rate of return on their investment, while you may be happy with less return. Equity partners also may try to “manage” the business and the owner might lose control. The advantage is that there are no short-term payments.
Debt financing allows you to maintain control of the business, but loans still mean dealing with creditors. Creditors want to know how much money is needed, for how long, what you are going to do with it, when and how you will repay it and what protection (collateral) can be provided. Debt financing requires periodic payments, has a maturity date and increases the risk of a small business.

The Decision to Use Debt
The critical decisions you need to make are how much debt financing is needed, for how long (e.g., short term vs. long term), and how will it be repaid. Short-term loans typically are used for operating capital needs (e.g., one year or less) or seasonal demands of the business. Short-term loans are paid from current assets: cash, liquidation of accounts receivable or sales of inventory.

Long-term loans are used to acquire assets, including fixed assets (e.g., land, buildings, equipment) that the small business needs to generate sales. Long-term loans are repaid with cash flow. A company’s cash flow is generated from profits, depreciation and asset sales. Managing cash and cash flow is critical to the overall success of a small business.

Fran Jabara, principal, Jabara Ventures Group, and former professor and dean of Wichita State University School of Business, explains it best in his “rules of business”:

Rule 1: Never run out of cash
Rule 2: Never, ever run out of cash

What Do Bankers Evaluate?
Banks are typically a source of financing for an operating business, not start-ups or speculative ventures. When approaching a bank with a loan proposal, be prepared to present the purpose of the loan, financial statements, tax returns and the business plan. Understand and communicate the risks of your business, and invest the time and effort to inform the banker.
When evaluating a loan proposal, a banker evaluates the “C’s” of credit: cash flow, capacity, condition, credit, collateral and character.

•    Cash flow (net income plus depreciation) is the most important factor because that is the primary source of repayment of a loan.
•    Capacity (current assets/current liabilities) is an indication of a small business’ liquidity and ability to meet current obligations.
•    Condition (total debt/total assets) is an indication of how much financial leverage or risk is present.
•    Credit indicates how well the small business pays its bills with trade creditor and personally (FICO score).
•    Collateral offers additional protection for the loan and often is a secondary source of repayment.
•    Character is a subtle but important factor.

Small business owners looking for debt financing should focus on the fundamentals first by building a profitable operating business with positive cash flow. Use debt financing to maintain control and only to the extent of risk you as owner are willing to take. Building a long-term relationship with a banker that understands your business can be a critical factor in your overall success.

Bruce B. Morgan, Ph.D., is chairman, president & CEO of Valley State Bank. He can be reached at (913) 362-1400.