Excessive Debt

If you have not already heard, the city of Detroit, Michigan is planning to default on a large portion of its debt and probably reduce pension payouts. So what is the lesson for your business?

Borrow Carefully

There are times when a business really does need to borrow to continue growing. However, there are also times when a business may borrow for the wrong reasons. In the case of Detroit and many other municipalities, commitments were likely made that far exceeded reasonable expectations of tax collections. One reason this could have happened was to avoid the current pain of reducing expenditures. In essence this is a classic case of kicking the can down the road and now there is excessive debt with little likelihood of being paid off in full.

Long-Term Debt

Long-term debt is intended to fund purchases of things that have a long useful life. When a company needs equipment that will be used to conduct activities that produce income and cash flow, long-term debt can make sense. It is important to carefully analyze whether the expected return is sufficient to cover the debt obligations. Ideally this return should be more than enough to account for returns being lower than forecast.

Short-Term Debt

Unfortunately, many companies end up with long-term debt that started out as short-term debt. A classic case is a line of credit which normally should be paid down at least once during each year. That is because the primary purpose of a line of credit is to fund an immediate need with the intention to pay the loan off from proceeds in the near future. A business that is highly seasonal may be in this situation as their cash flow fluctuates significantly during the year. However, it not uncommon to find a company that has used short-term debt for the wrong purposes. If the shortage of funds is on-going then short-term borrowing is not the solution. In this case it is more appropriate to identify areas where expenditures can be reduced. Are all of the full-time employees really needed or would part-timers be sufficient? What positions can be consolidated? Are there fixed assets that are not being utilized that can be sold? Are inventory and accounts receivable being managed carefully? Generally, there are numerous areas where costs can be reduced and cash flow enhanced.

Remember to only use short-term debt for short-term obligations and long-term debt for long-term asset purchases. This is a key to avoiding excessive debt. One other thing is to try to finance as much as you can from current cash flows. If money is set aside in anticipation of the purchase of a long-term asset it may be possible to avoid assuming more long-term debt.

If you want to know more, contact AimCFO – Contact

As always, your comments are welcomed.

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