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Can you afford to increase your business debt right now?

2020-10-29


Confidence in a continued economic recovery is growing shakier by the day as more provinces declare a second wave of COVID-19. While legislators would prefer to avoid another lockdown, they are urging consumers to limit social gatherings and non-essential activities outside the home. This is bad news for business owners whose revenues and cash flow already took a significant hit in the first quarter of 2020.

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It’s unclear how severe this next wave will be or how unemployment levels will affect consumer spending. There are also questions around creditors’ capacity to defer payments a second time and what kinds of government subsidies will become available.

The temptation of external financing

The lure of debt can be difficult to avoid even for businesses that managed to avoid payment deferrals or over-leveraging themselves during the first wave. It’s impossible to run a business without working capital. Expenses still need to be paid — even in the absence of revenue. For many business owners, the question isn’t necessarily whether to take on debt, but when and how much.

Obviously the first consideration is how to increase cash flow without external financing. Forecast how steps like selling assets, rolling back wage costs, stretching accounts payable and reducing other overhead can improve your forecast over the next 12 to 24 months.

If you’re still concerned debt in the form of bank loans or bonds may be necessary, your next step is to assess how favourable your balance sheet is to potential lenders by assessing the following ratios.

Use these three metrics as canaries in your financial coal mine

1) Debt vs. shareholder’s equity

As a rule, your total liabilities should be no greater than double what your shareholders have invested in your business. But the lower you can keep the former, the better.

How to calculate debt-to-equity ratio


Total liabilities (e.g. accounts payable, debts, taxes)
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Shareholders' equity (common shares, preferred shares, and retained earnings)

 

We’re currently navigating through an extremely high-risk period. Both lenders and investors are being extra cautious about where they put their money, so focus on getting this figure in balance now before you need to increase cashflow. 

2) Debt service coverage

At a minimum, your earnings before interest, taxes, depreciation, and amortization (EBITDA) should be equal to at least two months’ worth of interest and principal payments on your business debt.

How to calculate debt service coverage ratio


EBIDTA
-------------------------------------

Debt service costs (interest + principal)

 


The smaller this number is, the less confident lenders will be that you can pay your debts on time. Your best-case scenario as this number declines is creditors will be more hesitant to lend to you. However, this can also be a harbinger of impending creditor action if you’re not able to course correct.

3) Debt vs. assets

Ideally, you want your business debts to equal no more than 40 percent of your total assets.

How to calculate debt-to-asset ratio


Total debt
-------------------------------------

Total assets (e.g. cash in hand, machinery, real estate, inventory, etc.)

 


Fifty percent is a major tipping point here. As you trend upward from there, creditors will begin viewing your business as debt dependant and a significant credit risk. And by the time you hit 60 percent, it’s unlikely you’ll be able to secure new financing at all.

Look at all your options and their broader implications

Before calling your lender, consider speaking with a corporate recovery specialist. This is doubly true if your above ratios exceed industry standards.

Debt may provide immediate relief in the form of a cash injection, but it will not solve the underlying issues. Taking on extra leverage while facing potentially further declines in revenue also puts all the power in your creditors’ hands and could place you in an extremely compromising position. At the very least, evaluate how and whether your company can repay current debt in addition to any new advances. It’s one thing to access the financing, but it won’t do you a lot of good if you don’t have a plan to repay it.

On the other hand, being proactive to find out what options you may have to deal with your situation  keeps you in more control of how your business moves forward. If nothing else, at least do yourself the service of putting all your cards on the table before you play your hand. You may discover there’s a more sustainable solution, even if it’s not the most conventional one.

It’s important to remain optimistic we can once again flatten the curve and that a vaccine will eventually bring the pandemic to an end. But we have no idea when that will be, and we must also acknowledge there will be a long and potentially challenging winter ahead.