One of the first things the bank will look at is your Balance Sheet Leverage.
Total Debt / Tangible Net Worth
In other words:
“How much debt does the business have compared to the worth of the company?”
But the question they are really trying to answer is:
“How much does this business rely on debt to fund their operations?”
You would think the problem is usually too much debt,
But I see not enough Tangible Net Worth just as often.
I once had a profitable law firm come in and ask for a loan.
They had very little debt considering how much cash flow they had in the business.
What debt they did have, they used to buy out partners.
But now they needed a loan in order to acquire a few other firms.
We started analyzing the company and found the balance sheet leverage to be MUCH higher than we expected.
We dug in and found the story behind it.
At the end of every year,
The firm’s policy was to distribute every ounce of net income to the equity partners of the firm.
So every January, the firm had almost 0 equity.
They would build it back up throughout the year,
Just to go back to 0.
Good for the lambos and yachts that the equity partners were buying.
Bad for the ability of the firm to acquire other firms.
Even though they had minimal debt,
Their tangible net worth hovered around 0.
So next time you’re interested in a loan,
Remember:
Distributions are great for individuals.
Not for businesses.
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