Assessing your debt needs

June 1, 2008 By    

The dramatic rise in wholesale propane costs has created serious pressure on everyone in the retail propane distribution business.

Whether it’s customers resistant to higher prices, difficulty collecting larger bills or the overall pressure on net profits due to higher operating expenses and squeezed margins – they all create increased capital needs. For most, that additional capital is met by some form of debt.

Carl Hughes
Carl Hughes

The reality of our current operating environment is that more capital is required to operate the same size business as in the past. What we want to determine is whether the additional debt is normal for the situation and therefore manageable, or whether the debt is growing significantly enough to indicate that something in our business is amiss.

Let’s examine specific areas of the propane business that are requiring additional debt capital and determine if the situation is good – meaning expected and acceptable – or bad, indicating that the business is in need of fundamental adjustments.

Debt to cover operating expenses – In the short-term seasonality of retail propane, there are months in which gross margin is below operating expenses. For degree-day-driven retailers, these are normal cycles. Utilizing short-term debt to cover off-peak expenses is acceptable, as long as this debt does not creep into some permanent role throughout the year.

It is critical to understand that all annual operating expenses must be covered by total annual gross margin. If your overall debt has increased throughout an annual period – and a portion of that debt has gone to cover operating expenses – your business is in need of a fundamental review.

Debt to purchase new trucks – It is certainly acceptable to finance trucks needed to handle new customers as part of an overall growth strategy. It is also perfectly fine to finance the replacement of bulk or service fleets with short-term debt.

However, all replacement fleets should be financed, in the long term, from gross margin. Otherwise, you are failing the rule that says that total annual gross margin must exceed both total operating expenses and annual maintenance needs.

Debt to finance accounts receivable and propane inventories – Both are working capital items that have clearly gone up in total value and clearly are an appropriate use for short-term borrowing. However, financing a receivable from an account that will go bad and be written off is simply more debt that will have to be serviced. Also, your profits must increase sufficiently to cover the higher interest costs.

Debt for growth – Investments in which the year-in, year-out profits create a return greater than the cost of the debt is always a good thing. Example: The $1,000 investment from setting a domestic tank generates $700 in annual gross margin ($.70 per gallon), covers incremental delivery costs of $400 ($.40 per gallon) and creates a pretax profit of $300 per year. This is a 30 percent return ($300/$1,000), which is obviously superior to whatever lending rate you will be required to pay.

Debt for renovations and plant upgrades – This answer is similar to that of trucks, above. All maintenance expenses should be financed in the long run through cash flow.

Debt for acquisitions – This is an easy area to point out that debt has an appropriate place. Acquisitions require diligence in establishing a realistic financial model for the acquisition performance and then establishing an appropriate level of debt to service it.

More than ever, timely and accurate measurements of profitability are required to determine whether growing debt is a sign of weakness. Strong financial controls are needed for a propane company to assess whether the debt load is acceptable and easily serviced. If not, the demand for more unexplained debt to run the business may be a precursor to a business that will need triage at some point.

Carl Hughes is senior vice president of business development for Inergy LP. He can be reached at Chughes@InergyServices.com or 816-842-8181.

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