DEBT…It’s Not Always Just a Four-Letter Word

March 31, 2014

The media would have everyone believe that debt is a bad thing.  Like anything, too much of it is obviously not a good thing.  It is analogous to sun and water for farmers. They need  sun and water to maximize their crop at harvest time, but too much sun or too much water and the crop fails.  It is this same fine balance between debt and equity that businesses need to grow and maximize profits to owners.

This can be best displayed with an example that shows how debt can be used to maximize profitability:

Example: Consider Business A and Business B.  Both businesses are in the same industry and have similar capital structures.

John, the owner of Business A, is very conservative and refuses to take on debt to grow his business (which is currently earning \$15,000 per month in profits). Thus, he will wait to expand his inventory product line until he can pay for it and the new equipment needed to manufacture it until he has the necessary excess cash on hand, which will be in two years.

Bob, the principal of Business B, is willing to use debt to grow his business because he feels the opportunity exists in the marketplace today.  He reaches out to his local banker to help him finance the growth.  The bank offers him the \$190,000 he needs at 8% for the equipment.  The bank loan amortizes over a 5-year period.  As a result of the investment in the new equipment, monthly profits can increase from \$15,000 per month to \$25,000 per month.

The Result: Total Profits at the End of Two Years

\$15,000 per month x 24 months = \$360,000

\$15,000 profit/month x 24 months = \$360,000
Plus: Incremental Profit on new sales
\$10,000 profit/month x 24 months = \$240,000

Less: Interest on Bank Debt Year 1 and Principal Paydown Year 1
\$190,000 Loan x 8% = \$15,200 in Interest for Year 1
Principal Payment (assuming 5 years amortization) - \$38,000

Less: Interest on Year 2 and Principal Payment Year 2
152,000 (\$190,000-\$38,000) Loan x 8% = \$12,160 in Interest for Year 1
Principal Payment (assuming 5 years amortization) - \$38,000

Summary:

 Business A Business B Profit from Operations for Year 1 and 2 \$360,000 \$360,000 Incremental Profits \$240,000 Interest and Principal Year 1 (\$53,200) Interest and Principal Year 2 (\$50,160) End of Year 2 Profits \$360,000 \$496,640

Using this very simplistic example, Bob’s use of debt in a proper manner yielded him significantly greater profitability in the short term and there will be many more years of increased profitability as a result of his decision.   (Someone reading this will say that I didn’t take into account the cost of operation of the maintenance on the equipment, but this analysis also does not take into account the tax benefits of the depreciation and interest expense coupled with the fact that the machinery may last far more than the five years over which it is being amortized.)  This is a perfect example of how debt can work to increase profitability.

If you look at successful businesses, almost all of them used some form of Debt to finance and grow their business.  In today’s highly complex economy, business owners need to invest in the new equipment and technology to stay competitive.   Failing to invest in a business is one of the quickest ways to destroy the value of the going concern a business owner has built over the years.

Debt comes in many forms and styles.  I am sure many business owners have been approached by lenders who use terms like “Cash Flow Lender,” “Asset Based Lender,” “Factor,” and/or “Purchase Order Finance;” the list goes on and on.  Not all debt is the same and not all debt fits every situation.  The professionals at EisnerAmper can assist you in identifying what type of debt is best in your specific business situation.

Remember, good debt is used to grow your business.  Resist the temptation to use debt to cover losses or to give your key employees additional compensation, including yourself.