This article explains three important rules that if broken will overwhelm operations and working capital, in most cases it will doom the business to failure.
- RULE #1 – Proper leverage for the respective asset
- RULE #2 – Debt’s amortization should be less than 80% of the asset’s expected life
- RULE #3 – Net earnings from the asset must exceed the debt service cost
The following sections explain these three rules in more detail and in addition provide examples to illustrate the value of the respective rule.
Rule #1 – Proper Leverage
One of the forms of leverage is financial. This means borrowing money to fund expansion, in this case purchasing and asset, and increasing overall profitability. In effect the borrowed money acts as a lever placed against the fulcrum (the asset) to increase profits. In business it means adding more equipment to increase production thus increasing sales and the corresponding profit.
Leverage works well with high growth business because it provides the necessary tooling to expand and meet demand.
In small business it is almost always adding additional transportation equipment, a new truck or van to expand the fleet and do more work. Invariably, the best approach is to determine if the existing assets can be leveraged higher, if they can’t be utilized more, than will the addition of another asset increase the sales? Finally how much financial leverage is appropriate? To answer these questions let’s look at an example of a small business and how to properly approach solving these questions.
CHAD’S TREE SERVICE
Chad is an arborist conducting services in three different counties. The bulk of his work involves clearing bushes and small trees from residential lots. He is contracted a couple of times each week to take down some large trees. His current method is to climb them and tie himself to the tree, trim it down and then work his way down. One of his thoughts is to purchase a cherry picker (think of a bucket on a hydraulic boom) to make the work go faster and make it safer. He believes that a cherry picker will allow him to cut an additional 40 trees per year. He charges about $1,400 per tree.
The problem is that due to manpower limitations he’ll have to reject about $30,000 a year of bush clearing work to have the time to cut down 40 more trees. So the total change in sales is as follows:
So the first question is ‘can the existing asset increase it’s utility?’
Answer: Chad is the existing asset and so, can he climb 40 more trees per year and still be as effective? He explains that the climbing process is time consuming and in reality he could climb 20 more trees per year but would have to give up $30,000 of bush clearing work. So the expansion of the existing asset has this financial result:
The second question is ‘will the addition of the asset expand sales?’
Answer: Yes, it will expand sales by $26,000 as illustrated above.
Now for the final all important question: how much financial leverage is adequate?
After extensive discussions with the supplier, a slightly used cherry picker and hauling trailer will cost $47,000. The bank will allow Chad to borrow $35,000 to purchase the picker. The supplier’s lender will loan $42,000. Here are the respective terms:
Bank Supplier’s Lender
Maximum Amount of Loan $35,000 $42,000
Amortization Period 45 Months 45 Months
Payments (Principal and Interest) $900 per Month $1,200 per Month
For Chad, if he goes with the bank loan his marginal down payment is an extra $7,000 ($42,000 – $35,000). He would use a bank loan to cover 74% of the cost. Whereas the supplier’s lender will loan 89% of the cost. Here are the marginal cash differences for 12 months between the two options:
Bank Supplier’s Lender
Gain in Sales $26,000 $26,000
Loan Costs 10,800 14,400
Cash Flow $15,200 $11,600
Chad will get his $7,000 back in less than two years. Leveraging to 89% reduces Chad’s cash flow $3,600 per year or to put it another way, just slightly more than two trees per year. It is obviously too much leverage. The bank loan is more appropriate.
There are other options for Chad. They include:
1) Pay more down on the cherry picker. The bank will loan the difference and reduce the payment accordingly.
2) Shift the business operational focus to strictly large tree removal increasing the utility of the cherry picker.
3) Train a new apprentice to climb trees and cut them down instead of purchasing a cherry picker.
As other options are reviewed; some subjective information can sway the decision. In effect not all decisions are strictly based on value based outcomes. Here are some concerns:
1) Higher Down Payment – Chad has saved up $20,000 as working capital and using the bank loan consumes $12,000 (price of $47,000 less loan of $35,000) leaving Chad with only $8,000 for working capital. Based on business history Chad isn’t comfortable with any working capital balance of less than $6,000. So additional money down is not really a viable option.
2) Shifting of Work – Although it appears a good idea to shift focus to tree work only, it is the fact that he performs all levels of landscaping that appeals to the broadest market which gives him access to tree work. To increase utility of the picker would require increasing the scope of territory and volume of work. Chad doesn’t have enough working capital to expand to that level of workload.
3) Apprentice – A new apprentice could cut down about 130 trees per year at $1,400 per tree or around $182,000 per year of additional sales. The apprentice will cost upwards of $90,000 in compensation, tooling and insurance. So there would be a tidy profit. The problem is that Chad fears that once the apprentice has the knowledge and experience he’ll quit and become competition. He as dealt with this before. This is how he got into the business; so the fear is legitimate. To Chad, he would be training his competition.
Based on the rule’s primary goal of proper leverage the $35,000 bank loan is the best choice and addresses the subjective concerns posed. In addition it passes all three leverage tests.
Test #1 – (Best Answer is a ‘No’) – Can the existing asset be leverage higher? Yes, but the cost in loss of work exceeds the value generated. So it is a ‘No’ for the answer thus passing the test.
Test #2 – Will an additional asset expand sales? Yes, sales will expand by $26,000.
Test #3 – Is there proper financial leverage? Yes, the down payment does not consume all working capital and the bank’s terms create a faster payback of marginal down payment. Other options have subjective drawbacks.
Rule #2 – Debt Term is Less Than 80% of Asset Life
A primary business principle used in financing fixed assets is matching of the debt’s payback period to the life of the asset. If the asset’s life is seven years then the debt obligation related to that asset should not exceed 80% of that asset’s life; in this case, five years. The principle is based on the premise that the asset earns money to cover the related debt service.
The 80% rule is a general guideline due to the nature of fixed asset performance. As fixed assets mature the maintenance costs begin to increase disproportionately to the earlier years. Therefore any additional revenue generated by the asset no longer services debt payments but is used for maintenance and repairs.
A secondary aspect of this rule is the efficiency of the asset. All assets are significantly more efficient in the earlier stages of life than in the latter years. Downtime increases with age, thus reducing earnings to service debt.
To illustrate these two reasons, let’s look at a couple of examples.
Chad’s Cherry Picker
Continuing with Chad’s tree service above, the cherry picker is expected to last 96 months without major repairs or extensive use. Chad bought the bucket lift used with 12 months already consumed on the machine. So there remains 84 months of life before any major overhaul is required. Reading the owner’s manual and the service schedule the manufacturer identifies three critical maintenance cycles. All three cycles time out at 96 months of use. Two of the cycles time out for maintenance at 72 months requiring $4,000 of maintenance.
Since the machine is already 12 months used, there remains 60 months before the first major maintenance expense occurs. Based on the rule, the loan’s amortization should not exceed 48 months. The bank’s loan period is 45 months, well within the 80% rule.
In effect, once the loan is paid, Chad should use the savings from debt service to set money aside for these maintenance cycles.
For the second example, I will illustrate this rule using a standard cube truck. A cube truck has a life expectancy without major drive train issues for 140,000 miles. From 120,000 to 140,000 miles an owner should expect several thousand dollars of maintenance related to chassis, suspension and exhaust systems. In effect 120,000 miles is the 80% point at which time maintenance costs increase significantly. The business should not have a loan amortization beyond this mileage point.
Based on current utility the business expects the cube truck to be driven between 18,000 and 20,000 miles per year. This means it will take six years before the cube truck surpasses 120,000 miles. Therefore the loan’s maximum amortization period should not exceed six years.
Rule #3 – Earnings Must Exceed Debt Service
The goal of adding additional fixed assets is the generation of more profit. If not, the associated investment is merely a drain on cash. To be effective the asset must cover all associated costs of operations and the debt service (principal and interest) before contributing to the overall profit of the business.
For the reader, covering costs can be as simple as machine operation costs (lubrication, supplies, cleaning etc.) or as complicated as calculating full operational costs such as additional labor, labor insurance, taxes, storage, subcontractors for specific maintenance issues; loss of margin for substituted sales as in Chad’s tree service example. Even subjective issues are considered.
To explain this rule, let’s review three illustrations each more complicated as the examples progress.
A water catastrophe company provides emergency water damage mitigation services. The company is turning down industrial level jobs because it lacks a desiccant drying machine. The machine costs $45,000 including all tooling. The loan service payments will run $1,200 per month. Operational costs per year will approximate $8,000. Total annual costs to own and run the machine will run close to $22,200 per year. So the question at hand is: ‘Can this machine generate more than $22,200 per year in sales without affecting existing sales?’
Adding an Additional Revenue Stream (Division)
A trash hauling company is considering adding a new trash truck to its existing pool. It is considering competing in a neighboring county to expand operations. For the truck to be effective it must earn more than $28,000 to service the debt. This company’s gross margin percentage for hauling is 20%. Office operations associated with route issues (collections, customer service and planning) is 7% of sales. Therefore the additional earnings a trash truck can provide is 13% of sales to offset debt service.
To generate enough cash to service debt the trash truck must have sales of more than $216,000 ($28,000/.13) per year.
For management to evaluate this opportunity it must determine the maximum revenue that can be generated and the likely percentage of utility for the new truck. So if the maximum earnings is $250,000 for a truck, a new truck must have at least 86% utility. This is going to be extremely difficult to achieve in a highly competitive environment such as residential trash hauling.
A baby bottle liner manufacturer is negotiating terms to expand a long term contract for production with a buyer. To facilitate the required production level the company must install a new extruder line. After analysis the margin is well within the range to serve the associated debt for the new line.
The problem arises with the raw resource initial processing. The existing equipment is designed to only handle up to 110% of the maximum feed input for the existing lines. To fulfill the additional demand and meet the input feed of the new and existing lines it would require 170% output from the raw resource processor. The cost to install that size and volume of output equipment exceeds the net earnings from the new machine after servicing the new machine’s debt.
In the final example I illustrate that even though the machine is profitable to cover debt service, it may impact other areas of production creating additional costs that exceed the net earnings generated.
The overall goal of the rule of covering debt service is not in isolation but for the company as a whole. So consider these auxiliary issues. To help you understand this concept better please read: Range of Production.
Summary – Fixed Assets to Debt Relationship
There are three rules for a positive outcome when using debt to finance the purchase of fixed assets.
- Rule #1 – Use proper leverage to purchase the asset.
- Rule #2 – The debt’s amortization period should not exceed 80% of the fixed asset’s expected life.
- Rule #3 – Net earnings from the asset must exceed the cost to service the debt.
By applying these rules, a business will increase net profit and cash flow ultimately increasing the wealth of the owners. 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. If interested in my help as an accountant or consultant, contact me through the ‘My Services’ page in the footer.