The problem with too much debt
I saw an interesting contrast between two client experiences recently. Both clients operate businesses providing services to the mining sector in the Pilbara. The recent spate of bad press about the iron ore price and reactions have affected both businesses – but one is far better prepared to ride out any storm that may be coming.
There are several similarities between the two businesses but a fundamental difference means one is in far better shape than the other.
First, the similarities. Neither businessmen have any previous experience running a business yet both have quickly built a business with annual revenues of at least $25 million. There is no documented strategy in either business, both have average-to-poor financial record keeping and no formal systems and processes. You could say that they have been successful in spite of themselves!
The first client, Mike* runs an equipment for hire business. He is very entrepreneurial and has an uncanny knack for ‘sniffing out’ opportunities and often goes on a spending spree to buy more equipment, usually on a hunch and with the hope that “we’ll find some work for it”. Mike’s business is heavily geared and makes very good profits but in the past six months the gearing level has been increased by more than 50% – on his assumption that “this mining boom has years to run”. The monthly finance payments are staggering – this business consumes cash like a gas-guzzling V8 supercar and it is highly susceptible to a hiccup in demand for its equipment.
The second client, Mal* is a regular user of the type of equipment rented by Mike’s business but rather than borrow heavily to buy all the plant and equipment it needs, Mal took the decision to sacrifice some potential profit by hiring it in. Mal received notice last week that he was being stood down indefinitely from a project that contributes approximately 35% of their revenue.
What actions have the two business owners had to take in light of the changing circumstances? Mal has a relatively easy decision to off-hire the now surplus plant and equipment which immediately reduces costs and preserves valuable cash. The decision to lay off dozens of workers will be more gut-wrenching but necessary in order to preserve his cash and ride out this downturn until it can replace the lost revenue.
On the other hand, Mike is now rapidly turning grey and losing a lot of sleep! His regret about taking on 50% more debt was palpable at a crisis meeting he called this week. The decision has (belatedly) been taken to conduct an across the board cost review, list some equipment for sale, prepare and monitor a weekly cash flow forecast and look for opportunities in other industry sectors to diversify and spread some risk.
What is the lesson here? It is easy to run a business when there is booming demand for your product or service. The challenge is to keep the ‘greed gene’ in check and manage your debt and balance sheet for the long term survival of the business. Merely knowing there are risks to your business doesn’t do anything to mitigate them, some affirmative action needs to be taken.
I have long held the view that Mike will either be spectacularly successful or go down in a spectacular crash! I hope for his sake this last few week’s reduced confidence in the iron ore sector is just a hiccup and it will not be the latter.
* Mike & Mal are not their real names.
About David Officen
David is the Founder and Managing Director of proCFO. David combines an accounting and consulting background with commercial experience both as a manager for large commercial businesses and as the owner of private and family businesses.