This post is part of a series, “How to Boost the Value of Your Business.”
With apologies to Homer Simpson… To debt: the cause of — and solution to — all of your business problems.
This post has several parts:
- Pros and cons of using debt financing in your business
- How to evaluate if your business has high financial risk
- Action steps to boost your business value by reducing your cost of debt
Business Debt Pros
The upsides of using financial leverage in business are clear.
- It’s not your money
- Fund expansion or acquisitions
- Even out cash flow for seasonal businesses
- Lower cost of capital than equity
- Amplifies success
Business Debt Cons
The downsides of financial leverage are also clear, or should be after everything we’ve seen the past couple of years.
- You no longer control 100% of your business
- Interest rates can be raised, lines of credit dropped, covenants changed, etc.
- Often used to mask operational problems
- Reduces net cash flow and/or eventual sales proceeds to the owner
- Amplifies failure
How Leveraged Are You?
One of the most common ways to measure leverage is the debt to equity ratio. However, in recent years many tools that are more sophisticated have been developed. One of the most popular of the recent tools is the Altman Z-Score, a formula for predicting bankruptcy.
You might be surprised at what it takes to qualify as high-risk. According to the latest Duff & Phelps Risk Premium Report, nearly 25% of public companies fall into their “high financial risk” category. This includes:
- Companies in bankruptcy or liquidation
- Companies with negative 5-year average earnings
- Companies with negative book value
- Companies with debt-to-total capital of more than 80%
The average debt to market value of invested capital (MVIC is debt financing plus equity value) ratio for this high-risk group ranged from 25% to 60%. For companies in the “gray” or “distressed” zone (measured by Z-Score), average debt to MVIC was roughly 50% or more.
Does high financial leverage really make a difference? High financial risk companies pay a higher rate on debt financing. Importantly, high financial risk companies have a higher cost of equity capital (e.g. opportunity cost to the owners) in addition to higher direct financing costs.
Don’t be afraid to talk with your banker. Most bankers I know wish they were able to have candid conversations with their customers and work with them to improve their business. If you’re afraid of your banker, you might need a new financing partner or you have something to hide.
Ask your lender what it will take to eliminate personal guarantees, simplify or eliminate restrictive covenants, reduce your interest rate by 1/4 point, 1/2 point, etc. Develop a plan to meet the targets and demonstrate your ability to manage your business.
Too many business owners run from fire to fire rather than stopping to take an objective look at their operations. Doing so will improve your borrowing relationship, lower your borrowing costs, and ultimately increase the transferable value of your business.