"Is debt financing a good or bad thing?"
Perhaps let's ask the question differently. "How can I slightly increase my write-offs but significantly grow my revenue and profits?"
In times such as these, it will be the careful extension of trade credit that will get the wheels of commerce moving again. Savvy business owners and finance professionals may want to "zig" and use trade credit to gain market share from your gun-shy competition who may be "zagging."
Extending credit to your customers (debt financing) will become a big point of differentiation in the months ahead. If you develop a new plan now, you have an excellent chance of building your business.
So how does one marginally increase write-offs and significantly grow revenues and profits?
The Secret is in Your Margins
Your ability to accept a higher amount of risk is directly proportional to your net margin. If your industry profit margins are 3 to 5%, you can't afford to make many mistakes, whereas, if your margins are 6 to 10%, then you can have double the write-offs of your competitor and still make some money.
The above example is highly simplistic. Every business owner, finance professional, and salesperson should know their company's net margin or profit margin. However, it shocks me when giving credit training to salespeople; many have no clue what margins their companies produce.
We recommend obtaining profitability statistics from your industry association. Your ranking will determine how competitive you can be when extending credit terms to your customers. If you are on the lower end of the profit scale, then your energy is likely better spent taking steps to increase your profitability rather than taking on additional risk. However, if your firm is on the high end of the scale, or perhaps the leader, you can accept a higher degree of credit risk with debt financing and not impact your business.
Let's consider a couple of examples of good debt financing:
- An industrial equipment and parts importer sells customized embossed carpenter pencils to his retail customers for $1 each. His cost is 4 cents per pencil, a mark up of 2500%, and he is writing-off 20% of all credit sales. While regular companies could quickly bleed to death, writing off 20% of credit sales, the importers' margins are so high they can easily afford to accept riskier customers. The trick in debt financing in this situation is to sell items with low product value when compared to its selling price.
- A shipping company is hired to move freight from Toronto to Edmonton, with no return load (generate no revenue on the trip back to Toronto). There are costs associated with returning empty such as fuel, maintenance, driver's wages, and insurance. Understanding that their margins are negative on the return trip, they decide to accept a load going from Edmonton to Toronto from a highly risky shipper. They take 30% down and extended payment terms to 60 days on their balance owed. So what if the shipper refuses to pay the 75% remaining? At least the shipping company generated some revenue on the return trip instead of zero.
In conclusion, not all bad debt is bad. Firms can justify additional bad debt through debt financing, provided they understand their product or service value at the time of the transaction. The extension of trade credit will become the oil that lubricates our economic recovery and will contribute to your companies profits if used correctly