How much is too much debt?

Our manufacturing clients often ask “how much is too much debt?”

The simple answer is “that which begins to restrict your decisions”.

A good rule of thumb for SME manufacturers is 1/3 debt, 2/3 equity. Beyond which, decisions often do start to be affected. If you have lots of capital, you can afford to grow quickly. The cheapest form of capital is debt. So, it’s tempting to take as much debt as you can.

Yet debt comes with obligations. Debt must be repaid. With interest. And whilst observing covenants. That is to say, debt is temporary – you could even call it impatient.

It’s therefore unforgiving of underperformance, delays and/or fluctuations in performance.

So, whilst debt can be your friend, beware. Here our top 5 watch outs.

1. The mismatch of benefits against cash outflows
   • You invest in better equipment now – you get the benefits in two years’ time. But you have the repayment obligations starting today.
2. Waste
   • You borrow money, and it disappears into working capital. Let’s say in an endeavour to grow your brand. It doesn’t work, you still have the debt but no money to repay it.
3. The impact of covenants
   • You start taking decisions to maintain appearance. Unearned income slips into the P&L. Obsolete stock is not written off. Hmmm. Dodgy.
4. The repayment profile
   • You promise to pay the debt back too quickly. You thought it would be OK. Or maybe you didn’t know you could negotiate this. Or maybe the bank has suggested a portfolio of loans that suit them, but don’t quite suit you. Still, you got a ‘yes’, so don’t rock the boat, right? You should be grateful, right?
     
   • But things don’t always turn out as planned. Now your cash is draining away and its making operations harder. Yeah, the ‘amortisation’ profile of your loans is pretty important!
5. Interest and other charges
   • Just about the least important thing, but usually the thing the borrower pays most attention to. Why? We all like a bargain. We all like to think we’re getting a better deal than the next person. That we’ve won. But we suggest you get everything else right first, then negotiate terms. It works.

If you’re not sure you have the right debt to equity mix, or if you’re not sure your loans are supporting your manufacturing business, give us a call on 1300 656 141. We’ll review your situation, make the right recommendations and help you do something about it.

Talk To

Nicholas Petrakis

CLIENT DIRECTOR

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