In addition, every debt agreement has interest involved. Sometimes these arrangements can be overwhelming for the business as the cash to cover the interest and amortization of the principal can deplete the cash reserves. So you need to consider this issue seriously as the owner so as to protect yourself from insolvency and possibly bankruptcy.
The following sections cover the relationship issues and the debt service compliance.
Introduction to Long Term Debt
The most common long term asset that is purchased in business and in life is a vehicle (cars, trucks, tractors etc.). They are also the most commonly financed asset. The financing arrangement is to pay off the amount borrowed over a period of time. The key for the business owner is to put the asset to work in order to generate revenues that can pay the debt. In exchange for lending the money the financing institution requires interest as a return for their risk.
So there are a lot of factors involved that affect debt. They are as follows:
- Time – the period of months or years to repay the debt back to the institution
- Interest Rate – the cost to have the money over the period of time
- Ratio Financed – the portion of the total amount to purchase the asset that is financed
Younger business operations depend greatly on using debt to purchase long term assets. The reason relates to the high difficulty of raising capital to finance the overall business. This increases the risk to the lender and therefore the interest rate is generally higher in comparison to other businesses and even in comparison to the personal level.
As a business owner, you need the capital and the key to success is to put this capital to work earning revenue for the business. To do this successfully, you need to understand the various relationships between debt and the revenue it generates.
There are several relationships that exist with debt. The most important relationship is to the asset itself. The debt should be paid in a shorter period of time than the utility of the asset. Another relationship includes the nature of the industry. Those industries that are service based should have less long term debt as a ratio of overall capitalization than industries that rely heavily on industrial equipment. Heavy equipment or equipment intensive operations need long term debt to purchase this equipment and generate revenues.
There are other issues related to debt, timing is one. With timing the borrower needs to look at the long term picture for the business. If the business is going to endure a growth period, then long term debt is appropriate. If the business is consolidating, debt is not the solution; it will merely exaggerate the overall poor performance. So timing does have an impact on the overall picture.
Finally, there is one relationship for the owner to monitor. This is the balance sheet relationship. I cover this and the others in the following sections.
Balance Sheet Association
One of the tools used in analysis is a ratio referred to as the debt to equity ratio. In general the formula is as follows:
All Debt on the Balance Sheet
All Equity on the Balance Sheet
This ratio includes all debt and long term debt is only one element of all debt. So another ratio (a subset of debt to equity) exists whereby the owner restricts this ratio to just long term debt; this is called Long Term Debt to Shareholder’s Equity Ratio. This is used to determine the leverage the business is using to operate the company. Naturally the higher the ratio the more leverage the company is using. The problem with leverage is the volatility involved in earnings. As a company borrows more money it needs more revenue in the form of sales to service that debt (pay the interest and principal). As a company increases the requirement for sales, there is risk that the economy or the customer base may not fulfill the quota of sales. Competition alone can reduce the sales volume enough to create problems in servicing the debt.
To address this, owners should use the help of an analyst or an accountant to determine the respective zones of leverage. It isn’t difficult to determine the safe zone of leverage, i.e. the maximum amount of long term debt to equity for the company to comfortable operate without worry over servicing the debt. The next zone may be a risk zone and the owner should generate certain requirements to operate within this zone to minimize the risk. Examples of requirements can be long term contracts guaranteeing sales or a reserve of cash that is restricted to pay down the debt in case of reduction in sales or economic adversity. There are several different steps an owner can take to reduce this risk exposure.
A final zone can be determined as the danger zone and only exercised in extreme conditions such as natural disasters, war or extreme economic circumstances. As the owner, you need to identify these zones and generate the variables to warrant the respective level of debt.
The following is an example of this association:
Erik owns a site development company. Most of his work relates to clearing housing lots and small shopping center lots. He then installs the drainage systems, ditches, water retention ponds. Afterwards, he lays out the parking lots, installs curbing and buries the sewer/water/utility lines. The final step involves setting the foundation for the building pads and the housing footers. He uses outside engineers and uses a lot of different pieces of heavy equipment to perform the various jobs.
Erik currently farms out his equipment servicing to an outside contractor. This vendor brings in fuel as needed, greases the equipment, does some minor maintenance and tops of the fluids etc. The guy is like a mobile Jiffy Lube and gas station. Erik is considering purchasing a specialized truck that can do the same function. This particular truck along with all the accessories and tools will cost $125,000. Erik’s concern is how much to borrow to purchase this truck.
His current long term debt to equity ratio is .60 as he has $600,000 of long term debt and a little over $1,000,000 of equity on his books. In communicating with his accountant, he has determined that the maximum long term debt to equity ratio for his small business can be no more than .69 (his safe zone). However, Erik can go beyond this ratio contingent upon enough sales for at least three years to service the debt. Most of Erik’s sales are short term because the respective projects are usually completed within four months. So Erik has no ability to gauge future sales beyond six to seven months.
So the question is as follows, should Erik borrow money to purchase and tool up the specialty truck. If yes, how much should Erik borrow and how much of his working capital should be used to purchase this specialty truck. Let’s do a little math:
Erik has determined that he will save about $20,000 per year with a 60% up time with the service truck. This includes the associated cost of labor. Erik has also received assurance from another small site developer that he can use around 20% of the up time of the service truck. Altogether, Erik believes he’ll save roughly $25,000 per year if he has this service vehicle.
The bank has informed Erik that they will lend up to $100,000 for this service truck without question. The debt service (interest and principal) per year will run $22,000 with $17,000 as the principal amount in the first year.
If Erik uses $45,000 of his equity and borrows $80,000 from the bank, what will be his new long term debt to equity ratio? Answer:
New Debt Position – Existing $600,000 plus the new amount of $80,000 = $680,000
Equity Position – Existing equity of $1,000,000 will not change as the down payment comes out of the working capital (current assets less current liabilities)
New Long Term Debt to Equity Ratio – .68
Based on Erik’s requirements and the accountant’s recommendation, Erik should not borrow more than $90,000 to purchase the service vehicle as the risk is too great. Erik’s accountant reminds him that he shouldn’t forget that he could borrow a little more and pay a smaller down payment because Erik will be comfortable retaining as much working capital as possible. Therefore Erik borrows $90,000 and uses $35,000 of his working capital to purchase and accessorize the new service vehicle.
The above example illustrates how an owner should think about borrowing money from a financing institution for the purchase of long term assets. For Erik, this is suitable and normal in his industry due to the nature of industries using heavy equipment. Site developers require a lot of heavy equipment and this equipment is customarily financed. Typically this industry has long term debt ratios greater than 1 and rarely in excess of 3. Think about a 3 in Erik’s case. This would mean debt in the neighborhood of $3,000,000 with equity of only $1,000,000. That is a lot of debt to service. So each industry is different. This brings us to the next relationship issue: industry suitability.
Some industries do not warrant long term debt. The closer your operation gets towards pure service, the less long term debt you should carry. Some service based operations do use specialty equipment such as medical professionals, engineers, transportation and waste management. On the flip side of this are equipment intensive companies that warrant the use of debt to finance their equipment. These include airlines, manufacturers, shipping, large contractors (not residential types), mining, research and real estate.
Each industry has standards related to the respected ratios. You should research yours or talk to your CPA for guidance.
For those organizations that depend on equipment, facilities and real estate the length of debt payment will have a closer correlation with the life expectancy of the respectful asset. The following section explains this in more detail.
This particular aspect of long term financing is the most important of all the relationships. I can’t tell you how many times I have seen the debt repayment periods extend beyond the estimated life of the corresponding asset. Look at our modern transportation debt situation related to the family car. When I was a boy, the debt repayment period was no more than four years. In the 80’s and 90’s the repayment period extended to five years. Today, new cars can be financed upwards of seven years. Used cars can be financed for five years.
Think about this for a moment, you have an asset that is probably used for 15,000 miles per year. Five years in the asset it will have 75,000 miles on the odometer. What is the value of the asset? Does it correspond to the remaining principal on the note? Often the note is more than the value of the asset. This is referred to as being upside down in the asset. This is so common now; I don’t understand how creditors can justify this exposure. As a business owner, you don’t want to be upside down in the debt. What this means is that some of your equity will have to cover the difference in case of extreme financial difficulties or failure to make your payments. Imagine the impact on the debt ratio?
As a business owner, your long term debt associated with that respected asset should never be more than 75% of the fair market value. If the particular asset in question is a vehicle, right from the start, your down payment should cover 25% of the actual purchase price. This doesn’t include your taxes, titling costs and registration fees. Pay attention to this relationship on your books as it really sets the tone for good financial management.
I once saw a client borrow 80% of the cost associated with a piece of production equipment. It seemed to be a reasonable position at the time. However, the client proceeded to burden this piece of equipment with a high utility rate and within three years, the equipment was used up. That is, it was worn out from over production during that period. The client did not keep up with reducing the principal portion of the corresponding debt and when it was all said and done, he owed money to the bank and had no asset in case of default. There was literally no value left in the asset. He did this frequently and it finally caught up with him. When he proceeded to purchase a very expensive and necessary piece of equipment, the bank required all the assets appraised to provide adequate collateral value. The existing pool of collateral was worth about 30% of his corresponding long term debt. The bank had no ability to justify the loan. Actually the bank wanted to call his existing notes because the terms of the notes required the fair market value of the collateral to exceed the principal portion of the corresponding debt.
In more modern banking arrangements, banks use personal assets, recourse and require minimum deposits on hand to reduce their risk related to the collateral. This further restricts the ability of the business to use the tied up resources as working capital.
So asset matching to the term of the loan is important. The following chart illustrates a reasonable comparison of debt duration to the actual life expectancy of the corresponding asset.
Asset Description Asset Life Corresponding Debt Term
Transportation 7 Years 5 Years
Real Estate 39 Years 30 Years
Heavy Equipment 7 Years 5 Years
Farm Animals 10 Years 7 Years
Marine Vessels 15 Years 12 Years
Industrial Motors 8 Years 5 Years
Notice how the corresponding debt term is no more than 80% of the actual asset’s corresponding life. This is reasonable in business. When the debt life begins to exceed this ratio you are opening up financial risk and you will need to use capital to maintain this safe ratio. So borrow the money accordingly.
Even if you do everything correctly, timing plays an essential role in safely repaying and controlling the debt.
Another relationship issue related to long term debt addresses timing. In recent years, many companies have refinanced their debt for lower interest rates due to the timing in the market. The problem with this refinancing relates to extending the time repayment period. Thus this creates a situation very similar to what I discussed above in asset matching. So as an owner I caution you in refinancing an asset for a lower interest rate. If the amount of time remaining on the debt is less than two years, you are almost better off not refinancing. Typically the fees and cost of work required to refinance exceeds the value you will derive. For periods longer than two years, you should consider the refinancing, but don’t extend the period of the refinancing as it impacts the asset to debt matching principal as described above. In addition, if you are not achieving a 1.5 to 2% reduction in the interest rate, there may not be enough savings to justify the associated refinancing costs.
Timing also comes into play related to growth. When companies began to achieve 10 to 20% growth per year, it is difficult for the current earnings to capitalize the necessary change in fixed asset purchases. Effectively the profits are inadequate to pay for the physical expansion. Thus there is a need for capital and long term debt may be appropriate. The risk is a sudden reduction in growth or a slowing down of the growth rate thus lower profits than needed to service this debt. If the long term debt has a short window i.e. three to four years out and you know this industry will continue this upward trend during this window, then long term debt is justifiable. However, the further out in time from the current period you predict growth the more difficult it becomes to warrant the increase in debt.
If growth is a temporary function related to a known situation, leasing may be a better alternative. The following is an example:
The town of Bedford has one high school and the football stadium has seating for 1,000 spectators. The town has recently seen a dramatic increase in growth related to a new industrial plant in the area. The town decides to build a new high school. The problem is that during the next three years while the new school is under construction, the town has decided to use trailers as a temporary fix to the classroom shortage. Your company has been hired to provide these trailers. You have two choices: you can buy the trailers for $35,000 each or lease them for $7,000 a year.
Since the contract is only guaranteed for three years and the debt service to borrow the money obligates you for eight years your safest choice is to lease the trailers.
In the above example, you don’t want to be holding a trailer and the corresponding remaining balance of debt once the three year contract is over. You have no guarantee these trailers will be used in another contract in the future. This is why you often see school systems lease trailers and not buy them as permanent mobile fixtures in their construction program.
Other timing issues include cash flow, call provisions in notes, other long term business obligations such as payments to retirement plans or certain key employees retiring. So timing does not necessarily correlate to work, it can be associated with other factors too.
Debt service refers to the reduction and elimination of long term debt. In simple business terms, it refers to the amortization of the principal and the corresponding interest earned by the lender related to the loaned amount. Most business owners fail to incorporate both the principal and interest in their thinking patterns related to the note payments. The problem is directly related to how information is reported for accounting purposes.
In traditional accounting, the interest is an expense on the financial reports and the principal portion of the debt is a balance sheet item. The following example illustrates the reporting format of these two components of debt service:
Marty purchased a truck three years ago and makes monthly payments of $340. His loan has a current remaining balance of $13,250. The next payment coupon identifies two components within the payment, the interest of $193 and the principal payment of $147. When the next payment is made, the entry to the books is as follows:
Cash $340 *Payment amount, reduction in the bank account
Interest $193 *Profit & Loss Statement Value
Principal $147 *Balance Sheet Item
Marty generated a profit during the month of $420. Since Marty is on the cash basis of accounting, his bank account received this cash. Marty is elated and wants to expand operations by getting another truck. The bank has agreed to do a similar deal for a new truck. Marty’s thinking is as follows: Hey, I’m making $420 a month! I can afford to pay $340 per month for an additional new truck which leaves me with $80 left over.
The problem with this thought process is that in debt service, the principal portion is not reported on the profit and loss statement. In reality the following is the correct thinking process:
Cash Profit Earned: $420
Principal Payment (147)
Actual Cash Available $273
New Payment (340)
Actual Cash Shortage ($67)
Ah, not enough money to cover the payment!
Now I know a lot of you are thinking, not a big deal. But in business, this is normally on a much larger scale. So accountant’s use cash flow statements to help business owners see this cash issue. For you as business owner when taking on additional debt, one of the first questions to ask is ‘How much are my principal payments over the next few years?’ Then ask, how much more will it be per year with the additional debt.
To get an understanding of how to answer this, the reader must first understand how to read the balance sheet related to long term debt. I have another article in the accounting section under the page entitled: Report Analysis – How to Read the Financial Statements.
Summary – Long-Term Debt
Often owners consider alternatives to long term debt such as leasing assets. Under current Generally Accepted Accounting Principles, leases are treated more like long term debt than 10 years ago. If you desire to learn more about when it is appropriate to lease an asset, I suggest reading my article: Lease or Buy.
In general long term debt requires monitoring, management and proper relational behavior to the asset, the balance sheet, industry standards and timing. As an owner of a small business, gain an understanding of this form of capital and use it wisely to maximize profitability. Act on Knowledge.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you.