Like most of you reading this, I appreciate not having a lender breathing down my neck. I have never enjoyed the stress of carrying a mountain of debt. However, blindly throwing money at paying down debt because ‘debt is bad’ isn’t a sound business management strategy. This may sound odd but let me explain.
Maybe you have some extra cash laying around after wrapping up a good year? You wanna throw some of that against the debt you are carrying. Well, it might not be a good idea from a financial point of view.
Paying down debt doesn’t change your net worth. Remember, your net worth is how much money you’d have if you sold everything and paid off all your debts. It is a snapshot of an instant in time and it is always moving. Paying off debt just moves an asset (in this case cash) from the asset side of your balance sheet and cancels out a liability.
Balance sheet before paying off debt:
Balance sheet after paying off debt:
In the example above we took all the cash we had and threw it against paying off the debt. Notice the net worth didn’t change. However, this business is now in a very difficult situation. We have no money to pay our bills. Sure, the business has $1.8 million in assets, but they don’t have any cash in the bank. This business is now in a cash-flow crisis and will have to sell something to put food on the table for the family or go borrow money using their assets.
At Ranching for Profit we teach you how to use some tools to evaluate the health of the business in relation to the borrowed money.
Debt Coverage Ratio: How comfortable is this business servicing its debt with current cash flow?
Days of Working Capital: How much cash (or other assets that can easily be converted to cash) do we have relative to the money that leaves our business each day.
There are other questions that are important in the debt issue. How profitable is the business? How debt averse or risk accepting is ownership? How variable is our income and expenses from year to year?
Many of our clients are pretty averse to carrying debt. I get it. I’d rather not owe people money either, but most healthy businesses carry some debt. Blindly throwing money at paying down debt can put you in a bind. Having a healthy amount of cash on hand can put you in a position to seize opportunities or weather a bad spell.
At Ranching for Profit we improve the financial aptitude of our clients. In our school, we give participants multiple case-study ranches where you calculate the profit and loss of the ranch and produce a clear, easy to read profit and loss statement by enterprise. We then help you produce a simple balance sheet for that ranch and calculate key ratios from these two documents. Our goal with these exercises is for participants to lay these two documents side-by-side and be able to quickly read the vital signs of the business. Is this business healthy? Where are the stress points? What can be done to fix the unhealthy areas or prevent future problems? Paying down debt can sometimes be an appropriate use of profit, but it can also cause problems when not implemented in a balanced approach.
For over 40 years Ranching for Profit has been the go-to source for business management in the ranching business. Whether you have a MBA or have never looked at a balance sheet we are excited to help you increase your skill set in your business management game. Visit our schedule page to find upcoming Ranching for Profit Schools and workshops near you, let’s work together to build the business skills that will move your operation forward!
