Business Intel: Strategizing your Debt Instruments– May 20, 2020 by Rudy Barry

In this installment of our “Business Intel” series — helping you monitor, understand and maximize your organization’s liquidity and cash management processes — we provide insights on how to make your debt instruments work for you.


As we continue to face disruption while making our way through the COVID-19 pandemic, cash needs have become more and more important. The hardships organizations are now facing, including lost revenue and poor trading conditions, are putting pressure on working capital and liquidity. In addition to other strategies we’ve provided in the “Business Intel” series, another fundamental driver in supplementing liquidity and working capital relates to debt and financing.

Debt can either support an organization during an economic downturn, helping to accelerate growth, or debt can leave an organization swimming in deep waters if not approached properly. This fine line depends on understanding business debt and healthy loan practices. Further, it is imperative for an organization to distinguish between healthy debt, which helps accomplish goals and activates growth to build business, and bad debt, which is money an organization spends without an understanding how it will directly impact the business.

To examine these strategic organization debt related concepts further, let’s first look at the different types of debt and then transition to how investors use leverage ratios to gauge financial health.
The three different types of debt we will be discussing are supplier debt, bank debt and mezzanine debt.

>> Read “Business Intel: 4 Areas of Your Balance Sheet That Could Be Hidden Sources of Capital”

1. Supplier Debt

One form of debt organizations often fail to notice is supplier debt. In a roundabout way, your organization has the ability to treat the supplier debt as if it were bank debt. Your organization is borrowing money from the supplier in a sense that there are terms that state the time between when you receive the goods and when payment is due. On a larger scale, the in-between period can equate up to millions of dollars that you may be able to use elsewhere in your business for an extra 30 to 60 days. As we discussed in last week’s blog, many organizations try to extend payables as long as possible. Although there is no cost, e.g. interest, to this form of debt, there is a potential risk in deteriorating the relationship between you and the vendor by abusing the terms of payment.

Maintaining a healthy relationship with suppliers while navigating an economic crisis will prove to be challenging. First and foremost, once you see your cash diminishing and before bills are past due, begin to open the lines of communication with your creditors. Being transparent with your suppliers will increase your chances of receiving some sort of relief during the downturn. Forms of relief include extending payments of current bills, short-term reductions, or even trading goods/services on a barter exchange instead of cash payment.

2. Bank Debt

Forms of bank debt range from unsecured credit cards with higher-interest rates, short-term commercial loans for one to three years, lines of credit or longer-term commercial loans generally secured with some form of collateral.

A line of credit offers more flexibility to a customer compared to an installment loan. A line of credit allows the borrower to access funds when they are needed, providing the freedom to draw from the line and repay as frequently as they please. Whereas, an installment loan provides its proceeds to the borrower in a lump sum once the loan application is approved.

A recent Forbes article, “Impact of COVID-19 on Lines of Credit,” discusses the effects the COVID-19 pandemic is having on lines of credit for small businesses. Banks know businesses will frequently use lines of credit during an economic crisis to merely cover ongoing operations, so they’ve adjusted their policies to provide financial support and relief to their customers. Various methods of relief include deferring payments, reducing interest rates, waiving late fees and increasing credit lines.

3. Mezzanine Debt

Mezzanine debt is a hybrid between debt and equity financing. This type of debt does not require a form of collateral and often has the highest risk. A mezzanine lender is generally a private equity investor or a group of investors. The risk is due to the loan being unsecured and the fact that it’s subordinate to other secured debt the organization may be using. In other words, if an organization defaults, the mezzanine debt is only repaid after all senior obligations have been accounted for.
 
Similarly to the disarray in the credit markets and the scarcity of capital during the previous recession, or other times when the credit environment experienced some sort of disruption, mezzanine investors could again find themselves extremely useful. As the economy maneuvers through this downturn and as sources of capital begin to thin out, mezzanine capital will remain available as an investment vehicle to help you maintain your organization’s operations.

Using Leverage Ratios to Gauge Financial Health
Banks and investors use leverage ratios to get an idea of how sustainable an organization’s borrowing practices are and to separate healthy borrowers from organizations drowning in debt.

Debt to Equity Ratio
The debt to equity ratio is calculated by taking total liabilities divided by total shareholders’ equity. This ratio measures the degree to which an organization’s shareholder equity covers all outstanding debts in the event of a revenue downturn. The higher the ratio, the less risk an organization is assuming, as it can easily service its debt obligations through cash flow. On the other hand, the lower the ratio, the more risk an organization assumes because it is less capable of covering debt obligations.

Interest Coverage Ratio
The interest coverage ratio is calculated by taking earnings before interest and taxes (EBIT) divided by the total amount of interest expense on all of an organization’s outstanding debts. Simply put, the value speaks to how many times the organization can pay its interest expense obligations using only its earnings. Similar to the debt to equity ratio, the higher the interest coverage ratio the better. A ratio above one indicates the organization can cover its current interest payment obligations. Whereas, a ratio below one indicates a company cannot meet its current interest payment obligations and, therefore, is at risk of bankruptcy.

The above ratios on a standalone basis will only provide a limited scope of an organization’s borrowing habits; these ratios used collectively will provide a more appropriate conclusion.


All things considered, determining the amount of debt that best suits your organization is a challenging task. Too much debt will take away from revenue, meaning an organization may not be able to make its interest payments, and establish the potential danger of bankruptcy. However, an organization that does not use debt capabilities may miss out on significant growth opportunities.

As we continue to stress, managing cash flows takes many considerations, and the best way for an organization to withstand an economic crisis is by having reliable sources of working capital.

>> Download our PowerBI Liquidity Dashboard to help get control of your finances during these unprecedented times and continuously monitor the health of your organization.

Contact Rudy Barry at rbarry@cohenconsulting.com, Mary Washburn at mwashburn@cohenconsulting.com or a member of your service team to discuss this topic further.


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Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.