When deciding where to invest money in the business, are you taking the time to calculate the cost of capital or going off gut instincts alone?
While you may be able to afford the monthly payment on a new piece of equipment, you also need to ask if it is the best use of your money.
“You can end up tying up cash in something that earns four percent when that same cash deployed elsewhere in the business would have earned 20 percent,” says Andrew Trower, CPA and founder of Andrew Trower & Associates. “The mistake is invisible because nothing looks wrong on the bank statement. You simply left money on the table.”
How to Think About Capital
Trower recommends treating every dollar as if it has a job and a required return.
“Cash is not free just because it is sitting in your account,” Trower says. “The owner’s job is to keep moving each dollar toward its highest and best use, whether that is equipment, people, marketing, or paying down expensive debt.”
The cost of capital is the return you give up by using your money one way instead of another.
“For most owner-operated landscape companies it is higher than the bank’s interest rate, because money reinvested in your own crews, equipment, and growth tends to earn far more than a loan costs,” Trower says.
When calculating your cost of capital, ask the question: “When I put cash back into this business, what return do I typically get on it?”
“If a dollar invested in another truck, crew, or sales effort reliably turns into more profit, that return is your cost of capital,” Trower says. “You do not need a complex formula. A good working estimate is the return your best recent investments have actually produced. That becomes the hurdle every new decision has to clear.”
As your company grows, Trower notes the easy high-return opportunities get used up so the cost of capital comes down.
“A mature business should expect a lower hurdle than a hungry young one, which also changes how aggressively it should borrow and reinvest,” he says.
Mistakes When Calculating Cost of Capital
When you fail to consider the other possible uses of your cash on hand, you can end up buying a building outright when leasing would have freed up cash for crews and sales or overbuying equipment that sits idle half the year. Paying cash for equipment when financing was available and cheap or stockpiling cash in the bank while turning down growth are other common practices that don’t look wrong at face value, but often aren’t the highest and best use of the dollar.
Trower says one of the most common mistakes when it comes to calculating cost of capital is when owners forget to apply the principle to their own cash, not just borrowed money. This is why paying cash feels free when it’s not.
“Second, they anchor on the loan interest rate and ignore the much higher return their business can earn,” Trower says. “Third, they leave out their own time and risk. If you can earn 20 percent reinvesting in the business, then spending cash on something earning less is a loss even if no bank is involved.”
Owners can also make the mistake of confusing what’s affordable with what creates value.
“Affordable just means you can make the payment,” Trower says. “Value means the investment earns more than your cost of capital. A piece of equipment can be easily affordable and still destroy value if the cash it ties up would have earned more elsewhere. Always ask the second question, not just the first.”
When considering the cost of capital, don’t ignore the investments that may result in breaking even.
Examples of this include safety upgrades that result in fewer injuries, lower workers’ comp, and less downtime, software that allows you to scale without adding office staff or jobs you can bill for that you previously missed or a hire that pays back in capacity and margin.
“When an investment looks like a break-even on the narrow numbers, the right move is to put a reasonable figure on those second-order benefits and bring them into the calculation,” Trower says. “Most of the time they are not unmeasurable; they are just one step removed, and once you count them, the investment is often clearly worth it.”
Using Debt as a Tool
You also don’t have to limit yourself only to cash readily available. Trower says debt can become a tool for growth when the money used earns more than the loan costs, and you can comfortably cover the payments.
“It becomes a burden when payments outrun the cash the business produces,” Trower says. “The cleanest test is your debt service coverage ratio, which compares your cash flow to your loan payments. As long as that ratio stays in a healthy range, borrowing to free up cash for higher-return uses is usually smart.”
The best rule of thumb is to let your cash flow set the speed limit. Trower recommends setting a reserve you do not touch and monitoring your debt service coverage ratio.
“Inside those guardrails, lean into growth, because for most landscapers reinvesting in the business beats hoarding cash,” Trower says. “Grow as fast as your coverage and your reserves let you, and no faster.”
