Current or Long-Term Debt

There are many ways for a company to get into financial difficulties. One that is very common is misuse of debt. In a past blog, the risk of allowing accounts receivable to become overdue was discussed (see 3 Reasons Past Due Receivables May be Worthless). Also, in the blog posting 80/20 Rule for Receivables Management a way to help manage receivables was discussed. Another leading cause of financial distress is the mismanagement of inventory. See 3 Low Cost Sources of Cash – Part 1 for an example of the impact of this.

The problems of excess receivables and inventory are relatively easy to understand. But, the misuse of debt is a little more hidden.

What Kind of Credit Problem?

When people think of credit problems they are normally thinking in terms of not being able to obtain sufficient credit. While that can certainly be true, it often is the result of other underlying problems.

For example, many companies have a line of credit that is intended to meet fluctuating cash needs due to such things as seasonality of a business. It is generally expected that this will be paid down completely at least once during each year. When this does not happen, the loan becomes what is commonly referred to as an evergreen loan and the bank or other financer gets concerned about the company’s ability to meet its obligations. This can cause a tightening of credit. Like receivables and inventory, this is fairly straight forward and easy to comprehend.

The credit problems that are not so clearly obvious involve current or long-term debt. Issues arising from this tend to be a little less obvious and prone to sneak up on us.

Short-Term Credit

Short-term credit is used to make purchases of such things as inventory, rent, supplies, repairs, or anything that is expected to be used within a year. Some things, like rent or supplies, are used almost immediately or within a month or two. Since these things will likely be needed again soon, it is important that these debts be paid within a month or just a little longer. It is best to stay within a vendor’s credit terms to avoid having your account placed on hold and also to take advantage of early payment discounts. However, it is not unusual to find that a company is not paying in time.

Some companies take so long that they still owe for inventory that was purchased well over a year ago. In essence, they have let a current debt become long-term. This can happen because they are carrying too much inventory or failing to collect receivables on sales in a timely manner. Ideally inventory can be sold quickly enough to keep inventory levels low and allow the company to pay for inventory as it comes due. But, if a company is carrying say an eight months supply of inventory, it is highly unlikely that enough will be collected from sales to pay on time. This is a situation where many companies misuse a line of credit to pay for what should have been funded with sales, thus creating another problem.

Long-Term Credit

Long-term credit should be used to finance the purchase of assets that have a useful life of more than a year, typically three years or more. Included are such things as land, buildings, leasehold improvements, furniture and fixtures, manufacturing and warehouse equipment, and data processing equipment. This is commonly financed with the belief that some of the profits of the business will be used to pay these debts as they come due. This makes complete sense as these purchases are used in the business over a long period of time, as opposed to something like inventory that should be used quickly.

Problems arise when a company allows debt for purchases of things that should be used within a year or less (usually a month to three months) to become long-term debt. For example, if inventory is purchased one month and sold the next month, it is expected that some of the sales proceeds would be used to pay the obligation for the inventory purchases. If not, the debt becomes past due and can eventually become long-term debt owed for something used long ago.

Problems can also occur when a company over commits and purchases too much in the way of fixed assets. If sales do not materialize as expected, there is a strong likelihood that they will be unable to pay this when it is due.

The bottom line is to carefully manage all purchases, use current or long-term debt appropriately, and have good cash flow forecasting with built in buffers in case the forecast is incorrect.

Take a look at your company’s balance sheet and see if you are making purchases with the right kind of debt.

If you want to know more, contact AimCFO – Contact

As always, your comments are welcomed.

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