Debt Isn’t a Four-Letter Word; It’s Part of a Healthy Balance Sheet

Debt structure

Small business balance sheets need to reflect a healthy debt structure. Is your debt appropriated correctly?

As advisors to small businesses, bankers will regularly evaluate balance sheets as an important indicator of the health and vitality of a business. A good banker will be well versed in standard benchmark balance sheet ratios for specific industries as a guideline for assessing stability of an individual business. Experienced bankers will also  monitor trends of key balance sheet ratios as indicators of improving or declining health of a business as a component of the credit underwriting due diligence process.

Here’s a pop quiz regarding balance sheet health: What’s better to have on a balance sheet: A) short-term debt, or B) long-term debt?

If you answered either A or B you were wrong – the correct answer is: It depends. Debt is a financing instrument whose form is driven by the needs the business has, and the timing surrounding those needs. Good debt decisions, like any important financial decisions, should be made in the context of an open evaluation of the situation the business is in, which includes the snapshot of where they currently are, and the expectations of the road ahead.

Debt decisions should always start with an evaluation of the current balance sheet, cash flow statement, and profit & loss statement. All three statements are utilized for the five key elements assessed during the bank’s credit underwriting due diligence process. These elements are: character (integrity), capacity (sufficient cash flow to service the obligation), capital (net worth), collateral (assets to secure the debt), and conditions (of the borrower and overall economy). The balance sheet is used to understand and analyze capital and collateral position to determine an appropriate credit decision.

So, when it comes to properly using debt, what kind of advice should you expect to hear from your banker? The best advice starts with fully understanding the purpose (why use debt?), the use of the proceeds (where is the money going?), and the duration of the need.

As an example, imagine a profitable manufacturing company with a healthy balance sheet has  identified a need to upgrade equipment to improve productivity (reduce costs). Typically the bank’s standard lending policy will allow the business to finance this over the useful life of the equipment, up to a seven-year payback. Other factors considered would be the positive financial impact expected from this equipment upgrade and available historical & future cashflow to repay the debt. Business owners will demonstrate this by providing profit & loss and cash flow projections. A good banker will assess all the facts and make financing recommendations that meet the specific needs of the borrower. In some cases, it may be advantageous for the business owner to utilize creative financing programs, such as local revolving loan funds or the Small Business Administration (SBA) program to enhance their financing options.

Now consider another manufacturer that wants to expand their product offerings and his company will need additional working capital availability to produce an ample inventory supply to properly introduce it to their distributor network. In this case a short-term loan is the right debt approach, because the increased inventory levels are not intended to be permanent, and the working capital should be back to normal in less than a year.

In some cases, longer term debt structure is appropriate as the new product offering results in need to maintain higher levels of inventory. A good banker will make the proper debt financing recommendations upon analyzing facts and information provided by the business owner.

Experienced bankers and business owners understand the importance of the Balance Sheet. Income Statements often get the most attention because they show Net Profit/Loss, but the Balance Sheet has critical information that will ultimately illustrate the health and stability of the business.