Finance Friday – When is Debt for a Company a Good Thing?

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Many people if asked, will say that having debt is bad for a company.  We hear that debt is having a crunching effect on businesses, consumers, and on our national economy.  So when, if ever, is having debt a good thing for companies?   I recently posed that question to Bob Coleman, the editor of a weekly small business lending newsletter that I subscribed to, The Coleman Report. Bob responded by reminding me that more small business fail due to lack of cash flow than for lack of profit.   He said that many business owners focus a lot of their efforts on increasing sales to achieve profitability and growth, but unfortunately often neglect to monitor their cash flow situation as carefully.  The problem he said is that it almost always takes longer to convert sales into cash than we originally thought.  Ideally, a company’s customers pay in 30 days or less, but it’s variable.  On the other side of the coin, the two things that eat up cash are increases in inventory and increases in accounts receivables.  Because small business owners aren’t consumers with weekly paychecks, their cash outflows don’t always sync nicely with their cash inflows.   It’s the classic reason why companies need loans, i.e. debt.  After establishing that debt in such a case may be useful, I asked Bob to give me a specific example of when debt can be ‘good” in bridging this company’s cash needs and supporting its sales and profitability.  Bob related the following basic example, taken from his book “Money Money Everywhere, but not a Drop for Main Street:

“Say you are a small manufacturer, producing widgets, and you purchase $50,000 of material from your vendor and contract $50,000 for labor. Your cost is $100,000.  However, your employees want to be paid right away, so you’re immediately out of the $50,000 for the month. Likewise, your vendor expects to be paid not later than 30 days.   If you are a manufacturer that adheres to a daily management of cash flow, then you will likely sell your widgets for $125,000.   Your customer has said that because he/she won’t get their money for 30 days, they will only be able to pay you in 45 days. And it may take a week for you to ship your goods to your customer, and week to receive the check.   As a result, you are out $100,000 in thirty days, and you will receive the $125,000-the money you generated from your $100,000 expenditure—in 60 days.   And this is why this company needs a loan or short-term debt in this case.   Without $100,000 in credit, there is no order, profit, and ultimately no company or employees.

The thing to understand from this example said Bob is that banks want to know this cycle when they are approached for a loan.  Banks want to know if the proceeds from any loan they make to a company are going to finance the costs of the new sales as working capital,  or are being diverted to other purposes or to make up for past failures.   While every business has skeletons in the closet when it comes to debt, Bob said the last thing that a banker wants to hear is that their money, their inventory, is being used to make an “accommodation” with a past vendor to pay off a previous credit line.  Bob said the simple takeaway for ensuring that debt can be good for a company ‘is don’t pay retail when it comes to taking on debt.” If the banker perceives you don’t understand the value of cash, you must convince them that you do and that you understand that cash leads any transaction.

Bob Coleman is editor of the Coleman report, a weekly small business lending newsletter and a frequent guest on Fox business news.  He is also the author of Money Money Everywhere, But Not a drop for Main Street. http://www.colemanpublishing.com/

(Note:  the information contained in this article should not be interpreted representing the opinions of the MEP, nor as constituting borrowing or lending advice, and is not intended or written to be used, and cannot be used, by the reader for the purpose of  promoting, marketing or recommending any matter or actions addressed in this article  to other parties. )

About Author

Doug Devereaux

Doug Devereaux is a Senior Industrial Specialist at MEP, where he focuses on the capture and dissemination of financial resources and strategies that can be used by MEP centers to help manufacturers develop innovative products or expand markets and sales. Over his 25 years experience at the state and federal Departments of Commerce, Doug has led industrial missions to the Pacific Rim and produced various publications involving such topics as laboratory technology transfer, business incubator practices, science and engineering trends in Asia, and community approaches to angel capital investment.

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