- June 24, 2020
- Posted by: Brian Post
- Category: Accounting Advice
Whether your business is just starting out or has been around for 50 years, debt is a tool that can be utilized to help facilitate growth, but it’s also a tool that can be often mismanaged. In the early stages of a pest control or lawn care business, the initial debt load can be quite extensive. The purchasing of a vehicle, equipment, inventory and much more can quickly get away from a business owner, and problems will rapidly develop if he or she doesn’t properly manage the company’s debt. Developing systems early on, such as a proper customer payment policy, will enable a business owner or manager to minimize the cash flow impacts debt can have.
Throughout my years as a consultant in the pest and lawn industries, I’ve come across several common scenarios that plague my clients as well as scenarios that have helped my clients when it comes to managing debt. In this article, I’ll discuss how to measure your business’s debt load, the differences between good and bad debt and the best practices to ensure you’re managing the most common debts properly.
There are many types of debt I consider to be good debt. Common attributes of good debt include the appreciation in value of the asset being purchased through debt or if the return on investment is greater than the interest rate associated with the debt. The most common good debt types for our industries are the following.
Vehicle notes: As you purchase more vehicles, your monthly debt load is likely to increase. This is a good thing because it means you’re adding customers, which means you are increasing the number of routes you are servicing. Recently, interest rates have been very low, which makes taking advantage of financing vehicles the most appropriate move for business owners. Low interest rates require a much lower return on investment to make it worth taking on debt. Another reason vehicle notes are typically seen as good debt is the debt is secured with the vehicle, which allows the business owner to come away close to break-even in the event of a downturn in business.
Real estate mortgages: Following the rule that good debt consists of an asset that will appreciate, real estate traditionally falls under this category. By purchasing a building for the business, you now are no longer flushing money down the drain with rent payments. Typically, I see most businesses in the pest and lawn industry purchasing a building as they near the $1 million in revenue mark. Again, the debt is secured by the asset, so it allows an owner to come out unscathed in the event that the need to sell arises.
While these types of debts can be classified as good, there is a such thing as having too much good debt. In order to understand if you fall into this category, continue reading to learn how to calculate your debt-service coverage ratio and see if you can support the level of debt you currently have.
Mismanaged debt can cripple a company regardless of how long it has been around. Most commonly, debt that would be considered bad is typically unsecured and occurs due to underlying problems. Here are the most common issues that make up bad debt on a business’s balance sheet.
Outstanding credit card debt: One of the most common bad debt issues is usually related to the inability to pay off credit card debt monthly. Maintaining a high balance on a credit card is expensive. The interest incurred can often be more than the payments being made. If this is the case for you, there are many steps you can take to help reduce this type of debt and get out from under the stress it may cause.
Step 1: Minimize/stop credit card purchases.
Step 2: If you have multiple cards, develop a plan to pay off balances. There are many strategies you can implement. You can choose from paying off the highest interest-bearing card or starting with the card that has the smallest balance. I prefer paying off the smallest balances first because paying off debt is a mental undertaking. Seeing a card paid off is what I consider a “win,” and it can help a business owner stay the course. Also, once the payments are complete on one card, rolling them over into the others creates a snowball effect and will help pay off balances faster.
Step 3: Once your credit card debt is in a more manageable state, slowly reintroduce credit cards for certain purchases like fuel, chemicals or meals, and pay off those purchases monthly. Breaking up the statement balance due over a four-week period and setting target payment amounts each of those weeks can help manage the balance month to month.
Line of credit: Like credit cards, lines of credit with an outstanding balance do not help your balance sheet and can be detrimental to company operations. Developing a plan to pay off the outstanding balance can be aided by treating it like a loan with a maturity date. Once a line of credit is under control, use it only to fill in short-term capital needs. Once you receive a large deposit after utilizing the line of credit funds, make it a habit to pay back the line.
Many small business owners focus primarily on their profit and loss statement, naturally. They often overlook the balance sheet. Being able to properly calculate the financial health of the business is vital in order to make proper management decisions, such as buying a new asset or saving money by purchasing a used one. Two key financial metrics you can use to quickly help identify your business’s financial health are the debt-service coverage ratio and the debt-to-asset ratio.
Debt-Service Coverage Ratio (DSC) = EBITDA/Total Principal + Interest Paid
The debt service coverage ratio calculates how much free cash flow your business is generating and that is available to service the debt payments. For example, if you have annual EBITDA of $100,000 and total principal and interest payments for debt of $50,000, your DSC would be 2x. This means that for every dollar of debt you must pay, you have $2 of free cash generated from operations. Ideally, this ratio should never be below 1x and the target would be over 2x.
Debt-to-Asset Ratio = (Short-Term Debt + Long-Term Debt)/Total Assets
The measurement of this ratio is what percentage of the business’s assets are financed. Having a lot of debt increases the ratio, while lower debt decreases the ratio. When assessing the ratio, below 0.5 means assets are equity financed and above 0.5 indicates assets being debt financed. A ratio of 0.4 or lower is a great target for most lawn care or pest control operators.
If you’re in a position of having more bad debt than good debt, not all is lost. If you follow the steps above to help manage bad debt and review key debt metrics regularly, your path to managing debt properly will be much easier. As always, PCO Bookkeepers and Turfbooks are here to help provide the information and trusted consultation that many owners and managers have come to trust. Give us a call today!