Although the lure of refinancing and generating additional cash through a new loan during this time of super-low interest rates may be very enticing, getting your company too highly leveraged could be a very dangerous thing as we enter 2003. To keep your company safely operating next year under hypermarket pressure, stay conservative in your approach to debt.
The term leverage applies to your company’s total amount of liabilities compared with total assets. For instance, a company with $4 million in total assets, and $3 million in total liabilities (this includes trade and tax payables as well as mortgages) is considered to be 75% leveraged. If that same company’s liabilities were $3.5 million, the company would be 88% leveraged.
Bank studies have proven it is very difficult for any company to maintain financial viability, without using any outside capital, at any leverage rate over 80%. Because of this proven statistic, bankers prefer for any company’s leverage not to exceed 75% (so there is a little extra cushion). With hypermarket activity continuing to squeeze gross margins downward, and very few companies able to trim operating expenses proportionally to the margin decline, most companies are experiencing reduced cash flow. Unfortunately, it’s cash flow that pays mortgage debt. As tempting as it may be to refinance a particular property and produce temporary cash, you could be putting a band-aid over a broken bone. It may look better for a while, but you won’t have use of the limb.
To keep your company viable during this challenging time of hypermarket stress, strategically approach debt in this way:
• If current leverage rate is over 80%, reduce existing debt down to no more than 80%.
• Finance all new expenditures and new projects at 75% loan to cost.
• Lock in low fixed rates on any new debt.
• Convert any existing variable rate mortgage debt to fixed rates. (Keep short-term working capital lines, however, on variable rates providing the best blended rate scenario that doesn’t require market timing.)
• Watch out for any pre-payment penalties that can negate the effect of refinancing.
• Don’t take cash out of a property unless you know for certain the cash will be in a project that will return in excess of the loan interest rate.
Staying conservative about your debt structure today, and living within your company’s financial means during these difficult times may mean survivorship. You will be secure knowing your company can service its debt while you watch financially aggressive companies around you fall. So, now matter how seductive the lure of immediate cash from more debt is right now, don’t go there. You’ll be glad you exercised restraint.