Debt Done Right: Finding the Right Balance Between Growth and Profit

Debt is a term that typically has a negative connotation. It can bring to mind collection companies and possibly even bankruptcy if it is allowed to get out of hand. However, debt can be a useful tool for growing your business when utilized properly.

“‘All debt is bad debt’ is a common misconception among people in the industry who are afraid to commit to payments and are willing to grow slower,” says Quinten O’Dea, owner of Q&A Landscaping, LLC, based in Pittsburg, Pennsylvania. “While this strategy can work, it takes years longer to build a sizable business, and you will miss opportunities.”

Demystifying Debt

You may be wondering now what is considered ‘good debt.’ Olin Unruh, owner and CEO of Wetlands Irrigation, based in McPherson, Kansas, advises analyzing potential debt in terms of tangible financial return as a starting point.

“Will this debt increase value to our clients?” Unruh says. “Is there a tangible asset tied to the debt? How easily can I liquidate the asset to get rid of the debt? Unpaid taxes are always bad debt.”

O’Dea agrees that good debt is associated with assets that produce more revenue and allow the company to increase efficiency or grow service lines.

“Bad debt is any high-interest debt or debt that is taken out simply to provide relief for a cash crunch, which is really just kicking the lack of cash flow problem down the road,” O’Dea says. “Any short-term loans or quick funding options are typically bad debt unless absolutely needed.”

Andrew Trower, CPA and founder of Andrew Trower, M.B.A., C.P.A., says leverage is a valuable tool in the financial toolbox that should never be overlooked. The key is to have your debt-to-equity ratio in alignment.

“As long as your debt ratios are adequate after the new debt, and as long as the debt has a lower interest rate than your cost of capital, you will be still creating economic value even by adding additional leverage to your company,” Trower says.

What an acceptable level of debt-to-equity ratio is depends on your personal goals for your company and the level of stress you are willing to endure.

“My rule of thumb is that as long as your net profit is one and a half times your debt service, you will be fine as long as all other things stay the same,” Unruh says.

Trower says landscape companies should strive to keep their debt-to-equity ratio below 2.0.
“When the D/E ratio exceeds this amount, it is likely that the company may struggle to meet its debt obligations if profitability takes a downturn,” Trower says.

O’Dea encourages not having the yearly principal and interest payments exceed more than 5-10% of company revenue.

If you are in a good position, taking out debt with reasonable interest rates can allow you to purchase revenue-producing assets that can increase your profitability.

“I would also be willing to take out debt for a location for your business or land that will help your business since these will hold their value well and allow your business to grow,” O’Dea says.
Unruh acknowledges that any debt is a financial risk to varying degrees.

“Stress-test the assumption by having someone not invested in the decision come up with worst-case scenarios,” Unruh says.

When Debt Gets Out of Control

Unruh has experienced firsthand what a worst-case scenario with debt is like. In May 2023, the bank auditors flagged his credit line at his main bank as substandard. As a result, the bank could no longer lend any additional credit to any of Unruh’s businesses or to him personally.

“This was a huge blow to me personally and commercially and was a fact I could no longer ignore,” Unruh says. “I was now facing the very real possibility of losing the business that I had poured my heart into and having to face my team and clients and tell them I had failed them.”

He says many factors contributed to his situation, but the main two were poor growth management and lack of profitability.

“I had a grow-at-all-cost mentality and the entrepreneur’s eternal optimism that said ‘just grow/sell more and these issues will work themselves out’ while ignoring the fact that if you are not profitable, growing just causes you to lose money even faster!” Unruh says.

Trower says debt simply gets out of hand when a company becomes overleveraged or doesn’t enough income to cover the debt service.

O’Dea says it’s important to pay attention to your current debt level before adding more. He notes some owners can want to ‘keep up with the Joneses’ after seeing their competition buying new trucks and equipment.

“Grow slow and know your numbers,” O’Dea says. “Do not compare yourself to other companies and feel the need to keep up with your competitors. Do not get sucked into social media.”

Unruh agrees you should be careful about who you are comparing your company with. Instead, compare yourself to where you were a year ago.

When a company becomes overleveraged, debt can consume all the free cash available for growth. O’Dea says sometimes businesses will have to seek out short-term funding and quick capital loans to cover essentials like payroll and supplier bills.

“When debt gets out of control, companies can experience increased financial risk because it becomes more likely that they will be unable to meet their debt obligations if profitability declines,” Trower says. “Also, higher interest expenses could lead to higher payments, further limiting cash flow. Your lender(s) may be more reluctant to provide you with additional financing if you have too much debt.”

Unruh says, in his case, his outlook became very short-sighted as he was worried about making payroll on Friday or what to tell a vendor who was demanding payment.

“It makes it really difficult to do the long-term strategic planning that is critical to moving past the current situation,” Unruh says.

Metrics to Monitor

If you lack financial awareness, you should avoid adding on debt.

“If you know on at least a weekly basis what your profitability is, it is easy to correct issues before they put you out of business or require you to take out a (bad) loan to fund your operation,” Unruh says.

Aside from monitoring your debt-to-equity ratio, Trower says the Debt Service Coverage Ratio (DSCR) demonstrates whether the company can generate sufficient income to satisfy its debt obligations. You can calculate DSCR using the equation below.

DSCR = EBIT/(Total Debt Service)

EBIT = Earnings Before Interest and Taxes
Total Debt Service (TDR) = (Interest x (1-Tax Rate))+Principal

Trower says that the Total Debt Service must be adjusted to account for the deductibility at the ownership level of interest expense. Your DSCR should be at least 1.25.

O’Dea suggests monitoring your free cash flow and how it compares to the debt payments to ensure they are not taking up too much of the available cash flow.

“This would then hinder the ability to grow and invest back into the business,” O’Dea says.

Unruh says your gross profit margin (subtract material + labor from total revenue and divide by total revenue) is probably the single biggest indicator of how well your business is operating.

“In most companies, your minimum target benchmark should be 50%,” Unruh says. “In a seasonal industry, you traditionally have a limited window to make your profit for the year, so you need to have this number dialed in and review it weekly.”

Righting the Ship

The good news is that even if you find your company drowning in debt, there are still ways to correct it.

The first step is to take stock of the situation. O’Dea advises selling your lowest profit-producing assets that have positive equity to either eliminate payments or pay down debt.

In Unruh’s case, he says the mindset shift from what would be nice to what makes financial sense made a huge impact.

“Take an unemotional audit of the fixed expenses you may have (however small) that you can operate the business without and cut them out,” Unruh says. “If it doesn’t directly contribute to your bottom line, get rid of it. Sell any equipment that you use for less than 200 hours per year and rent it when needed. Analyze your product lines and cut or raise prices on any services that aren’t profitable.”

Unruh says he also turned over the cash flow management to his office manager, Stacy.

“I was terrible at this, but I thought I had to do it!” Unruh says.

Trower advises compiling a debt schedule that lists all your debts by interest rate and prioritize paying off high-interest-rate debt. You can then seek to renegotiate terms with creditors or refinance to get lower interest rates/consolidate your debt.

“Compile a 12-month budget to assist with managing cash flow and determining if profitability will cover the debt service over the next year,” Trower says.

Trower says as a last resort, filing for Chapter 11 bankruptcy allows the company to restructure their debts to create a management repayment plan while continuing operations.

If delinquent customers are part of the reason your company doesn’t have enough cash flow to pay your debts, Trower encourages owners to always evaluate the creditworthiness of clients before entering a contract.

“If you choose to finance customer debts, be sure to charge a market rate of interest to avoid losing economic value over time due to the time value of money,” Trower says.

Taking non-paying customers to small claims court can also be used as a last resort.

“Due to the informal nature of small claims, most jurisdictions allow businesses to represent themselves without an attorney,” Trower says. “You will recoup your court costs in most cases, too, with a judgment.”

O’Dea says if you wish to keep the relationship intact, you can offer to help them restructure the debt in a way that gets you more money from them over time.

Operating Debt-Free

On the other hand, it is entirely possible to operate debt-free. Trower and Unruh suggest operating this way early on, especially if the profitability is unpredictable.

“To operate successfully with leverage, you must know for certain whether you will have adequate profitability to service the debt,” Trower says. “Companies that are very cyclical, without stable profitability, may need to keep their debt very low.”

Unruh says that healthy growth without risky debt is certainly achievable.

“It does take a small amount of patience and recognizing, as Mike Andes of Augusta Lawn teaches, if you are in a growth mode or profit mode,” Unruh says. “Healthy businesses can switch between these two modes, but it should be intentional.”

Unruh says they still have debt and he is sure he’ll use it in the future. He says it’s okay to take a break from growth to focus on profitability, as profit is the gas that fuels your business.

“There is great value in having very low debt, but being afraid to have any debt would result in missed opportunities, especially with some rates on equipment being 0%,” O’Dea says.

This article was published in the Jan/Feb issue of the magazine. To read more stories from The Edge magazine, click here to subscribe to the digital edition.