Debt service & Growth – Minimax Situation:
To cite an example, in mid-2003, management of Minimax believed the business cycle was due to turn for its industry in 2004. It therefore considered investing $5 million in a major expansion. It would take three years to get to effective capacity, when the project was expected to earn $1.3 million before taxes. These profits would provide coverage of almost four times the $350,000 annual interest of the 7-percent, 15-year debt alternative management was considering, which seemed adequate.
Earnings of $694,444 would be required before 40 percent taxes to generate after-tax earnings (and funds) to pay the $416,666 annual repayment of principal (which would probably not begin until the third year). Total before-tax earnings requirements to cover both interest and principal were thus about $1 million. This amount perhaps presses the ability of this project to cover its financing by 100 percent debt over an entire business cycle.
An examination of a company’s behavior during a severe cyclical downturn, such as the one Minimax experienced in 2000 and 2001, is more encouraging and points to effective management. In 2000,sales fell slightly, but cash dropped by $1 million to provide funds to operate the business (probably reflecting a run-up in receivables and inventory). An additional $210,000 in after-tax interest plus $416,666 in debt repayment to service the debt could have caused considerable strain. Earnings remained at a reasonable level, however, providing good funds generation for the business. This would have encouraged the company’s banks to extend additional short-term credit.
In 2001, when the earnings level dropped precipitously, Minimax generated some $2 million in cash. These funds, likely coming from a contraction of current assets, provided funds to prepay whatever short-term borrowing Minimax incurred in 2000 and also an adequate amount to service the new debt.
Minimax is thus a cash-hungry company that will probably have needs for net new financing in the future. Earnings from the new project will provide reasonable funds generation to service the new loan. Funds generated from the firm’s present asset base provide a further cushion. In a financial pinch, expansion might have to be curtailed to free funds for debt service.
Debt service: Does new loan help?
In periods of distress, Minimax does generate cash from its assets. Thus, in the future, more rapid response to the cycle would be helpful so a repetition of 2000 could be avoided. The cycle does not appear to be so long that the company’s average earnings would fail to support the debt over a period of several years. Provided current interest was paid, a waiver of the principal debt repayment for a short period could probably be negotiated. A lender, after all, is reluctant to force a healthy company into financial difficulty when a one or two quarter deferral of a principal repayment is all that is required while the company restructures its assets.
The loan is thus not likely to threaten the solvency of the company. Until a higher level of earnings has been sustained over a period of years, however, the risk aspects suggest there may not be room for much more permanent debt than the $5 million under consideration.
Lender’s refinance in debt service:
In summary, when you are concerned about growth of your company you should consider how the company’s cash flows respond to whatever the company’s risk events are. If the business is going well, lenders are usually willing to refinance debt so debt repayment is effectively deferred. The problem arises when business is on the downward slope of the cycle, when operating cash flows are still negative. It is in this period when the lenders may be much more reluctant to refinance maturing debt. Thus, it is in this period that the cash flows provide the limit on the funds available for debt service. These funds, in turn, put a cap on the amount of debt the company can safely take on.