Pinnacle Consultants L.L.P.

Helping Businesses Reach Their Financial Peak

Financial Review

Is Your Company Effectively Managing Its Debt?

For a growing business, having a manageable level of debt can be an effective way of doing business. While some small business owners are proud of the fact that they've never taken on debt, that's not always a realistic or optimal approach. Significant growth often demands considerable capital, and getting that money may require you to seek a bank loan, a personal loan, a revolving line of credit, trade credit, or some other form of debt financing.

The question for many small business owners is: How much debt is too much? The answer to this question will lie in a careful analysis of your cash flow and the specific needs of your business and your industry. The guidelines below will help you analyze whether taking on debt is a good idea for your company.

Explore your reasons for borrowing

There are a number of scenarios that may justify taking on debt. In general, debt can be a good idea if you need to improve or protect your cash flow, or you need to finance growth or expansion. In these cases, the cost of the loan may be less than the cost of financing these moves through ongoing income or external equity. Some common reasons for seeking a loan include: Working capital - when you're looking to increase your company's work force or boost your inventory and sales. Expanding into new markets - when companies enter new markets, they often face a longer collection cycle or must offer more favorable terms to new customers; borrowed funds can help weather this period. Making capital purchases - you may need to finance new equipment in order to move your business into a new market or expand your product line. Improving cash flow - if you have less than 10 years left on an existing long-term debt, refinancing can improve cash flow. Building a credit history or relationship with a lender - if you haven't borrowed before, taking out a loan can help in developing a good repayment history and can help you obtain financing in the future.

Plan effectively

Before taking out a loan or any other kind of debt financing, you should spend time planning your capital needs. This point cannot be emphasized enough.  Many companies fail to do this planning and find themselves in a tight situation when they need the financing. The worst time to take on any kind of debt is during a crisis. A sudden loss of trade credit, the inability to meet a payroll, or other emergency could force you to take on debt immediately, and that can result in highly unfavorable terms. A plan forecasts your cash requirements, allowing you to determine what you will need and when you will need it. Planning ahead will give you the time to explore all possible borrowing sources and negotiate the most favorable terms. It will also allow you to determine whether or not your company has the ability to make the principle and interest payments on the new debt. A capital plan should consist of a complete review of your income statement, balance sheet and cash flow statement to help you analyze current cash flow, assets and liabilities. It should also consist of a 3 year financial statement forecast to evaluate how your business is projected to perform in the future with this new financing.

Examine short-term vs. long-term debt

Just as you need to be certain you're taking out a loan for the right reasons, you also need to make sure you're taking out the right kind of loan. For example, taking out a short-term loan when a longer term loan is required can quickly create financial problems since you may be forced to take unnecessary measures (such as selling a piece of the business) to meet the obligation. In general, use short-term loans for short-term needs. This will help you avoid the higher interest expenses and more restrictive conditions of longer term borrowing. For instance, if you experience a temporary rapid increase in sales -- such as that brought on by increased seasonal demand -- then you should look at a short-term loan. If the growth will continue over a long time, take a look at longer term options.  Such options may include an expanding line of credit - based on sales, accounts receivables, or inventory ratios or term loans between 5-10 years.

Base new debt on current needs

When interest rates are low and money is cheap, you may be tempted to take out loans to buy equipment or make other capital purchases. If that's the case with your business, be sure to base your decision solely on your current needs. The possibility of rates increasing is not a rationale for spending money on something you don't need.

For a growing business, having a manageable level of debt can be an effective way of doing business. Significant growth often demands considerable capital, and getting that money may require you to seek debt financing. Taking the time to plan for your growth needs and identify the right type of financing for your business, can really help to ensure your company is positioned for success.

Thank you for your continued interest in Pinnacle Consultants.  If you would rather not receive e:mails with news, updates and tips from the financial world, please click the following link paul@pinnacleconsultants.org


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Special Points of Interest

  • Before taking out a loan or any other kind of debt financing, you should spend time planning your capital needs. This point cannot be emphasized enough.

  • Use short-term loans for short-term needs. This will help you avoid the higher interest expenses and more restrictive conditions of longer term borrowing.

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Pinnacle Consultants L.L.P.

20704 N. 90th Place

Unit 1049

Scottsdale, AZ 85255

P: 480 980-3977

F: 480 585-1920

Website:

www.pinnacleconsultants.org

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Contact Us:

paul@pinnacleconsultants.org

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