Debt is a double-edged sword, capable of doing a lot of good, but also capable of destroying your business (or, the nation). Handle that sword with the utmost care and deliberation, not with a flippant attitude.
Do you remember the game that we used to play when we were kids? We’d sit in a circle and then we would take a potato and pass it from one kid to the next kid in a circle until the music stopped or until somebody said stop. The person holding the potato was out of the game.
According to Joel Block; some business, financial, government… debt issues work a lot like the kids’ game but, unfortunately, it’s more like a ‘hot potato’ game. In this economy, where mortgage debacles are taking down some of the big financial institutions that exist in the country, it’s all related to the concept of a ‘hot potato’. When banks make mortgage loans to consumers, they accumulate the paper that secures the mortgage money that’s been loaned.
They package it up and they sell it to larger organizations that, in turn, accumulate a portfolio for many financial institutions into giant bundles. These bundles, in turn, are sold to other investors. These investors either hold the paper or sell the paper to someone else. The paper keeps moving around and around in circles among giant investor groups. When the music stops, and loans start going bad, some investors are going to get stuck holding the bag full of potatoes.
Although the original game was played with a real potato, today there are many variations of ‘hot potato’, and no single version is the right way to play. The word ‘hot’ is the operative word in any variation, as players do not want to hold on to their ‘potato’ any longer than is possible. Variations can be created to suit most any theme and any situation…
A debt is an obligation owed by one party (debtor) to a second party (creditor); usually this refers to assets granted by creditor to debtor, but the term can also be used metaphorically to cover moral obligations and other interactions not based on economic value. Some companies and organizations use debt as a part of their overall corporate finance strategy.
A company uses various kinds of debt to finance its operations. The various types of debt can generally be categorized into: 1) secured and unsecured debt, 2) private and public debt, 3) syndicated and bilateral debt, and 4) other types of debt that display one or more of characteristics noted above. Debt allows organizations and people to do things that they would otherwise not be able, or allowed, to do.
Commonly, people in industrialized nations use it to purchase houses, cars and many other things too expensive to buy with cash on hand. Companies also use debt in many ways to leverage investment made in their assets, ‘leveraging’ the return on their equity. This leverage, the proportion of debt to equity, is considered important in determining the riskiness of an investment; the more debt per equity, the riskier.
For both companies and individuals, this increased risk can lead to poor results, as the cost of servicing the debt can grow beyond the ability to pay due to either external events (income loss) or internal difficulties (poor management). Excess in debt accumulation have been blamed for exacerbating economic problems… and these debt issues in business, financial, government… become the ‘hot potato’…
In the article Managing Business Debt by Lea Strickland writes: The debt clock is ticking up to over $16 trillion. Student loan debt (which has exceeded $1 trillion) now exceeds credit card debt (approximately $800 billion). Politicians are debating its impact and how to address it. But any way you look at things (right or left), debt is a major issue, whether it’s the national debt, student loan debt, or debt needed to finance businesses and homes.
As the country (and world) struggle to deal with debt, individual business needs access to capital, but face limited availability under tighter lending guidelines, markets. Whether you are entrepreneurs or major corporations you have one thing in common: the need to manage debt. For most organizations, debt is a necessary part of the growth equation, often used to smooth out the temporary fluctuations in cash flow. However, debt is not a solution or a fix for bad business practices, inefficient operations, or overly ambitious plans; neither, ‘build it and they will come’ or ‘spend it and figure out how to repay it later’ are sound business practices…
Debt is not about borrowing as much as you can get. Instead, it’s about wisely borrowing an amount sufficient to meet well-reasoned, planned, and temporary condition in the business… Carrying debt is usually necessary at some point in the life of a business. However, carrying debt and making payments on principal and interest means that you begin to have fewer options the larger the debt obligation becomes.
Debt must be temporary, not a crutch or long-term strategy: If you consistently borrow money against credit cards, equity lines, and on vendor terms, juggle payments and scrape by to meet payroll, then you must take hard look at the business and determine what needs to change.
If you are debt dependent, then you need to understand why. If you don’t know why, you must acknowledge that your profitability is being reduced by cost of borrowing funds. One final point: Growth is not always a good thing: Sacrilege, you say! If you are growing sales and operations, but profitability is not increasing and you are not cash positive (i.e., have cash on hand to meet current demands), then you need to take a breath and stop growing until you raise both profitability and cash flow. Growth in sales that does not include comparable growth in profitability and a move to positive cash flow does not generate adequate return on the investment being made…
In the article How much Business Debt is Appropriate? by DB writes: Some conventional wisdom suggests that businesses should only use enough debt to support growth; and in amounts that can be serviced even if revenues decline, significantly. Businesses should be continually forecasting operating revenues to help them decide the maximum amount of debt that can be carried. Once the debt limit is reached, businesses should look to equity or other types of financing to make up required difference.
Most companies that go bankrupt in tough economic times are ones where revenues and related company values declined below the principal values of the business debt. When a company’s market value declines, and the effective loan to values ratios increases to greater than 1, then that means owners no longer have equity in the company. Once owners are ‘upside-down’ in their loans and no longer have any equity in their business, they have no choice but to relinquish control to the lenders.
Most of these situations occurred because the owners took on too much business debt and could no longer service minimum monthly debt payments. To manage debt correctly, owners should understand terms and legal obligations stated in the loan documents. Terms should be analyzed as part of the company’s cash flow forecasting, and in determining appropriate amount of debt required to support business growth without increasing risk of loan default.
Business should refrain from paying debt haphazardly, and instead make payments as set out by a well crafted debt management strategy.
In the article Does ‘Good’ Debt Really Exist? by Marcia Frellick writes: Does ‘good’ debts exist anymore? Financial experts differ, but many say that in today’s economy, it’s time to reconsider how we look at some common types of debt. Traditional thinking separates debt into ‘good’ and ‘bad’. Mortgages and student loans have been considered good debt because they have fairly low-interest rates and hold the promise of a substantial long-term payoff. Auto loans and credit cards usually rate a bad debt label.
Noted personal finance author David Bach says, no. The recession, he says, taught us that ‘all debt is bad, if you can’t pay it off’. ‘For many Americans today, almost 30 to 50% of their paycheck is going just to interest payments,’ says Bach, ‘There’s been a real awakening that debt is bad’. Others say ‘good’ debt still exists, that buying a house is still a sound investment over the long-haul, and borrowing for college education is good risk; if borrowing is kept down and the education is for a profession that can pay it off…
Businesses and debt go hand in hand, particularly when they are new and need funds to get off the ground. The ubiquity of debt in business, though, can make it seem deceptively easy to handle when in fact it can be dangerous. Borrowers should have a plan for money they take, and fully understand payment terms and consequences for failure. Hoping to be able to pay it off later is not the same as knowing how it will happen.
Debt should never be a long-term strategy; ideally, it should be a temporary bridge between cash-out and cash-in. The lending industry has become a huge, nationwide game of ‘hot potato’, which worked well enough in good economic times, but as the economy has faltered we’ve started to see some of the huge problems that exist with a lot of these loans, and the so-called sub-prime mortgage crisis is looking more and more like it’s just the tip of the proverbial iceberg.
The global debt situation is getting even more precarious. The world (i.e., governments) has kicked the proverbial can down the road each time debt market threatens to revolt. The problem is that now debt problems are compounding. The global debt bubble is continuing to peak its head through the curtain and remind the world that it’s still here, and that it’s still deflating.
According to Chris Whalen; deflation is like the cancer that is progressively getting worse, and it will continue until debt is repudiated or restructured to be in line with the ability to pay… Intentions are good, but sometimes they lack common sense: For example, there was a political push by U.S. Congress to increase homeownership among all people, but no one seemed to ask; ‘Wait, what if some people cannot afford a home?’
Apparently, no one cared. Because in the insane grab for more and more volume, you can significantly enlarge pool of borrowers, if there are ‘no standards‘. For example: No down payment? We don’t care. No job? We don’t care. Bad credit? We don’t care. It’s amazing how many borrowers you can find when there are no standards and a ‘we don’t care’, attitude.
There was a widespread belief among the entire lending community that everyone was playing ‘hot potato’ game; and, if you get rid of the loan before it goes bad, it was OK. Ultimately, someone gets stuck with the ‘hot potato’, and that’s what happened; but, it continues to happen and more notably with governments…