December 16, 2020
When it comes to household financial management, most people avoid debt like the plague. But when it comes to running your independent pharmacy, an aversion to debt can actually hold you back.
“In a business environment, debt can be a really important tool,” said Joe Knight, co-owner of the Business Literacy Institute, and author of the book Financial Intelligence with Karen Berman.
David Worrell, partner and CFO at Fuse Financial Partners and author of The Entrepreneur’s Guide to Financial Statements, argues that most small businesses should take on debt. “You can certainly have too much, but you can also have too little,” Worrell said. “That means you are not growing as fast as you could.”
From taking out an installment loan for new robotics to maintaining a line of credit to help with cash flow, well-managed debt can keep your independent pharmacy running smoothly and efficiently.
If you want to grow a business, you’re going to have to spend some money. “The more you grow, the more employees you take on, the more space you need. All of that is limited by the amount of cash you have to support the business,” Worrell said.
In business, there are only two kinds of money: debt and equity. Equity is money that you can pull out of your pocket, while debt is money that you borrow from someone else. “There’s a principle developed by Hewlett Packard in the 1950s that says you can only grow as fast as you can finance your growth. But you have to finance that growth by injecting more equity or borrowing more money,” Worrell said.
Many small businesses don’t have the equity to invest in growth opportunities while also meeting expenses. For those businesses, borrowing is their next option. But even if they do have the equity to fund it themselves, debt could still be a better choice than dipping into their cash. You could spend $30,000 all at once to buy a new delivery vehicle upfront, or you could take out a loan and spread the cash around to other investments that would keep your pharmacy growing. Knight explained, “One of the benefits of debt is that if you’re making a higher margin of return than the interest rate on your debt, borrowing can increase your rate of return. That’s financial leverage.”
“Let’s say you want to start a business, and you have to come up with $1,000. In the first year, that business does $100 of revenue and costs are $80. So you make $20 of profit.
Now let’s say you have an opportunity to invest in two companies at $1,000 each and they both make $20 return. You only have $1,000. So at this level, if you take $500 and put it in one business and $500 to put in another similar business, and you borrow the other $500 for each investment from a bank at 10% interest, the new income statement that has $500 invested and $500 in debt, and your income statement is $80 of costs, and then you had to pay the $5 interest on the debt at 10%, you’ve still made $15. So you’ve made $30 with the same $1,000 as in the first scenario. That $1,000 returns $20 with no debt and $30 with debt.” – Joe Knight
Another alternative to funding growth is seeking an investment, but with that approach you end up giving up more than you gain.
For most pharmacy owners, borrowing money from a bank is a much cheaper option to finance growth. Worrell explained, “If you come to me and say, ‘I want a million dollars, and I don’t want to take on debt,’ I would say ‘Great, I’ll give you a million dollars, but I want 50 percent of your business forever.’ ” On the other hand, if you ask a bank for a $1 million loan, instead of taking half your business, you only have to pay them a small amount of interest on the loan.
Though Worrell points out that “there are as many flavors of loans as there are for ice cream,” business debt breaks down into two essential kinds: secured and unsecured.
A secured loan is used to pay for a concrete piece of property, and that piece of property serves as collateral for the loan. Use this type of loan to purchase capital equipment for your pharmacy, like a delivery vehicle, a building, furnishings, or robotics technology that helps you automate. “You’re borrowing against your equipment and using debt to pay for it, which leverages your business. Especially now, when interest rates are relatively low, financing equipment is well worth it in order to keep cash in your business,” Knight said.
Unsecured loans don’t have a tangible piece of collateral associated with them, and they’re backed only by the faith your financial institution has in you to pay them back. Your credit card or a line of credit are examples of unsecured loans.
Both have a place in running your pharmacy. Knight explains that a revolving credit line can be an invaluable tool for managing the day-to-day cash flow of a small business. “The products you sell, you can’t collect on immediately,” he said. While you’re waiting for reimbursements, you can dip into your credit line for when you need working capital. “Banks will offer credit lines as long as you have the assets to back it up.”
Banks will let pharmacies borrow a line of credit based on their inventory as long as they can verify the inventory actually exists.
Knight explained, “Then as you sell that inventory off, you collect the money and you have cash to pay down that debt.”
Having a line of credit can keep pharmacies afloat during temporary lean times, but it’s crucial that they not wait for cash flow troubles to pop up before applying for revolving credit. “When you’re out of cash it’s the wrong time to negotiate for a credit line. The bank will tell you to go home,” Knight said. “What you need to do is plan for a credit line early on. Get projections and work with someone who can do an analysis and tell you that if you grow to this level, you’re going to need this kind of line of credit.”
While unsecured debt can provide important working capital for your pharmacy, Worrell warned, “That’s the dangerous kind of loan, because you aren’t investing in something specific. A lot of people run up unsecured debt and end up upside-down.”
In Knight’s eyes, one of the biggest mistakes independent pharmacies can make is refusing to take on any debt at all. “You limit your growth when you don’t finance your business,” he said. “If there was some piece of capital equipment that could be used to make the pharmacy more efficient, and the owner is reticent to take on debt even though they have good cash flow, that business won’t grow.”
While there are a lot of people and organizations willing to offer financing to small businesses, that doesn’t mean they are offering a good deal. One pitfall some business owners fall into is taking on higher-interest debt with unfavorable terms. “Companies can get put in a situation where they have a debt burden that can actually put them out of business,” Knight said. Especially if business is cyclical with periods of high and low cash flow, an extended period of lower cash flow can end up being a death sentence.
“During the COVID crisis, there have been a lot of businesses whose loans have gone bad because they overextended their debt, and when business dropped, they couldn’t service that debt,” Knight said.
Worrell recommends that owners comparison shop for terms to make sure they are getting the best deal. “Some people put long- term big purchases on a credit card, and then they have $50,000 on a card that charges 24 percent interest when they could have gone down the street to the bank and gotten $50,000 on a five-year note at 4 percent interest,” he said. “It pays to shop around for the right kind of loan.”
Owners should also match the term of the debt to the lifetime of the asset. “You don’t use a 30-year mortgage for next week’s payroll,” Worrell said. “You want to match the length of the loan with the usefulness of what you’re doing with that money.”
And when it comes to buying technology that is going to become obsolete, Worrell recommended not taking out a loan at all and renting the tech instead so you can upgrade to the newest version when it comes out instead of being stuck with an older version.
The biggest risk of debt is that you acquire so much that you can no longer pay it. Even if you don’t default, if you take on too much debt, it won’t ease your cash flow, it will restrict it. “Once you can’t pay your rent or payroll because of loan payments, that’s when you get in trouble,” Worrell said. Even if your entire business isn’t forced into bankruptcy, “If you default, someone is going to come knocking on your door looking to take your collateral. If your collateral is the building you occupy, it’s no fun when someone takes that back from you.”
Here are a few rules of thumb used by banks and financial institutions to determine how much debt a business can take on.
The coverage ratio is a formula that banks and financial institutions use to measure a business’s ability to pay the interest they would owe on a loan. A higher ratio is better, as it indicates a business has enough money to satisfy the interest on its debts. It’s calculated using this formula:
Coverage Ratio = Earnings Before Interest and Taxes / Interest Expense
The quick ratio is a measure of liquidity, sometimes known as an acid test. It shows whether you have enough assets to cover your liabilities, like debt. A quick ratio less than 1 signals that a business doesn’t have enough liquid assets to cover its liabilities, while a quick ratio greater than 1 means they are equipped to handle their commitments. Here’s how to calculate it:
Quick Ratio = Total Assets / Total Liabilities
Some financial institutions use your cash flow to determine how much they are willing to loan you. “If you go into a bank and say you want a million dollar loan, they might tell you they want to see that you have operating profits of at least 1.25 times the debt payments,” Worrell explained. “So if that million dollar loan costs $10,000 a month to repay, they want to know that you have $12,500 in cash profits coming out of the business to pay it.”
Once owners have acquired business debt, they may be tempted to pay it all down as fast as possible, but that’s not usually the wisest decision. “You might want to pay down your mortgage or pay down your personal debt on the car, but in the business world, as long as your debt is reasonable, has good coverage, and you’re able to pay it, debt is an engine to fuel growth,” said Knight.
When you have excess cash, it usually makes more sense for you to reinvest it rather than making extra loan payments. “Focusing on dropping debt might limit your potential opportunities,” Knight said. Instead, you can focus on things that will open up new revenue streams like investing in a new location, expanding your marketing efforts, or hiring someone to help you develop the business.
Worrell says to concentrate on getting your current bills paid and building a few months of emergency funds before deciding to pay off your debt more quickly than you need to. “Allow the cash to build up in your business so you have a cushion. But not so much that your money isn’t working for you,” he said. Once you have a reasonable cushion, whether you decide to pay off debt depends on your long-term goals. If your goal is to grow, then investing in growth areas is a better decision than paying down debt. If you simply want to maintain your current business, paying down extra debt isn’t a bad idea.
This article was published in our quarterly print magazine, which covers relevant topics in greater depth featuring leading experts in the industry. Subscribe to receive the quarterly print issue in your mailbox. All registered independent pharmacies in the U.S. are eligible to receive a free subscription.
Read more articles from the December 2020 issue:
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