Unless you pay COD for all of your purchases, you have debt. How much debt is too much debt? And, if you find that you have too much debt, what are some strategies to reduce that debt?

There are two types of debt: current liabilities and long-term liabilities. Current liabilities are debts you owe that must be paid within a year. These are supplier invoices, other accounts payable, taxes, deferred income, lines of credit that must be paid down to zero at least once per year, a current portion of long-term debt, and other bills you incur that must be paid within a year.

Long-term debts are those debts that you incur that are longer than a year in duration. Typically these are truck notes, bank loans, and long-term owner loans. There is a current portion of long-term debt. For example, if you have a three-year truck note, than one year’s principal is due within a year — that is a current portion of long-term debt. The remaining two years’ principal goes into long-term liabilities.

How do you know if you have too much debt?
Calculate the long-term debt-to-equity-ratio: Long-term liabilities / Total equity

Equity has many names: net worth, stockholder’s equity, owner’s equity, and capital to name a few.

This result should be between zero and one. If it is over one then, in most cases, you have too much debt. If it is negative, you have a negative net worth meaning that your company has been unprofitable for a period of time. Debt-reduction strategies might help. However, if your company has a negative net worth, you must find a way to get it profitable again, or you will be out of business.

Many companies have zero long-term liabilities. Owners have made the decision to buy or lease all vehicles and equipment, and have no long-term liabilities on their balance sheets.

Why don’t I consider the current debt-to-equity ratio? I’ve worked with companies that have extremely high debt-to-equity ratios (5 or higher) whose long-term debt-to-equity ratio is between zero and one. In most cases, as long as the long-term debt-to-equity ratio remains between zero and one, and the company’s acid test (current assets minus inventory divided by current liabilities) remains over one, the company can pay the debt.

If your company has too much debt, here are six debt-reduction strategies:

1. Increase profitable sales.
Assuming you know your costs and can increase your margins and sales volume without increasing overhead expenses, this increases your bottom line. When you collect for those sales, you can use the extra cash to pay back debt.

2. Ask your employees how to reduce overhead.
They know where the waste is. They may not tell you. However, they do know when time, materials, and overhead are being wasted. Here’s how to ask: What would you do to reduce overhead by $100 per month? If you implemented all of the ideas from all of your employees, then you’d significantly reduce overhead each month; thus reducing your accounts payable each month, increasing your bottom line, and therefore equity.

3. Watch inventory.
Inventory is a bet. It is one of the biggest uses of cash for most contractors. Many times your technicians have the parts on their trucks but it is easier for them to run to the supply house than find the part. When they use the parts on their trucks, then you don’t incur an additional payable for an unnecessary part.

4. Restructure debt.
Restructuring debt doesn’t necessarily reduce the debt you owe. However, it can increase cash and disposable income. If you find that you don’t have the cash to pay your debts, then talk with the creditor. See if a supplier will extend terms — giving you longer to pay the bills and reduce the monthly payments.
Interest rates are low. If you have a high interest loan, see if you can restructure it to reduce the interest rate. It doesn’t change the amount of principal you owe. It does decrease your interest expense, which increases your bottom line and equity, thus reducing your debt-to-equity ratio.

5. Sell assets and lease them back.
Sometimes you can reduce debt by selling the asset (assuming the asset has more value than the amount owed on it) and leasing the asset back. I’ve seen this successfully used when owners convert their trucks from owning them to leasing them.

6. Bring in an investor.
This is my least-favorite option. However, you might want a partner who can take over a certain segment of your business. As an equity investment, your debt-to-equity ratio decreases.
Implementation of one or more of these strategies will help you to reduce your company’s debt. 

Ruth King has over 25 years of experience in the hvacr industry and has worked with contractors, distributors, and manufacturers to help grow their companies and to become more profitable. She is president of HVAC Channel TV and holds a Class ll (unrestricted) contractors license in Georgia. Ruth has authored two books: The Ugly Truth about Small Business and The Ugly Truth about Managing People.  Contact Ruth at ruthking@hvacchannel.tv or 770-729-0258.