The sage advice of your grandfather for wealth and happiness was to work hard, save your money and stay out of debt. This was a good philosophy at the turn of the century when information circulated the world in a number of days and market development was measured in years. Today, however, with the rapid change of technology, information can be instantaneously transmitted around the world in countless directions. Today's markets are developed, saturated and depleted in only a fraction of the time it used to take to simply identify past market potentials.
With the fast pace of business and markets today, businesses must be able to capitalize their business operations rapidly to meet market opportunities. The advice of save today so that you can spend tomorrow might mean that you are out of the market and out of business.The capital structure of all businesses must be well balanced between debt and equity. A good rule of thumb for most business capitalization strategies is to have two dollars of debt for every one dollar of equity. However, the common mistake in debt structuring found in most businesses is that they carry all their debt in maturities due in one year or less - in other words, short term.
Long-term debt, loans that are agreed to be repaid in terms of five to 20 years, provides one of the best sources in developing a hard-hitting capitalization strategy. The primary advantages of long-term debt are:
Improved cash flow - because payments of debt are spread over a longer period of time, the amount of the payments are lower thus freeing more cash to meet market opportunities. Reduced cost of borrowing - the up-front fees assessed on long-term debt - are low compared to the annual fees on short-term debt. For example, an SBA long-term loan usually only charges a fee of 2 percent for the whole life of a loan (five to 20 years). Compare this with an annual short-term rollover that hits you 2 percent to 6 percent in fees every year.
Strong lending institution commitment - the lending institution extends a financial commitment to the business for a guaranteed period of time despite changing financial conditions of the business or the economy.
Long-term debt's primary use is to finance long-term assets such as machinery and equipment, furniture and fixtures, and land and buildings.
Long-term debt is quite often overlooked by businesses in today's rapid pace financial climate because of the ease with which short-term debt can be obtained. This is often a critical mistake. In their haste, many businesses will finance long-term assets with short-term credit. This prevents the business from paying the loan timely from current cash flow, increases the cost of borrowing and subjects the business to the buffeting of changing economic and financial winds.
Short-term debt must be used widely. A wise use of short-term debt is to smooth out the peaks and valleys of cash demands that occur from irregular obligations. Short-term debt should be paid back quickly from on-going cash flow. Appropriate uses of short-term debt are working capital, accounts receivable and inventory financing.
It is estimated that most financial institutions have 80 percent of their business loans extended in terms of one year or less. This evidences the opportunity for most American small businesses to gain a competitive edge by implementing long-term capitalization strategies.
R. Kent Moon is the senior vice president and manager of Zions First National Bank's Small Business and Entrepreneurial Department.