by Dustin Siggins
When the pandemic hit America, 74% of small businesses took on debt to offset COVID-related losses.
Much of this debt came through the Small Business Administration’s (SBA) 14 million-plus loans approved by Congress, while other debt was secured through personal collateral. A Fall 2020 Federal Reserve survey found the number of businesses with $100,000 or more in debt “rose from 31% to 44% in 2020.”
Some of this debt may be forgiven by the SBA, but what isn’t will act as a hidden land mine for small businesses. Companies with debt often have limited financial flexibility, must put repayment — often with interest — ahead of critical business operational expenses, and frequently, will not secure the most favorable terms and conditions for major capital purchases.
Despite these weaknesses, debt was popular even before the pandemic.
The 2020 Federal Reserve survey found that 71% of small businesses held debt in 2019, and nearly half in a 2018 Federal Reserve survey took on more debt than in 2017.
With the pandemic increasingly in the rear-view mirror, small businesses should also put unwise debt behind them by:
- Reducing unnecessary expenses to increase cash on hand to repay debt
- Streamlining operations to improve cash on hand and increase net profit to accelerate debt repayment
- Using newfound savings to make investments with long-term dividends
Reduce unnecessary expenses
The first harm of debt is that each monthly payment cuts into a company’s cash on hand. With more cash on hand, you can make everyday purchases, absorb surprise expenses and get favorable terms and prices when making capital purchases. Companies with high debt have none of these advantages — sending many further into debt just to get through the day, week or month.
The simplest way to increase cash on hand is to cut unnecessary expenditures.
As Jim Collins lays out in his classic Good to Great: Why Some Companies Make The Leap And Others Don’t:
- Wells Fargo eliminated expensive items, including their corporate jet, elevator and even the executive dining room. They replaced the latter with “a college dorm food-service caterer,” and CEO Carl Reichardt, who attended meetings “in a beat-up old chair with the stuffing hanging out.”
- In contrast, Bank of America kept their corporate jet, elevators and fancy “Oriental rugs… [beneath] floor-to-ceiling windows.”
For a small business, personal and business expenditures aren’t normally as extravagant as seen in national corporations — but they frequently play more significant roles in improving cash on hand. Low-hanging fruit can be business and golf club memberships that don’t drive revenue, expensive office locations rather than more affordable ones and modest executive compensation instead of large salaries.
Always keep the law of diminishing marginal return in mind when cutting expenses.
Streamlining operations often separates the wheat from the chaff. Part of the reason Southwest Airlines was profitable for 47 straight years was that it flies only one type of plane — streamlining training, maintenance, swapping out planes and getting deals from its plane supplier. It has also largely avoided the traditional airline hub-and-spoke model of flight patterns, keeping its planes more profitable and getting customers from airport to airport more quickly.
Dan Hoare, a logistics specialist who has worked for federal agencies and federal contractors, told Zenger News one of his past employers saved thousands per year by streamlining its off-site record storage process.
“Our vendor charged by both the number of trips made to our office site and by the number of boxes transported per trip. We streamlined the process by having four departments coordinate same-day pickups instead of each department ordering pickups at separate times,” said Hoare.
Other examples of streamlined operations include:
- Purchasing product in bulk from a large vendor that delivers on-time instead of small purchases from a local, more expensive vendor with an unreliable delivery schedule.
- Outsourcing critical, infrequent work to specialized professionals like accountants, attorneys and HR firms instead of paying salaries and benefits to staff who may not be as skilled.
- Increasing the number of sales and other meetings done remotely instead of in-person to save travel costs, up employee productivity and enhance morale.
One critical part of company operations is client payment systems. The best payment systems require payment in advance as work progresses. The worst ones put you at risk at each step of the transaction.
Federal contractors are often victims of poor payment systems, normally waiting 30, 45 or even 60 days after services are completed to be paid by the government. This often puts them deep in debt and decreases their ability to scale borrowing more. Any financial hiccup can become an emergency.
The same challenge exists for any company that has a delayed invoicing process, defers receivables as federal contractors must, or pays out for product orders before receiving customer payments.
“Payments in arrears is one of the most challenging factors for small businesses to overcome,” said pricing consultant Susan Trivers. “It is perhaps the factor most responsible for poor cash on hand.”
Some companies use streamlined operations to overcome payment process challenges.
Velocity Automotive Solutions Vice President James Boening said he makes this a priority for employee training because his industry regularly struggles with being paid in arrears. “When a car is sold through a lender, dealers sign a contract with the lender to put our cash on the line until the contract is funded through the loan,” he said. “This can take hours or days — and for larger dealerships, there could be $10 million in what we call ‘contracts in transit.’”
“Having an efficient operation to minimize this risk is critical,” said Boening. “A mismanaged ‘contracts in transit’ operation can and does put a dealer out of business.”
Pay off debt and invest in the future
Except in rare cases, debt is money spent on past decisions instead of money spent on investments in the future. Once debt has been eliminated, and company savings are adequate to survive hiccups, slow seasons and economic downturns, it’s time to invest in a debt-free, growth-oriented strategy. Valuable investments may include:
Technology and other infrastructure to increase operational efficiency.
- Hospitals that invest in better charting technologies reduce patient errors and save staff untold time compared to older, more complex and less reliable technologies.
- Home service companies with better vehicles spend less on maintenance and gas, while increasing staff safety.
Hiring more of the right people and paying them more than the competition.
- Staff with the right personalities and passion will create a high-morale company culture.
- Back-end staff will create in-house efficiencies that will increase productivity and decrease costs.
- Customer-facing staff will build great client relationships and find ways to add more value to those clients, thereby increasing both gross and net revenues.
- That saves time, money and other costs of hiring, training and firing the wrong people.
Increased marketing and branding to reach target markets more often.
- Potential customers need to be reached four to seven times to consider entering your sales funnel.
- Invest in branding and marketing messages that differ from the competition — like GEICO and the gecko vs. a simple insurance ad.
- What new ways can you reach target markets with your cash on hand — such as event sponsorships or influencer endorsements?
Improved market research. What new ways can you serve target markets to increase the value of contracts, fill in seasonal slow times, and expand your brand’s flywheel?
The one time to use debt
Debt should never be used to pay off old debt or cover short-term cash-flow problems. These are core problems solved by rethinking a company’s entire operation: cutting spending and improving efficiencies. Otherwise, it can kill your business over time.
The rare circumstance where going into debt can be a good idea is when it is explicitly focused on significant growth. Many federal government contractors use debt to hire staff and purchase product to fulfill a large contract they can’t handle with cash on hand.
One home services company used its debt-free past as powerful leverage to secure excellent terms for a large six-figure line of credit. The owners needed to build a large facility, which their 7-year-old company would not outgrow, so they contacted several lenders. The company’s resume includes commercial real estate, a modest fleet of trucks, and impressive bank accounts — a balance sheet with all the right stuff, including a zero in the debt column.
What happened next shows the power of going debt-free:
- The company’s existing bank outbid the competition.
- Three separate divisions within that bank underbid each other to have rights to the line of credit.
- The company’s line of credit was secured at a 2.8% interest — about 35% the interest rate of a normal line of credit in the company’s requested range.
- The contract arrangement includes zero closing fees, no prepayment fees and no transition fees.
The owners’ debt-free leadership saved the company more than $30,000 in fees and ensured that total owner involvement in the contract negotiations was less than an hour. By staying debt-free until debt could help the company strategically scale for the long-term, the owners created favorable circumstances which created the best opportunity for growth.
Debt-free is the goal
Millions of small businesses went into debt in 2020 to survive the pandemic. However, many of those companies were already in debt, which means they weren’t ready for an unexpected downturn. When the economy went south, so did their ability to be flexible and dynamic — their lenders had to come before the company.
Business debt, especially with interest on top of borrowed money, is a drag on growth in good times and an anchor on company survival in bad. As the economy bounces back, debt-laden business strategies should be left behind.