Five steps to more effective debt financing

Debt can play a pivotal role in helping to grow a business—but only if you do it right. That means financing your working capital needs with short-term debt—like operating loans and accounts payable, funding capital assets with term financing or leases, and matching repayment terms on your loans with your business’s cash flow ability.

These five steps can help you properly structure your debt most effectively:

The financial health of your business will usually dictate the type of lender that fits your business risk level. Generally, lower-risk businesses will deal with lower cost traditional or senior debt lenders, while higher-risk borrowers are more likely to pay the higher borrowing costs charged by subordinated debt, mezzanine or asset-based lenders. In all cases, be sure to work with a lender who understands your business and industry, particularly as these industry-focused lenders frequently offer better terms and pricing.

When entering into a financing agreement, borrowers are typically expected to maintain certain covenants or key ratios. If these covenants are not maintained, lenders can increase your cost of borrowing or even pull your financing. As such, it’s important to understand what can adversely affect these covenants.

Typically, lenders establish covenants in three areas:

• Working capital (current ratio) is calculated by dividing your current assets by your current liabilities and measures your business’s efficiency. It can be negatively affected by suffering business losses; using cash flow to fund expenditures; or shareholder draws that exceed the funds available after debt servicing.

• Debt servicing is the cash required to cover your debt’s principal and interest payments. This is calculated by taking your earnings before interest, depreciation and amortization (EBIDA) and dividing this by your annual payments. If you are struggling to service your debt, this may be an indication that your business is not generating enough profit or that your initial debt was improperly structured.

• Leverage (debt-to-equity ratio) is the amount of debt your business has in relation to its equity, and is calculated by dividing your total debt by your net equity. You may find yourself over-leveraged if your debt is increasing at a faster rate than your equity.

It is important to monitor your borrowing covenants on a monthly, quarterly, semi-annual or annual basis—depending on the frequency your lender sets. If you do notice that any of the required covenants are not being met, be sure to notify your lender and take corrective action. It can also help to monitor industry trends, as well as key performance indicators (KPIs), so you can more quickly determine how you are performing within your industry.

By using business plans, forecasts and/or budgets to monitor your financial performance—and updating them on a regular basis—you can make ongoing adjustments to improve revenue, reduce expenses and plan for growth. By continually managing your plan, you are able to make adjustments to the forecast in the event of a decline in your financial results—positioning you to take corrective action.  Being proactive typically increases your lenders willingness to continue working with you.

Last, but not least, aim to develop a strong relationship with your lenders so they will support you through your financial cycles; and with your business advisors, who can help you set KPIs, monitor financial performance, benchmark your company against industry norms and connect you with the right lenders.