The financial crisis of 2007 – 08 saw a lot of business owners lose their borrowing power from their “bank” the equity in their homes. The drop in value of the real estate market stopped the lending institutions from lending more “working capital,” but they still demanded payment on what was previously borrowed. The crisis was caused by individuals who borrowed large amounts on their credit cards and took out 100% loans on their homes. The economy went into a “freefall mode”, and some business owners used their credit cards or borrowed from other sources to keep their doors open. The problem was that the income generated in the business was not sufficient to carry the debt. We all know the “rest of the story”.
Fast forwarding to today, I am amazed how many businesses that started after the “crisis” or somehow survived it, have not learned the bad news about debt. It’s not just new businesses that are working out of their check books. I have seen businesses that have “survived” 10 to 20 years still following the checkbook method of accounting. Working without an active business plan and without a budget will lead, at best, to a marginal business that is constantly trying to cover its debts.
It’s important to remember that leverage carries risks for businesses. If a business is highly leveraged it can find itself unable to service the high debt levels and now face severe cash-flow problems.
My first recommendation for a business is to self-fund. If borrowed capital is justified, then I recommend that it is no greater than 25 % of the total long-term capital employed in the business. I used the word “justified”, and that requires a complete financial analysis of the business. Borrowing to grow a business does not mean that all the money will be available for product/service growth, the support system in staff, taxes, space, etc. all have to be considered and plugged into the final equation.
I am old fashioned in my budget recommendations to my clients. I work with their CPA to establish a budget that includes a mandatory reserve based on current and projected needs. Part of my job then is the enforcement, or the holding the owner or management team accountable to their budget. The “Cash is King” saying is something that I stress on a regular basis to all my clients. Plans and systems have to be adjusted to work within a budget so that cash can be saved and preserved for future unforeseen circumstances.
If you don’t have a working budget for your business, regardless of the business size, take the time now and put one together. It will save your business.
When you combine ignorance and leverage, you get some pretty interesting results. Warren Buffett
Nick J. Petra CFP