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Debt vs. Equity and Examining Debt Structure

Debt vs. Equity and Examining Debt Structure

| February 24, 2020
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So many people – business owners and employees alike – have one crucial issue in their financial lives: debt.

Debt is a wondrous and powerful weapon in your arsenal, and yet it is often self-destructive and can tear apart relationships and your financial life.

Small business owners especially tend to carry tremendous amounts of debt (a.k.a. leverage) relative to many individuals.

We want to answer the question, what is debt? Why do so many business owners carry large burdens of debt? How should debt be used and what kind of debt should I carry?

What Is Debt? What Is Equity?

What is debt? Debt is the amount of loans a person or an entity borrows from others. You can borrow from a relative, a friend, the government, a bank, or various companies.

Unfortunately, debt is not free. There is a cost to it.

The friend, relative, or bank who put money into your company wants a return on those funds. The note will pay interest periodically to the investor. Often, both interest and principal are due back to the investor.

Many small business owners obtain debt financing early on in their business. Why? Debt is usually obtained because the owner does not have the cash necessary to begin their company and then, as it succeeds, to improve their company.

They use the funds to buy working capital, to buy equipment, and to increase the size of their labor force. The more debt your company utilizes, the higher your company is “levered.” This is where the word financial “leverage” comes from.

Think of debt and the use of leverage like a jack raising your car up – the more you jack the car up, the more pressure you are putting on the jack. If you go beyond the jack’s limit, the car will collapse on the jack. Both the jack and the car could become damaged – perhaps even permanently.

As the business grows larger, the company needs even more money and so the cycle often continues as the business owner piles on more and more debt. Is this a bad thing? Not necessarily. We address this later in the chapter.

Let’s say the owner cannot afford the debt payments because the debt is too expensive. The owner may also want to consider equity financing. Equity is the ownership of the company (i.e. owning shares in a publicly traded company).

Initially, you and your business partners are the sole owners. You get to keep all the profits. However, as revenues and profits grow, you may find that debt financing does not make sense or it costs too much and instead you decide to use equity financing. By issuing equity to other individuals or companies, you are foregoing the future benefits of being the sole owner and raking in the profits and cash flow, but it may cost significantly less in the short-term.

Whether you use debt financing or equity financing, make sure you consider the costs and benefits of each.

Examine Existing Debt Structure

Whether you are a first-time business owner or a long-time business owner, we cannot emphasize enough that you need to take a long, hard look at your existing debt structure. How do you go about this process?

First, sit down with your financial advisor – or feel free to give us a call – and outline each of your personal and company assets and liabilities. Make sure to address both.

In relation to both the company and personal finances, develop a separate balance sheet for both. As a first step, write down and document each of the assets you hold – whether it is money at the bank, your investment accounts, or personal items like gold coins and other collectibles. 

Next, determine whether or not your assets are producing or non-producing assets (see our first book in this series, Your Guide to Financial Freedom for further details on this concept). Certain accounting programs like QuickBooks can also be particularly helpful calculating the business balance sheet.

Next, write down each of your liabilities/debts. Make sure you and your financial professional know the interest rate and term of each of the liabilities. 

For example, if you have a mortgage on your home, what kind of mortgage is it? Is it a 30-year fixed mortgage? Is it a 5-year ARM? What is the interest rate on the mortgage? If it is an ARM, when would the interest potentially change? If you do not know the answers to these questions, work with your board of directors including your CPA and financial advisor to help you outline your liabilities and determine your debt.

The interest rates and types and estimated pay-off dates are not always known. These are the pitfalls that can lead to disaster. Identifying those unknown factors is important to making sure you are not walking on a field of landmines.

By the end of this process, you should have identified which debts have the highest interest rate and which debts have the lowest interest rates as well as being aware of the provisions for each. Work with your advisors to consider consolidating the debts that have high interest rates and wrap them into the debts that have low interest rates.

Be wary of credit cards.

Why? Their terms on items such as introductory interest rates and late payments can change at any time. Consider consolidating your debts with key financial institutions like a bank and make sure you involve the board of directors with these decisions.

You may also want to consider re-negotiating any unfavorable interest rate notes directly with the lender. Shop out among several different companies and come back with quotes to show the lender. Let them know what interest rates you have been able to find. Maybe they will come back with a better offer! This alone could save you tens of thousands of dollars.

Besides refinancing, the next question as you examine your assets and liabilities is whether you can sustain your current debt payments even in a downturn in your business. If suddenly business revenues and profits dropped 30 percent, could you maintain your debt payments? Would you be able to maintain your most valuable employees?

Many of us, in our optimism, put on rose-colored glasses and assume the best for our companies. This is a terrific attitude to have, but use wisdom to be prepared for the good times and the bad times. Summer and winter come often too close and too unexpectedly for many business owners. Too many business owners are not prepared for the inevitable blizzards and storms.

Make sure you review your cash flow with your advisor and, if necessary, identify areas where you can cut spending and save more. There is no doubt that this will require some short-term sacrifices.

As an additional tool, we suggest looking at your bank accounts online. Many large banks such as Bank of America and Wells Fargo will aggregate debt even with outside banks and credit cards. This can help you categorize your spending automatically without you spending hour after hour budgeting.

If you enjoy even more detail, there is also a relatively newer website called Mint.com which we suggest over your current bank. They will send you notices automatically if you exceed your budget in any category. They also let you know if there are any large transactions in your bank account or on your credit cards.

Also, we have developed a straightforward system to track your spending habits for both your business and personal accounts.

1). Open one checking account at your bank as an income account. Have all paychecks and deposits go into this account.

2). Open another checking account at the same bank as an expense account. Write all checks and pay your credit cards and bills from this account. Make sure to count ALL expenses – even one-time expenses.

To check how much you are spending, count the total amount of transfers from your income account to your expense account.

Just as importantly, ensure you are developing enough of a cash cushion in your corporate, personal, and investment accounts. For the future, you will have excess money to pay interest in case winter comes sooner than expected.

Have any questions about how to use debt and which type of debt is right for your business? Send me an email at dave@david denniston.com or keep a lookout for next week's post on types of debt leverage for more information!

Advisory services through Capital Advisory Group Advisory Services LLC and securities through United Planners Financial Services of America, a Limited Partnership. Member FINRA and SIPC. The Capital Advisory Group Advisory Services, LLC (CAG) and United Planners Financial Services are not affiliated.

The views expressed are those of the presenter and may not reflect the views of United Planners Financial Services. Material discussed is meant to provide general information and it is not to be construed as specific investment, tax, or legal advice. Individual needs vary & require consideration of your unique objectives & financial situation. Neither United Planners nor its financial professionals render legal or tax advice. Please consult with your accountant or tax advisor for specific guidance.

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