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Debt is a tool that can be used to help facilitate growth, but often, it can be mismanaged. Purchasing vehicles, equipment, inventory, etc., on credit can quickly get away from a business owner — and problems can develop without a plan.
Here’s how to measure your business’ debt load, the differences between good and bad debt, and best practices to ensure you are properly managing debt.
GOOD DEBT, DEFINED
Common expenditures made using good debt include asset purchases that either generate cashflow or appreciate. Two of the most common types of good debt include:
⦁ Vehicle loans. Your monthly debt load will increase with each business vehicle you purchase. This can be positive, though, as it means you are growing your business. In a low-interest rate environment, purchasing vehicles becomes appropriate, as the cost of deploying that capital is cheap and therefore lowers your required rate of return.
⦁ Real estate mortgages. Following the rule that good debt consists of an asset that will appreciate, real estate traditionally falls under this category. By purchasing a building for your business, you no longer flush money down the drain with rent payments. Typically, most business owners in the pest management industry purchase a building as they near the $1 million revenue mark.
While these types of debts can be classified as good, there is such a thing as having too much good debt. See “The DSC formula,” at left.
THE CREDIT TRAP
Mismanaged debt can hurt a company regardless of how long it has been around. Bad debt typically is unsecured and often occurs due to cashflow problems. One of the most common ways to get into this situation is by not paying off your credit card(s) on a monthly basis.
Maintaining a high balance on a credit card is expensive; the interest incurred often can be more than the payments being made. If this is the case, take the following three steps to help reduce this type of debt and get out from under the stress it may cause:
- Minimize/stop credit card purchases.
- If you have multiple credit cards, develop a plan to pay off balances.
- Once your credit card debt is in a more manageable state, slowly reintroduce the card(s) with certain purchases like fuel, chemicals or meals, and focus on paying off those purchases monthly.
Like credit cards, lines of credit with an outstanding balance do not help your balance sheet. Develop a plan to pay off any outstanding balances. Treat them like loans with maturity dates.
MEASURING DEBT
If you focus primarily on your profit-and-loss statement, you may be overlooking your balance sheet. This is a common mistake that can cost you in the long run. Being able to properly calculate the financial health of your business is vital to making proper management decisions such as buying a new asset or saving money by purchasing a used one. One key financial metric that can be used to help identify your business’ financial health is the debt-service coverage ratio (again, see box at left).
If you are in a position of having more bad debt than good debt, not all is lost. If you follow the steps above to help manage bad debt and review key debt metrics regularly, your path to managing debt properly will be much easier.
The DSC formula
DSC = EBITDA/Total Principal + Interest Paid
The debt service coverage ratio (DSC) calculates how much free cash flow is being generated that is available to service the debt payments. For example, if you have annual earnings before interest, taxes, depreciation and amortization (EBITDA) of $100,000, and total principal and interest payments for debt of $50,000, your DSC would be 2x. This means that for every $1 of debt you must pay, you have $2 of free cash with which to pay it. This ratio should never be below 1x; the ideal target would be above 2x.
POST is partner for PCO Bookkeepers, an accounting and consulting firm that caters to pest management professionals throughout the United States. He can be reached at brian@pcobookkeepers.com.
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