The Theory of Debt Relativity – D = fc x 3

formulaFor many businesses, using debt to either acquire other businesses, databases or to fund expansion activities is the only way to increase sales and profits when organic growth is just not fast enough.

The question most don’t think about is whether the proposed debt-load can be paid for comfortably or at all. In fact, for some businesses the process of actually planning and forecasting the viability of taking on more debt is either too hard or doesn’t produce the answer the business owner wanted in the first place and so it is conveniently ignored.

To help you work out some basic numbers, you might like to use the following formula to assist with your decision making.

D = fc x 3

or to expand on this:

Debt = Free Cash x 3

That is, as a rule of thumb, the amount of debt you can afford to take on is relative to the amount of free cash flow you have in your business. The multiple that appears to work best in this equation is 3. First though, lets run a quick example of what Free Cash Flow is.

Free Cash Flow can be defined as the amount of actual cash you have left over, once you have paid for all of your operations, your taxes, your loan repayments and allowed for any increases in overheads due to growth as well as capital expenditure. Did you get that?

Here is one way to work it out:

To follow our formula, the amount of Free Cash Flow available in this business x 3 is equal to

$385K x 3 = $1.155M. – The business can afford $1.1M in debt.

Why is this amount ‘safe’ for the business?

Well, here are some reasons using the numbers as a basis.

First of all, lets cover on some basic ‘bank’ requirements. Many banks will provide you with a finance approval that have financial covenants such as an “Interest Times Cover’ of between 1.5 times up to 3 times.

They will also limit your loan repayment term to one that suits the purpose of the loan and the security offered for the loan.

While you may not want to believe it, these covenants, if met, usually mean the business is in a stable and secure position with sufficient monies to repay the banks debt. Further on, you will see that our formula meets the basic criteria for bankers.

Your first priority however, should be the strength and safety of your own business. So, here are some things to think about when taking on debt.

  • Will I have enough money left after I have paid all of my commitments to reinvest into my business and grow it further?
  • Do I have enough ‘surplus’ funds available to withstand a drop in sales and profits?
  • Do I have enough surplus funds available to withstand a competitor dropping prices or somehow eating into the business?
  • Remember, circumstances change, but the amount of debt will remain the same.

Here is an example of the impact of the extra $1.15M of debt on this business.

  1. The amount of interest payable at an interest rate of 10% is $115,000 per annum.
  2. The repayments on a 10 year term are $183,156 per annum or $15,263 per month.

In this example, the bank criteria of Interest Times Cover (that is, how many times can you pay your interest with your cash) is 3.33 – which is within most covenants of 1.5 to 3.0 times.

The surplus cash available AFTER repayment of all liabilities is $201,000. This is equal to 52% of the Free Cash Flow. A healthy amount to be used to reduce debt quicker, or to reinvest in the business.

From these numbers, there are plenty of business owners and financiers that might argue the business could afford a lot more debt. In fact if the business were to remain earning the same or more Free Cash Flow over time, year on year, this could be true.

What many business owners forget is that times change. New competitors enter the arena, pricing shifts, costs of supplies increase, freight costs increase and a myriad of other variables that are not thought about at the time of taking on this new debt.

The comfort in borrowing only 3 times Free Cash Flow is in preparing for the unknown. Should a business see a dramatic drop in sales and profits, it still has sufficient surplus cash-flow to both pay it’s bills, and to mount some type of marketing campaign (if that is what is needed) in order to lift its flagging revenues.

In this example, a 30% drop in sales and profits produces Free Cash Flow of $279K versus $385K the previous year. Because the business has a debt-load of FC x 3, the business was not overloaded with commitments and still has sufficient funds to pay its loans and to reinvest into the business.

This formula is useful for determining the amount of business debt that is affordable and still allows for unforeseen circumstances impacting on the business. Of course it assumes that the business has very little debt to begin with. Either way, the formula works. If you are buying a new business, simply add the FCF of the business you are buying to the current FCF to determine your total amount available and then multiply by 3.

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