h1

Debt, Darling Or Devil?

November 22, 2009

The torch of business leadership is passing from the generation that lived through the depression to the generation known as the “baby boomers”. Despite the obvious age differential , the attitudes of the two generations on a variety of business issues are remarkably similar.

On one issue however, their experiences and attitudes show a marked contrast. That issue is debt. The depression era business person developed a cautious approach to borrowing while many of today’s entrepreneurs cavalierly incur debt.

If the future is the history that we have neglected to learn, it is perhaps prudent to understand the considerations that led to the cautious attitude of the older generation. While I don’t number myself amongst the growing school of doomsday predictors, there are increasing numbers of businesses that are waking up with debt induced hangovers.

One of my first managerial jobs was with a small privately owned company. The Chairman and largest shareholder was credited with having “brought the company through the depression”. In the intervening years the company had not grown appreciably but had been successful in providing a nice income to its owners and employees.

While the company was in strong financial condition, the seasonal nature of its business required some bank borrowings for short term working capital needs. During the majority of the year the company was a net investor of short term funds.

At management meetings, it didn’t take me long to learn the Chairman’s primary area of interest. He would first ask the company’s treasurer about the status of the bank accounts. If the company had been borrowing at the time, he would then inquire as to”when will the bank be paid off.” Knowing of the company’s strong financial condition and the excellent bank relations, I was unable to understand the Chairman’s myopic focus on “when will the bank be paid off.”

It took me sometime before I could appreciate and understand the concerns of the man that had “brought the company through the depression”. Sales, product development and expansion were far more exciting topics. Credit was available to finance projects in these areas.

Time and experience with several businesses have since matured me sufficiently to appreciate the importance of “getting the bank paid off”. In recent times, unpaid loans are often “rolled over” or extended while in earlier times the control of a business may have been lost. The Chairman’s focus was on survival not growth. A business should have as its priorities survival, liquidity and profitability.

A number of companies, both small and large continue to accumulate debt in the pursuit of growth and the hopes of a better tomorrow. Debt can be effectively used to improve the financial leverage of a business, but for those who have established a pattern of extracting themselves from problems with growth financed by debt, there is an eventual price to be paid.

You have positive financial leverage when debt financing enables you to produce a greater total return than you would have been able to produce with your equity alone. Consideration also needs to be given to payback, risks and contingencies. Debt can be appropriate for capitalizing on established opportunities but is seldom appropriate for working out of problems. While additional funds may ease the symptoms, additional debt will often make the eventual financial hole deeper and more difficult than the current one.

If debt is part of the financial structure of your business and your financial controls are lax, you should take action to remedy the situation. Too often otherwise good business people with sales, technical or operational backgrounds find themselves “too busy” to fully review and understand the companies financial statements. This is an invitation to trouble.

There are indicators of a debt load that is becoming burdensome. Extending larger than normal discounts to customers for prompt payment or selling below established prices to generate cash flow are indicators of a pending debt crisis. When your bank is looking for additional collateral, subordination of personal loans or an increase in restrictive covenants, you should get the message that someone is concerned that they have already lent you too much.

Increasingly innovative uses of debt capital have played an indispensable role in the acquisition, development and building of many of today’s businesses. Some companies however, are suffocating under the burden of excessive debt that was incurred without the cautious scrutiny exercised by a management that “made it through the depression.” Because it’s your business, maintain a cautious attitude towards debt so that you won’t have to “bring your company through the depression.”

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

w

Connecting to %s

%d bloggers like this: