Debt Aversion…. The Future is Now

Nobody likes the idea of debt, yet it can be detrimental to businesses and their owners when they are unwilling to utilize the services or advice from someone who understands asset & liability management, risk mitigation and the benefits of a coordinated balancing of the overall process. This is an extremely important aspect of financial management which can help protect and expand an individuals portfolio or their businesses.

Most business-owners have a problem: They are debt averse. They don’t want to borrow money, so they keep too much cash in the business, or in low interest bearing or checking accounts—a costly decision in the long run.

We often hear that they don’t want to borrow money because that puts them at the mercy of their bank. Yes, having the bank out of your business is a nice thing, but understanding the true benefits, credibility, growth potential and tax credits available by borrowing and repaying can be enormous. Not to mention the unknown, unseen emergency scenarios.

If business owners don’t foster a strong relationship with someone who can assist them with credit, lending or loans in good times, many institutions may not be as helpful in tough times. Worse, if owners invest their own cash in good times, then need to borrow later, they may not be able to create liquidity when it’s needed. This can often cause a big problem—sometimes big enough to take down a business.

Cash was king. We feel our value added advice is in the proper use of capital and debt. This includes helping clients understand what banks look for when it comes time to make loans and what the client should ask for when they are looking for a loan.

Financial ratios

Most banks are interested in one thing when they make a loan: having it repaid, with interest. There are a myriad of ways to do that today, in regular installments, interest only, balloon, revolving. It is also a fact; many banks don’t want loans to be repaid quickly. What they do want is to make sure that clients have the ability to make their payments on a timely basis. There are several ratios to assess the risk exposure of every loan:

Current ratio. This ratio represents current assets over current liabilities. It tells whether the client has enough liquid assets to cover expected liabilities over the next year.

EBIDA (earnings before interest, depreciation, and amortization)-to-interest coverage. This ratio shows how many times the client can pay for the interest cost it accrues over the course of the year. For example, if a business produces $1 million in profits and depreciation, and if interest coverage per year combined with the interest cost is

$100,000 for the year, the EBIDA-to-interest ratio is 10 to one. Most banks will be happy with this interest coverage. It means that there is a high probability the business will be able to continue paying interest over at least the next year.

EBIDA-to-debt service. This ratio shows how many times the business can cover its entire debt service through the cash flow of the business. If we take our $1 million in EBIDA and have an annual principal and interest requirement of $300,000, our EBIDA- to-debt service ratio is 3.33 to one. Again, this is a very strong ratio, and most banks would be very happy to have it.

Debt-to-equity ratio. This ratio tells the bank whether the company is funding its growth with all bank debt or with a combination of bank debt and cash invested by the owners of the company. If the company has a total debt of $1 million and total equity of $2 million, then the debt-to-equity ratio would be 0.5. Anything less than one to one for a debt-to- equity ratio is considered strong in the private business world.

Expectations of the bank

When establishing credit, it’s important to know what to expect. Most banks treat private business loans like real estate loans. They want to see hard assets to cover the loan.

This is where a solid debt-to-equity ratio is important. If the debt-to-equity ratio is less than one, then the bank usually concentrates on the cash flow ratios (EBIDA-to-interest or total debt service analysis). For not-for-profit entities, associations, zero-balance situations, this always creates confusion and even more reason to work with specialists who understand and can explain the specific nuances on behalf of the client.

The next thing to understand is the security arrangements banks usually want—vs. the sort of security arrangements the banks should be given. Often these two arrangements are different depending on the credit facility, client and total financial relationship.

For example, if a business has a good debt-to-equity ratio, has been around for more than 10 years, with a history of consistent profits, and has sales of more than $5 million per year, there is a good chance that a financial institution may provide a loan with no personal guarantees from the owners.

Capital return of the business

We often see business owners have either too much or too little cash invested in their businesses. The test to see whether this is true is by looking at two additional ratios. These are return on equity and return on assets.

Today, most private equity firms require an annualized return of 25% or more from the investments in their portfolios. They achieve these returns by the appropriate use of debt in the companies they own. Our private business clients need to consider the same thing. For example, let’s say our clients have $2 million in retained earnings in their company, of which $1 million is cash or investments. If the company has profits of

$200,000, then they have a 20% return on equity. If those same owners remove the $1 million in cash and have the same $200,000 in profits, their return on equity will increase to 40%.

These clients could remove the cash, reinvest it in other assets and have the safety of the needed cash, then open a line of credit for the money they may need. This gives a double measure of safety. First, the cash accumulated is out of the reach of corporate creditors. And second, if there is a serious downturn, they have cash to keep the business going. Leaving cash inside the business can hurt on both fronts.

The second ratio we look at with our clients is return on assets. If the company has total assets, including cash, of $3 million and profits of $200,000, we have a return on assets of 6.66%. Again, if we remove the $1 million in cash, the return on assets improves to 10%.

Measuring both the return on assets as well as return on equity allows us to help our clients understand whether they are using their capital in an effective and efficient manner. With 30+ years in financial services, we understand (1) how banks think (2) how clients and businesses think about debt, and (3) how effective asset and liability management may assist our clients in protecting and growing their portfolios, strategically utilizing debt for growth as well as day-to-day operations.