Addressing these areas of your business could unlock its potential

Growing a business is important. It provides opportunities for earnings for both owners and employees, helps more customers with products and services, and many other benefits. But growing a business takes more than a great idea and some capital. In fact, history tells us that two thirds of businesses fail within the first two years and that only about one-third of businesses make it to 10 years.

Smart Business spoke with Todd E. Crouthamel, CPA, director of Audit & Accounting at Kreischer Miller, about the many obstacles to growth in today’s businesses, their sources and how to address them.

How does hiring affect growth?

Many middle market companies find themselves hiring people when their revenues have increased and they need additional people, or in the event of employee turnover. This staffing plan is reactive in that companies are hiring because of a need. Reactive hiring often results in bringing on people who aren’t the best fit for the culture.

Hiring people who fit a business, when they are available, increases the chances of getting the right people, which in turn increases the chances that they quickly become productive contributors.

Retention is another issue. Employees want to be challenged, valued and feel they are making a difference. That makes employee engagement a critical element of high-performing companies. Components of employee engagement include making sure employees have the right tools for the job, and listening, giving them individual attention and recognizing their accomplishments.

What is it business owners might be doing that could stunt their company’s growth?

How business owners and leaders spend their time is important. Many business owners and leaders work ‘in’ the business, but to be successful, they should spend more time working ‘on’ the business. Business owners who are involved in every decision at their company, from pricing to who to use as a coffee vendor, are too far into the weeds, which leaves little time for strategic thought and planning.

Business owners eventually need to transition away from being so enmeshed in the day-to-day operations. Otherwise, they may have issues with transitioning the business to an inexperienced next generation, or face a reduced selling price in the event of a transaction.

Consider what tasks could be moved to other people within the organization and start freeing up time to be more strategic. If the right people are in the organization, they should flourish with these increased responsibilities. This change will then free up business leaders to lead and do more strategic thinking about the business.

What is the relationship between a company’s value proposition and its growth?

A value proposition is a statement that identifies measurable and demonstrable evidence of the benefits that a customer receives from buying a business’s goods or services. A good value proposition will clearly communicate what the product is, who it is for and how it is good for the user. The value proposition should be communicated to customers, but it should also be communicated internally and woven into each employee’s workday. It’s also the foundation of the company’s branding efforts and training programs. Having a continuous focus on the value proposition will help get everyone on the team working together on delivering the value the company has promised.

An unclear value proposition can stunt growth. Consider reviewing the value proposition by organizing a client advisory board or engaging a third party to conduct a customer survey to ensure that the company is focused on what is important to customers, and that the company is providing the value that has been promised.

Focusing on these areas of a business will increase the likelihood of success. While there are many other challenges to growth, careful consideration of these items should help take care of many other barriers at the same time.

Insights Accounting & Consulting is brought to you by Kreischer Miller

Proposed tax code changes will require adjustments, eventually

The process of tax planning has historically involved some tension arising from ongoing movements of important pieces of a puzzle. This issue is particularly relevant this year.

“At the end of September, a nine-page summary titled, Unified Framework for Fixing Our Broken Tax Code, was released,” says Michael Viens, CPA, director of Tax Strategies at Kreischer Miller. “President Trump, legislators from both parties, tax reform proponents and critics, news media commentators and others all have opinions as to the merits of proposed tax changes as well as expectations for when and if enactment will occur in time to allow for effective tax planning for 2017.”

The framework specifies one effective date, that involving an opportunity for 100 percent expensing by businesses relating to capital investments in depreciable assets other than structures, which would apply to transactions occurring after Sept. 27, 2017. Best-case timelines for possible enactment of tax reform measures suggest December as the earliest date for the Senate approval, which would follow action in the House.

Smart Business spoke with Viens about how businesses should approach tax planning as changes to the tax code loom.

How should businesses approach year-end tax planning for 2017?
Do not wait for tax reform legislative actions to finalize before initiating current year planning. Effective planning often requires a fair amount of lead time for implementation and last ditch efforts in close proximity to the end of December can present formidable challenges.

Equipment purchases may not be received and placed in service in time. Funding arrangements to cover expenditures may involve credit or other financial transactions that take some time. Deferral of income may require some level of negotiation with other parties. Begin the planning process well before year-end while holding off on the final steps.

Following traditional tax planning approaches involving deferral of recognition of income while accelerating expenses should be valid strategies no matter what happens in the way of tax reform.

What are the relevant tax provisions that may change going forward?
A proposed material increase in the standard deduction may eliminate itemizing of deductions for many taxpayers going forward.

Acceleration of payment of certain items that may yield a tax benefit in 2017, but not in 2018, should be considered — for example, the timing of charitable contributions and payment of state and local income and real estate taxes. Be careful with taxes, however, in order to avoid the potential impact of alternative minimum tax should it still be around for 2017 and not go away until 2018.

Business capital investments will potentially be eligible for 100 percent expensing under tax reform proposals. Current law permits a 50 percent upfront write-off for qualifying capital expenditures, which is scheduled to drop to 40 percent in 2018.

Should tax reform run into legislative issues and current law provisions continue to apply, this would suggest a more favorable result if capital investments are placed in service this year rather than next year.

Effective tax planning may involve identification of the lead time for ordering and fulfillment processes and implementation of action steps developed to have equipment available with appropriate maneuverability in arranging a placed-in-service date this year versus next year.

What other changes might require action on the part of businesses?
Consideration should be given to updating partnership agreements, where applicable, to allow for new partnership audit rules that will be applicable for tax years starting in 2018.

These new Federal tax rules, where applicable, can require that adjustments be made at the partnership entity level with the partnership liable for any related underpayment of tax. Partnership agreements should be reviewed to determine whether any changes should be made.

The tax planning process this year will likely involve greater complexity than last year. More effective results can be achieved by not holding off in anticipation of tax reform that may or may not occur or for which effective dates may not apply looking back, but rather only going forward.

Insights Accounting & Consulting is brought to you by Kreischer Miller

Your company tripped a bank covenant. Now what do you do?

If you have ever turned to your bank for a loan or line of credit, you know about bank covenants and have agreed to them. A covenant is a clause in the loan agreement that requires the borrower to do, or refrain from doing, certain things.

“These typically get a lot of attention prior to signing the documents, yet become an afterthought the minute the agreement is signed,” says David E. Shaffer, CPA, Director, Audit & Accounting at Kreischer Miller.

“However, post signing, we often find that owners have either missed a covenant or have done some action that violates a negative covenant (i.e. the covenant that says that you will only borrow from the bank and you just signed a zero percent loan for a truck).”

Smart Business spoke with Shaffer about the next steps for a company that has violated a covenant agreement.

What’s the best way to avoid surprises when it comes to covenant agreements?
The ideal time for a business to talk about bank covenants is when a loan is coming up for renewal or you are negotiating a new loan. Your bank will typically use the financial projections you provide to set the financial covenants. Consider putting something in the loan document that states how you might rectify a missed covenant, such as putting equity into the company, subordinating existing or new debt to shareholders or adding collateral to the loan (e.g. pledging some stock portfolio or cash).

Sometimes, despite everyone’s best intentions, companies fail to meet their bank covenants. When this happens, you should meet the situation head-on. If you are in the middle of the year and believe there is a chance you may not meet a covenant, review current projections to determine what steps can be taken to remedy the situation. If it is a leverage covenant (debt and/or equity), consider collecting accounts receivable more quickly, or requesting customer deposits to pay down liabilities. Or you might decide to defer some fixed-asset additions until the following year.

If it is a debt service coverage ratio and you do not expect to meet the projected income, this can be tougher to resolve by year-end. You can consider deferring owner distributions and/or making contributions so the covenant is met. Be sure to read the definition in the loan agreement.

What if you expect to violate a covenant and are in serious doubt about what to do?
Discuss the situation with your banker before you have violated the covenant. The earlier this discussion takes place, the better. Explain why you might not meet the covenant and ask if it can be amended for just the current year.

Remember, your loan officer does not want to have to explain the violation to his or her superiors. If it is the debt service coverage ratio (the most common issue-causing ratio that we see) and you have easily met the covenant in prior years, but something unusual happened in the current year, you will have a much better chance of getting the modification.

If you have already missed the covenant and it cannot be remedied, take the following steps:
  Notify the bank as soon as possible that you will need a waiver, but only after you and your key advisers have developed a plan to remedy the violation.
  Provide projections that show you will meet the covenant going forward.
  Consider putting more equity into the company or adding more collateral to the loan.
  Request a bank waiver. Keep in mind this could generate an additional fee and some loan terms may be changed (e.g. higher interest rate).

What are some other things to keep in mind?
Your bank is a key business partner and should be kept aware of what is happening in your business so there are no surprises (good or bad) when financial results are shared. If you maintain a good relationship, you will be in a much better position to deal with a covenant violation.

If you are a new customer and selected the loan based solely on price, the bank’s profit margins are slim and your banker will have much less leverage with his or her superiors to request and obtain a waiver. You may also experience higher waiver fees and an increase to your interest rate.

Insights Accounting & Consulting is brought to you by Kreischer Miller

A look into the best practices of the highest performing private companies

Mario O. Vicari has the opportunity to work with hundreds of private companies and he gets to see it all — from the very best performers to those that seem to constantly struggle and lots in between.

“The bell curve is truly at work here,” says Vicari, CPA, Director at Kreischer Miller. “The majority of private companies fall within the middle (wide) part of the curve, which makes them marginally better or worse than average. On the other hand, there are very few companies at the far ends of the curve, which puts them at the extremes of performance.”

Smart Business spoke with Vicari about the most common characteristics that define the top 3 percent of U.S. private companies.

   Strategy — Strategy is not just a one-day retreat to clarify next year’s plan. These companies consistently spend real time to consider their strategy. They look at how to clarify the plan and how to adapt it to a changing world where technology is disrupting everything and competitive threats are greater than ever. These companies have the discipline to get their heads out of the details and focus on the big picture objectives that drive their business forward. Strategy should be an intentional activity, not an afterthought.

   Culture/values — Great companies are crystal clear about their core values, which are exhibited in the culture at the company and the attitude of the people.  These companies have clarity about what they stand for and it pervades the culture. It’s not about big signs on the wall, but rather alignment to the values that are exemplified by the leaders of the company.

   Market niche — Most of the highest performing companies exploit positions in the market that others cannot see, cannot serve or don’t want. They exploit places in the market that offer a competitive advantage and are willing to make tradeoffs about what customers and markets to serve. They do not try to be all things to all people and don’t stray from the place where they have the best advantage. They are disciplined and stay in their niche.

   Customer rules — The best companies have rules around customer acquisition. They take the act of adding a new customer very seriously and are discerning about who they will work with and what margins and payment terms they will accept. They are not afraid to say “no” to a business that does not fit their rules.

   Execution — The best companies execute at a very high level because they don’t try to do too many things at once. Because they have limited resources, they know that they can only take on so many new things outside of the day-to-day operations and still be effective. They prioritize the most important items and focus on those.
Many companies have a laundry list of things that they want to do to improve the business and make the mistake of trying to do too many of these things at once while getting nothing done. The best companies work on two or three important objectives and see that they get fully implemented.

   People — When selecting people, these companies are very conscious of the person’s fit with the company culture. They look beyond the technical and experiential requirements of the job and are not afraid to deselect people when they have to. They will confront thorny personnel issues if performance becomes a concern or if the person cannot grow his or her skills in relation to the increased requirements due to the company’s growth.

   Capital allocation — The best companies are thoughtful about how to allocate capital after earning a profit. They know that value is created based on the free flow of cash in the business — not its accrual earnings.
Therefore, they are very discerning about investing profits in capital equipment, or making other investments and acquisitions until they are convinced that the return on invested capital exceeds the cost of capital from the investment. They are also careful about not letting their profits disappear on the balance sheet in the form of excess inventory and receivables beyond the level needed to support the growth of the business. This means that they generate and keep plenty of cash.

Insights Accounting & Consulting is brought to you by Kreischer Miller

Wise companies explore every available avenue to reduce their tax liability

Three of the most common tax credits available to businesses are the research and development (R&D) tax credit, the health care tax credit and the foreign tax credit. Companies that can take advantage of these opportunities are able to save money by reducing their tax liabilities, says Richard J. Nelson, CPA, a Director in the Tax Strategies group at Kreischer Miller.

Smart Business spoke with Nelson about these tax credits and what companies can do to maximize their value.

How does the R&D tax credit work?
The research and development tax credit is the most widely used credit by businesses and was granted permanent status last year.

Businesses that utilize this tool include all types of manufacturing companies, architectural and engineering firms and software development businesses, as well as companies engaged in developing a particular technology to enhance their core business endeavors.

The Internal Revenue Service requires that qualifying research activities satisfy four tests: Activities must be technological in nature, they must be performed for a permitted purpose, the work must be undertaken to resolve uncertainty and there must be a process of experimentation. A good rule of thumb in estimating the credit is to take 10 percent of eligible R&D expenses.

The vast majority of eligible R&D expenses consist of the wages of the individuals working on the project. Other expenses, which are usually minimal, include materials and supplies which are consumed in the project and are 65 percent of the cost of contracted labor costs.

Beginning in 2017, qualifying businesses may offset the 6.2 percent Federal Insurance Contributions Act (FICA) portion of their payroll taxes using R&D tax credits claimed on their 2016 and future federal returns.

Qualified small businesses are defined as corporations or partnerships having gross receipts of $5 million or less during the taxable year. They must also not have gross receipts for any year preceding the five-year period ending with the taxable year. R&D tax credits are applied against quarterly payroll tax payments. In any given year, the maximum payroll tax offset allowed is $250,000. Unused credits may be carried forward and used against future payroll tax payments.

The second change allows eligible small businesses to use the credit to reduce their alternative minimum tax, as well as their regular tax. Eligible small businesses include corporations whose stock is not publicly traded, partnerships and sole proprietorships that had average gross receipts of $50 million or less during the prior three years.

Many companies are missing opportunities for the credit for expenses related to technology costs, specifically website design costs. There are also recent regulations that have been issued on internal use software. Not every website or internal use software will qualify for the credit, but it is at least worth investigating.

Who is helped by the health care tax credit?
The small business health care tax credit benefits employers that have fewer than 25 full-time equivalent employees, pay average wages of less than $52,000 a year per full-time equivalent (indexed annually for inflation) and pay at least half of employee health insurance premiums.

To be eligible for this credit, you must have purchased coverage through the small business health options program, also known as the SHOP marketplace. The maximum credit is 50 percent of the premiums paid for small business employers and 35 percent of premiums paid for small tax-exempt employers.

The credit is available to eligible employers for two consecutive taxable years. If you missed claiming the credit in a prior year, you may be eligible to file an amended return.

What benefits does the foreign tax credit provide?
If your company is paying income taxes to a foreign country or a U.S. possession, you may be eligible for a foreign tax credit. Generally, only income, war profits and excess profit taxes qualify for the credit. Foreign taxes can be taken as a deduction or as a credit. In most cases, it is to your advantage to take foreign income taxes as a tax credit.

Insights Accounting & Consulting is brought to you by Kreischer Miller

A proactive approach is best when considering your company’s future

There comes a time for every private company business owner to exit the business. Just as there is certainty with death and taxes, a business owner cannot ignore the fact that he or she will need to exit.
Planning for the event allows the business owner to exit on his or her own terms, says Mark G. Metzler, a director and Certified Exit Planning Adviser (CEPA) at Kreischer Miller.

Smart Business spoke with Metzler about things to keep in mind as you plan your exit strategy.

What exit strategy options are available to a private company business owner?
The most prevalent exit strategies include:
■  A strategic buyer — This person often is in the same business and is trying to increase market share, access new markets or acquire expertise or management resources.
■  A financial buyer — Generally referred to as private equity, venture capital or an investment fund. This type of buyer typically looks for undervalued companies, provides financial support and exits in the shorter to medium term.
■  Family members — This strategy may be accomplished through estate planning.
■  Employee Stock Ownership Plan  — An ESOP is considered a hybrid exit strategy as the owner is selling to a trust owned by the employees, but often is still managing the business.
■  Corporate partnership or joint venture — Allows the company to explore a relationship before jumping in with both feet.
■  Initial Public Offering  — A rather costly and complex option not suitable for most companies.

Why is choosing the right exit strategy so important?
Exiting a private business is complicated and often, the majority of the business owner’s wealth is tied up in the company. Unlike selling shares of your personal investments in Apple or Microsoft stock, selling your private company is not as simple as calling your broker or executing a trade in your E-Trade account.

When should owners think about exit planning?
As with many things in life and business, proper planning prevents poor performance. It’s never too early to think about exit planning and the most successful transactions occur where adequate planning has occurred. In order to allow for potential false starts, it is not unusual for owners to start the process five to 10 years prior to a contemplated event.

What first steps can be taken to ensure the right exit strategy and enhance value for the business owner?
Enhancing the business owner’s value begins with the process of identifying the owner’s business and personal goals and objectives. You cannot ignore this step. It’s critical that there is a clear understanding of these goals and objectives, as there are different advantages and disadvantages to each of the exit or transfer options.

It is also important to see the business through the eyes of the potential acquirers to understand how their various objectives and values fit with the seller’s personal and financial goals. Once this step is completed, finding the right buyer, preparing the business for sale and closing the deal can be accomplished.

What about the sales price? Isn’t money the most important aspect of an exit?
Companies that have been through the selling process understand that while everyone desires a fair selling price, money often isn’t the overriding factor.

Other motives, including employees, community, family and legacy are often very important to the seller and should not be ignored. Choosing the deal that’s right for the business owner may not be all about money. A business exit is an emotional event. Because the owner’s personal and professional identity is often associated with the business, there may be a psychological loss after an exit.

Therefore, owners should assess their readiness for an exit and evaluate life after the business. All business owners will exit their business at some point. Identifying the right exit is dependent upon, first, identifying your goals. You may then find that the rest of the process is just details.

Insights Accounting & Consulting is brought to you by Kreischer Miller

Why a strategic approach is needed to lure superstar executives

When companies seek to strengthen their executive teams by luring premier talent from outside the organization, they need to offer potential recruits a compelling reason to make a change, says Tyler A. Ridgeway, Director, Human Capital Resources at Kreischer Miller.

“It’s still a buyer’s market,” Ridgeway says. “At the same time, A-plus players do not lack for opportunities and thus, can afford to be selective. These are individuals who have good jobs and are part of their company’s inner circle. And yet, they have an inner drive to continue to grow. It motivates them to consider new challenges that might satisfy these lofty ambitions.”

The challenge for companies is to craft a plan that entices these talented leaders to change course and join their team. It can be a delicate process that requires both salesmanship and a willingness to demonstrate vulnerability. Care must also be taken to ensure that any new additions will mesh with the existing team.

Smart Business spoke with Ridgeway about how mid-market companies can position themselves to locate and secure the best talent.

What constitutes superstar talent in business?
These are individuals who can help drive a business forward. A players quickly grasp the fundamentals of how a company functions, building both rapport and a common sense of purpose with the people on their team.

At the same time, they are adept at creating healthy tension with other departments that keeps everyone alert and stretching their capacity to achieve new goals. People who fall into this category want to be engaged in the growth of the business and expect to be part of the inner circle that is part of any important decision that gets made.

Does the recruitment of outside talent ever create insecurity on the management team?
Companies should consider internal candidates for management openings. However, if a succession plan has not been developed, it’s often an indicator that the talent within has been assessed and deemed incapable at the present time of filling these positions. If there are feelings of insecurity, leadership needs to find a way to get past that so the company can present a unified front to potential recruits.

Keep in mind that A players will typically study the company they are interviewing with as intently as that company is assessing them. If everyone is not on the same page and offers differing points of view about where the company is headed, it can quickly derail an interview and push the recruit to look for other opportunities.

What role does vulnerability play in the recruiting process?
The willingness to be vulnerable empowers trusted advisers to speak openly about what a company needs to take the next step. These are people who know the company and understand how it functions. They are familiar with what works and they are also aware of that organization’s flaws. If leaders are open to this level of honesty, it can help fill gaps that may be holding the company back.

As the process moves to the interview phase, vulnerability provides an opportunity to learn how recruits view a company’s flaws and what insight they have on how to solve these problems. Remember, these are people who love a good challenge. Businesses that can present an opportunity for a talented executive to step in and elevate that company’s performance, both operationally and financially, often have an advantage over competitors.

The key is presenting the challenge and then offering an incentive that can be obtained when success is achieved. If an executive is recruited to a $100 million company and is able to take that company to $150 million in revenue, that individual will expect to be compensated for his or her efforts.

When the rewards are shared with the existing members of the team, it’s a great away to alleviate any tension that may have existed about the new hire.

Companies that go after A-plus talent need to treat those individuals as they would their best customers. And they need to present a compelling case to these people as to why they should make a change and join a new business.

Insights Accounting & Consulting is brought to you by Kresicher Miller.

Normalized earnings can be a helpful tool to assess your business

Normalized earnings represent adjustments to a company’s earnings to remove the effects of nonrecurring items, such as one-time gains or losses, unusual items and the impact of seasonal or cyclical sales.

This calculation is often used to provide business owners, prospective buyers and others with a company’s true earnings and its repeatable stream of economic benefits, says Richard Snyder, CPA, Director of Audit & Accounting at Kreischer Miller.

Smart Business spoke with Snyder about the benefits of determining your normalized earnings.

How are normalized earnings calculated?
There are generally different types of adjustments to normalized earnings: Non-recurring gains, losses and discretionary expenses and adjustments for seasonality or cyclical sales cycles.

Non-recurring, one-time items may include expenses such as lawsuits, restructuring charges, discontinued business expenses, one-time repairs, natural disasters, the write-off of a note receivable and other abnormal expenses.

Non-recurring gains may include the sale of real estate or investments, insurance payouts or a settlement from a lawsuit. Discretionary expense adjustments may include, but are not limited to items such as salary or bonus adjustments, or adjustments for related party rents.

Often, owners of closely held businesses may pay themselves a salary which is not reflective of current market rates that would be paid if an outside person were hired to run the business. In situations where a company pays rent to a related party, the rents may not be reflective of the current market, which may require an adjustment to normalize.

Cyclical sales or seasonality are typically adjusted using a moving average over the number of periods in order to present normalized earnings.

What are some important things to know about normalized earnings?
Normalized earnings provide the ability to develop reasonable projections of a company’s future income-generating ability and can play an important role for owners and other stakeholders for a number of reasons. These can include buying or selling a business, the valuation of the business or evaluating a business against its industry peers.

Past performance is generally relied upon in order to develop an expectation for future earnings and cash flow. In the event of a sale or acquisition of a business, earnings from the past three to five years are analyzed.

As part of this review, a number of adjustments may be required in order to better estimate what is reasonably expected to occur in the future. The selling or acquisition of a business relies heavily on adjusted earnings and cash flow figures in the determination of the purchase price.

Consistent, reliable earnings and cash flows are important as this lends credibility to the financial recordkeeping and reporting process, which in turn provides a level comfort to all interested parties.

Valuation of a business takes a similar approach in which the valuator is looking for one-time, non-recurring items to ensure consistent financial reporting in the determination of a business’s value.

What does the process of normalizing earnings allow a company to do?
Normalizing earnings allows businesses the ability to compare themselves against their peers. Comparing operating results and other important metrics can assist a company in determining its strengths and weaknesses against its peers.

This in turn provides companies with an opportunity to improve their business by analyzing those strengths and weaknesses and developing an action plan to address them.

Normalizing earnings is a common practice used for multiple purposes. Reporting financial information adjusted for one-time items or discretionary expenses provides users of that information a more realistic picture of a company’s financial results and a more reliable tool with which to estimate future earnings.

This can lead to a better decision making process for owners and stakeholders, whether it is for a valuation of the business, a buy/sell situation regarding a business or evaluating one’s business against its peers.

Insights Accounting & Consulting is brought to you by Kreischer Miller

The pros and cons of using debt to support your business

A business can finance its operations either through equity or debt.

Equity is cash paid into the business by investors who receive a share of the company, enabling them to receive a percentage of profits and appreciation in value. Conversely, debt is borrowing money from an outside source with the promise to return the principal, in addition to an agreed-upon interest level based on the risk being assumed, says Robert Olszewski, director at Kreischer Miller and leader of its distribution industry group.

“In a privately held company, investors have less ‘liquidity’ because the shares are not traded on the open market and a purchaser may be difficult to find,” Olszewski says. “This is one reason why successful and rapidly growing small businesses are under pressure by stockholders to ‘go public’ and thus create an easy way for investors to cash out.”

Smart Business spoke with Olszewski about how debt is interpreted by investors and what that means for your business.

What are the advantages of debt financing?
By borrowing from a financial institution or another source of funds, you are obligated to make the agreed-upon payments on time and to operate within specific financial covenants; this is the end of your obligation to the lender. A key advantage to debt is that you can run your business in accordance with your plan with limited outside interference.

How do owners maximize their return on investment?
Some leaders struggle with this concept early on, but over time, gain a better understanding of how it works. Simply put, if you have $5 million of equity invested in your business and the company generates $500,000 in profits, your return on equity is 10 percent.

Conversely, if you borrowed $2 million from the bank to invest elsewhere while maintaining $3 million in equity, your return on investment is now 16 percent. Granted there would be interest costs associated with the $2 million in debt. But you would still be ahead of the game at a 10 percent interest rate on the additional borrowing.

How do you know when enough is enough when it comes to debt?
Leverage ratios are often the measure of overall risk; debt-to-equity is the most common (total liabilities divided by shareholders equity). In general, a high debt-to-equity ratio indicates that a company may not be able to generate enough cash to satisfy its debt obligations.

However, low debt-to-equity ratios may also indicate that a company is not taking advantage of the increased profits that financial leverage may bring.

Lenders and investors usually prefer low leverage ratios because the lenders’ interests are better protected in the event of a business decline and the shareholders are more likely to receive at least some of their original investment back in the event of a liquidation. This is a common reason why high leverage ratios may prevent a company from attracting additional capital.

What if traditional debt is not an available option?
This is risky and may indicate that an owner is going too far. There are two common forms of alternative financing; equity based and mezzanine (each coming at an embedded cost).

Equity financing involves selling shares of your company to interested investors. Investors may also provide mezzanine financing which are debt instruments provided at significant interest costs (based on risk) and a provision to convert debt to equity.

Leverage in business is normal. The pros and cons directly correlate to the amounts and types of obligations that you are willing to incur.

Insights Accounting & Consulting is brought to you by Kreischer Miller

Debt is a cheaper way to grow your business, when done the right way

Companies seeking to enter a new market, expand their business or make an acquisition would be wise to consider leverage to achieve their growth goals, says Brian J. Sharkey, director of Audit & Accounting at Kreischer Miller.

“Using leverage is an instant shot in the arm of capital,” Sharkey says. “If you go to a lender who is familiar with your company, you may be able to obtain the necessary capital to help achieve strategic goals and move on them quickly.

“Companies that choose to grow organically need to stockpile profits that would otherwise be given as a return to equity holders. They put it aside to build up capital and then use that internal cash flow to support the growth plan. It’s a slower process and in some ways, you’re sacrificing profit for growth.”

One of the keys to effectively using leverage as part of a growth plan is a strong relationship with your lender.

“Keep your lender abreast of the company’s performance and any significant changes,” Sharkey says. “Being proactive with your lender establishes a comfort level and gives you a little more leeway when something unexpected occurs.”

Smart Business spoke with Sharkey about what to consider when using leverage to grow your business.

What’s the best approach to take with a debt financing plan?
First and foremost, know the anticipated return on your investment. Typically, when a business obtains debt or another type of financing, it’s for a specific purpose. Most companies will have a plan for what they are trying to accomplish, but what many fail to do is quantify the anticipated return on investment that is expected to be created.

If you do the math and find that your investment return is greater than the cost of debt, it’s probably something you want to consider pursuing. If you don’t go through the exercise, you may be leaving a lot up to chance.

It is also critical to stress test your plan. What happens if you don’t meet sales obligations? What if your profits aren’t what you expect? It is important to run various scenarios and use the findings to make informed strategic decisions. It’s important to have a plan, but it’s also useful to have financial information to back it up.

Do you see any common mistakes when businesses take on debt?
Typically, it’s not a good idea to borrow on a long-term basis for short-term needs. Long-term financing should be lined up with long-term goals and initiatives. Financing tools such as a line of credit should be held for working capital needs like the financing of receivables or inventory on a short-term basis.

A good way to look at this is to line up leverage with the assets you’re acquiring so the debt service period matches the time period you expect to receive returns from the asset. Otherwise, if things turn sour, you could be obligated to make debt service payments before receiving the benefits from an acquisition or machinery purchased.

What’s another reason to consider leverage or debt financing?
The cost of debt is much cheaper than the cost of equity. If you can properly balance the leverage and equity, you can increase the overall profits and increase the return on equity.

For example, if you have $10 million of equity in your company and you’re making $1 million a year, that’s a 10 percent return on equity. But what if you went out and got $10 million of capital via debt? Now you have $20 million of capital in your company. You may be able to double your profits to $2 million and may only have to pay $500,000 of interest to the lender.

The end result is with the same $10 million of equity, you have $1.5 million of return coming to the equity holders. You can increase the value of your company as well as increase equity returns just by adding some leverage.

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