How Much Debt Is Too Much Debt?
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There are few commercials on the radio that irritate me more than this one. “Don’t let your credit card company fool you into thinking you owe the full amount of your credit card debt!” Dah, of course you owe it. You consciously made a decision to purchase something (knowing what it cost) and buy it using your credit card. It’s called personal debt, and yes, you need to pay it back! That is what integrity is all about!
I understand our whole economy is built on debt, but guess what, one day it will catch up to us and it will not be a pretty picture. Many of you remember 2008 and 2009 when the stock market fell, and the economy went way south. I remember being totally shocked to hear how many of the Fortune 500 companies were in panic mode. It wasn’t because of the potential lost sales. They were panicked because of their, “unexpected inability to borrow money,” to meet payroll! Billion-dollar companies dependent on “borrowing money” to make payroll. Wow, that was an eye-opener.
Debt has serious consequences for individuals, small businesses, and corporations. Outside of the obvious additional overhead costs to the company, debt creates a false sense of profitability. Any, and all, principal repayment on debt reduces “cash flow” profitability dollar for dollar. The irony is that it does not affect the normal P/L statement from an accounting standpoint. Let me explain.
If the company has a $500 loan payment of which $100 is interest and $400 is principal, guess what shows up in the P/L statement. Right, only the $100 in interest shows up as an expense. However, from a cash flow perspective (dollars in and dollars out) the company wrote a check each month for the full $500. Where did the other $400 go? Well, pretty much off to never-never land. Sure, assets and liabilities are affected, but not the P/L statement.
Think about it this way. The company produced $1,000,000 in gross sales. They have multiple loan payments, plus money going out to pay off their line of credit, which is quite possibly maxed out. The principal portion of the loans, and line of credit repayment, total $35,000 a year. The company’s P/L statement shows a net profit of $63,000 for the year. Now 6.3% net profit isn’t great, but for many companies there would be a great deal of rejoicing with a $63,000 profit after all expenses, and salaries, had been paid. However, there is NOT $63,000 in the checkbook! Why not? Because the principal portion of the loans, and the line of credit repayment, sucked out $35,000 of what the CPA and Uncle Sam called profit. Worst yet, the company now needs to pay taxes on the “accounting” $63,000 when in reality they only made a cash flow profit of $28,000. Sound crazy? It’s not. I have worked with companies that found their entire net profit was eaten up by the principal portion of their debt repayment.
The question asked by the title of this article was “How much debt is too much debt?” The answer is quite simply, how much real profit do you want your company to make? If you want to keep what you earned…eliminate debt!
The reality is that most reading this article have at least some debt. My suggestion is quite simple. Be sure you include the full amount of the loan payment (or what you want to pay off of your line of credit) as an overhead cost just like rent and utilities. That means listing the entire loan payment, principal, and interest, as a cash flow expense. Once you know your true overhead, you will be able to set proper hourly rates to cover those costs while generating the profit you desire. The good news of including the full amount of the loan payment in your overhead is this: once the debt is paid off, the entire loan payment, principal, and interest, goes straight to the bottom line as profit. Each time a debt is paid off profitability increases…. without having to raise your hourly rate.
Debt may not be a four-letter word you think about a lot, but it’s just as destructive. Count the cost before you borrow those additional funds, no matter what the purpose. Remember, there will be another 2008–2009 in the future. The less debt you have, the better the possibly of staying in business when (not if) the next recession comes.
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Posted In: ACCA Now, Management, Money
