If your company’s growth strategy for the coming year includes acquisition of any existing companies, correct financing of these acquisitions can be critical to your company’s future financial success. Here’s how to put together financing that will keep your company in a healthy financial position:
1) Finance hard assets with long term debt. No matter how large the temptation, do not use a working capital line of credit to fund long term asset purchases. Sure, that’s easy. But using your line this way will destroy your current ratio (current assets divided by current liabilities) and could mean you don’t have access to quick capital when you need it.
2) Use realistic timeframes for acquisition debt payoff. The cash flow of the operations you are purchasing should dictate how quickly you can retire any acquisition debt. As a quick, general rule, total debt payments in any year (principal and interest combined) should be no more than 150% of the sum of profit, depreciation and interest expense for those same operations.
For instance, let’s assume you are buying a company that will earn $100K profit per year after $75K in depreciation. You are paying $1 million for the company and anticipate a loan of $750,000 which will have interest expense of approximately $70K per year. Using our formula, the $100K profit plus $75K depreciation plus $70K interest equals $245K. This $245K should be 150% of debt payments or $163K per year. Since we know the maximum payment, the loan amount and the interest rate, we compute the loan term to be 76 months or just over 6 years.
Paying debt more quickly could cause cash strain on other parts of the operation. If, for example, we did a three-year loan with the owner since that was the longest he would carry-back for, there wouldn’t be enough cash flow to pay back the debt.
3) Finance permanent inventory and accounts receivable increases with term loans. Many family businesses do a good job financing real estate, equipment and trucks on realistic term loan schedules, but forget about new inventory and receivables until the last minute. Since these are permanent asset increases, they too should be included in the term debt financing.
4) Avoid customer list, goodwill, or no-compete debt. This is the debt that most lenders will avoid like the plague. The truth is, there are very few times when a company is worth more than its assets. If a seller is demanding a premium for the business, consider walking away from the deal unless you already have the cash to fund the premium and know without question the customers will stay with you after your purchase.
