Does your business have too little debt?

On occasion, having too little debt can be bad for your business. If that seems crazy, take a look at the following case study and decide for yourself.

Gerald Martin, the second-generation owner of Davies County Propane, a retail propane distribution company, was pondering his current financial situation and was at a crucial point in making the capital expenditure decisions for the upcoming year.

Davies County Propane sells about 3.5 million gallons during an average heating season to its primarily residential customer base. In a normal heating season, each of the 4,375 customers on average will consume 800 gallons. Gross margins generally average 50 cents per gallon, and the company generates an average of 25 cents per gallon earnings before interest, taxes, depreciation and amortization (EBITDA). Davies County has set on average 350 new tanks per year, primarily 500 gallons in size, for the past five years. This excellent growth trend is expected to continue.

The business operates with a modest amount of debt and is in excellent standing with the bank. On Dec. 31, 2001 Davies County Propane had two primary borrowing facilities. One was an available working capital line of credit up to $250,000, which will be paid off in the summer. The second loan is a term note with an outstanding balance of $800,000.

Davies County’s borrowing position and relationship is sufficiently strong enough to allow for renegotiated terms at any time. The current term debt level as a percent of the market value of total assets is less than 25 percent.

Financial Objectives

Gerald planned for the internally generated cash to fund four primary financial goals:

Replace two delivery trucks $110,000
Set 350 new tanks at
$700 each: $245,000
Pay down principal on the
term note: $260,000
Distribute to owners: $100,000
Total Financial Goals $715,000

Gerald felt that this $715,000 goal was realistic given a normal heating season, and in fact his budget would anticipate some excess cash over this objective. In no small part was this plan driven by a preoccupation for him to keep debt as low as possible.

Figure 1

Actually, Gerald was looking forward to the day when Davies County Propane would be debt free. He continued to be disappointed at his inability in the past five years to make meaningful reductions on the company’s outstanding term debt.

Winter Results

From a financial standpoint, the winter of 2001-02 was just plain lousy. There were two root causes for the poor financial performance.

First, the season was significantly warmer than normal, an experience that had been all too common in four of the last five seasons. Because the primary demand period of October through April was about 15 percent warmer than normal, Gerald’s gallons were about 500,000 less than expected. As a result, his gross profit was roughly $250,000 less than his target.

Adding to his financial pain were the consequences of the inventory decisions Gerald made going into the last season. He purchased 1.5 million gallons of fixed-price contract gas that, as it turned out, was on average 20 cents per gallon above the available wholesale price throughout the winter. Compared to purchasing wholesale propane at the lower actual market pricing, Gerald lost an additional $300,000.

Combined, these two factors contributed to a financial result below the budgeted expectations by $550,000.

Due to the warm weather and fewer deliveries he was able to lower his operating expenses, but actual EBITDA for 2001-02 will be only $400,000. With annual interest costs of $100,000 the available “free cash flow” is $300,000. The term “free cash flow” in this example refers to the discretionary funds available to meet the various capital needs of the business.

Gerald’s Decision

Now Gerald was faced with the challenge of falling short of his four objectives by $415,000. Gerald felt that the conservative thing to do would be to not distribute to the owners and attempt to meet a portion of each of the other three main objectives. Gerald’s final decision for capital outlays was:

Replace only one delivery
truck: $55,000
Set only 200 new tanks at
$700 each: $140,000
Pay down principal on the
term note: $105,000
Distribute to owners: 0
Total capital outlays: $300,000

A Case for More Debt

Given the shortfall in the financial results over the expectations, making a reduced ownership distribution is a wise choice. And there is no argument with the replacement of a single truck. With no more information, we can assume Gerald knows the quality of the fleet and its needs.

The biggest issue here is with Gerald’s decision about the debt repayment and what is in essence a choice to throttle back the growth of new tanks and customers. It is clear that the business is not heavily leveraged and has excellent banking relations. It appears that Gerald has chosen to chase a dream of attempting to be debt-free at some point, with this year as a step in the process.

What Gerald has actually done, however, is to place the business in a less stable condition by choosing an 8 percent return over a 21 percent return. Here’s why:

The decision to pay down the debt by $105,000 reduces the company’s annual interest costs by $8,400 – or 8 percent – on the $105,000 not borrowed. In exchange, Gerald has chosen to reject a $21,600 annual return on the 150 new customers (See Figure 1 as well as the May column, “The Best Investment you Can Make”).

Setting tanks has been the lifeblood of Gerald Martin’s business, and his abandonment of this growth philosophy in the face of a difficult season is a poor decision. As you can see from this simple example, attempting a debt-free business plan within a profitable, growing propane business can be a poor choice.

Taking on more debt is not the best solution for everyone. But a modest amount of debt in your quality business will create a more profitable, valuable and stable business.