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I Hate Debt! Should I Pay It Off?

Posted on August 14th, 2017

Jack Kern
Owner, President
Outsourced Accounting Department, Inc.

Of course you hate being in debt.  Who really likes it?  But in business, sometimes it’s appropriate to borrow money to purchase equipment that will increase revenues or lower costs, and thus, produce greater profits; or, to borrow money to finance sales growth, and again, increase profits (“The Effect of Sales Growth on Cash Flow“). So you’ve gone ahead and incurred the loan.

But now you’re eyeballing those monthly payments, and worse, the amount of interest you’re paying over time.  You’ve got some surplus cash sitting around and you’re thinking about paying off the loan, and wondering, “Should I, or shouldn’t I.? What is my risk if I do this?”

A client came to me recently and asked me this very question, which in her case was loan on a vehicle. My initial response was, “Well, coincidentally, I wrote an article just recently on “The Effect of Funding Fixed Assets Out of Cash Flow,” and suggested they first read this article (the underlying premise of which is the importance of funding fixed assets with long-term sources of funds). They did, and then asked, OK should WE do it?”

In order to answer this question, you cannot merely look at what’s in your checking account today, you have to look further down the road at your future cash needs, and the potential consequences of paying off the loan in question. Here’s an example of what can happen:

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Note first on the Projected Income Statement that this business IS projected to be profitable, showing a projected Net Income Before Taxes of $324,000 for the year. Next look at the Monthly Cash Flow Statement under the month of July when they forecast paying off this loan. And finally, look at the immediate cash “over-advance” below.

The over-advance occurred because first of all, its  short-term line of credit is structured to fund short-term uses of funds, namely, accounts receivable and inventory, and the credit line’s use is restricted by the lender to this type of funding need (i.e., sales growth). The over-advance in this case thus represents the amount of long-term financing required to pay off the equipment loan, and if not from this equipment loan, then from the owner’s personal funds (Larry’s Fairy Godmother Strategies, Inc.).

Then, looking further down the road, note how long the funding requirement continues. If the lender won’t provide this financing under its line (meaning carry the over-advance), and the business owner doesn’t have the cash personally, then the most likely scenario is that the company will be forced to postpone payments on accounts payable causing his or her suppliers to become severely past due, or in other words, use short-term financing to support a long-term funding requirement.

For the above reason, in most cases, paying off long-term debt like this simply does not work, unless there are some unique circumstances in your business that enable you to do it. The latter was the case with my client.  They had a very strong cash flow due to their industry practice of requiring customer deposits up front, and the loan they wanted to pay off was relatively small. But we did a cash flow forecast just to be sure they weren’t putting themselves in a predicament like that of the sample company above.

Related Articles:

The Effect on Cash Flow of Slowing Payments on Accounts Payable

Larry’s Funding Strategies, Inc.

Larry’s Exit Strategies, Inc.

Financial Planning, or Business Turnaround – Your Choice

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