Smart ways to use and manage debt

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Debt can be a useful tool for growth in your construction business when handled correctly. This week we’re discussing the different types of debt, when it makes sense to use it, and the best ways to pay down debt without negatively affecting your cash flow and profitability.

Topics we cover in this episode include:

  • What is smart debt?
  • Debt, starting a new business, and survival mode
  • How much debt is too much when it comes to bonds and banks?
  • How Profit First looks at debt
  • Long-term vs. short-term debt
  • The best strategies for getting out of debt 

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Rob Williams, Profit Strategist |
Wade Carpenter, CPA, CGMA |
Stephen Brown, Bonding Expert |


[00:00:00] Rob Williams: Welcome to the Contractor Success Forum. Today, we are discussing smart ways to use and manage debt. On the Contractor Success Forum with Wade Carpenter, Carpenter and Company CPAs. And Stephen Brown with McDaniel Whitley bonding and insurance agency. And I’m Rob Williams with IronGate Entrepreneurial Support Systems. And we are here to discuss how to run a more profitable, successful construction business for you, our listeners.

We are, again, talking about smart ways to use and manage debt, man. This has come up a lot for me in these last COVID months and years, and it’s crazy some of the balance sheets that I’m seeing coming in here.

I know Wade has got a lot on this one, but Stephen you also look at this too. Wade is our CPA. He’s very familiar with these things, but Stephen, I’m curious from you too, as a bonding agency, how do you guys look at it and what do you think is smart and not smart?

[00:01:10] Stephen Brown: Well, we always agree on this podcast. We’re all pulling at the same set of oars right? Our objective is to help contractors have less stress and make more profit. And so from a bonding perspective, it’s no different from your perspective, except for the fact that the bonding companies look at your debt as how it affects your working capital, your ability to have cash. And we’ve talked so many times about cash flow, but debt, if it’s long term debt for equipment or some other financing reasons, is okay. It’s the short-term debt.

A lot of contractors say no, no, no, I don’t want long-term debt. I’m gonna pay it off. I’m gonna pay it off. When you have debt, it comes out of your profit. That’s the chilling part of it. Where do you get the money to pay for the debt you already have? And, we talked about this for a long time before we started the podcast. There’s just so much we want our listeners to know about debt.

[00:02:10] Wade Carpenter: One of the key things you just said there. What a lot of people don’t realize, and it was kind of eye-opening when I’d said it out loud the first time was like, you absolutely have to have profit to pay back any debt. There’s a lot of things we’re talking about today, the difference is are you in debt for your survival? Or are you leveraging debt for your growth? We were just kicking this around but, the different philosophy, of Dave Ramsey. Can’t ever have any debt versus leveraging debt for your growth and for smart growth.

What is smart debt?

[00:02:40] Stephen Brown: Yeah let’s talk about that. Every contractor has some degree of debt. In an ideal situation, you wanna have enough cash in your company that you don’t need to borrow money. That you’re financing things on your own, because there’s an expense to borrowing money and there’s stress to borrowing money. At the same time, it can be a good thing if you have something you want to accomplish. What if you need a new building? It may make more sense from a business standpoint to finance the cost of building your new building and that’s good debt. You’re managing it. It’s part of your business plan.

[00:03:14] Rob Williams: Yeah. I always hear smart debt and people say, oh, smart debt. I don’t know, what not smart debt is, is that dumb debt or stupid debt or something? When I hear a contractor talking about it, it’s smart because he said it was smart. So, well, okay. It was smart for me because I needed the money. So I wonder what smart is. What is smart debt and what is not smart debt?

[00:03:36] Wade Carpenter: I think about it like just for using the example of a line of credit. Are you using your line of credit to go buy a pickup truck? And then assuming that, hey, I got a big check coming in, but then that big check comes in and then you gotta spend it on something else? And then you’re stuck with a short term debt, that’s screwing up your working capital ratios. I think that’s the improper use of a line of credit.

[00:03:58] Stephen Brown: Right. A line of credit should be used when you know you’ve got a job coming up that’s gonna be slow pay and you’re gonna need to finance your payroll and other things until that money comes in. That’s the use of a line of credit. If you’re using it for trucks and everything else, and you don’t make a profit and next thing you know, it’s maxed out.

Then that’s bad debt, right?

[00:04:20] Rob Williams: Yeah. Yeah. I think that bad debt thing, I think everybody would agree on a six-figure automobile that you buy with your business line of credit. I think that’s pretty much the main example of not smart debt. Or that motor home that you buy with your business thing. I do know when we were growing up, we had a mobile office that was a Winnebago. So I was like, dad, I don’t know that smart. But I think in their mind, they literally thought they were gonna use that as a–

[00:04:48] Stephen Brown: No. I remember seeing that out at job sites.

[00:04:51] Rob Williams: Yeah. But there are other kinds of smart debt when you’re using that for your business and you’re using it for your overhead rather than what Stephen was talking about, I think that’s where a big confusion is where people think that’s smart debt. Because I don’t think they even understand that they’re borrowing it to finance losses or finance, their overhead is too high. Rather than cutting that overhead or figuring out a better formula, they use debt to get deeper and deeper in the hole. And I think that’s where people think they’re using debt smart, that they just don’t realize what’s happening.

And that’s where I look at my past history, especially when I was starting up companies, we were pouring it all into startup cost, which meant we were just very wasteful in using our overhead, trying to grow too fast. And we didn’t care how much we were spending, because we were just trying to get the revenue number up and we weren’t looking at the gross profits.

[00:05:49] Wade Carpenter: Stephen was talking about this before we kicked us off of. You were talking about the typical guy that kicks off his own business, starting off doing it on the side. You wanna talk about that?

Debt and starting a new business

[00:05:58] Stephen Brown: Well, say you’re starting a new construction business and you wanna start one from scratch. I would say that one of the first priorities is for you and your spouse to have good personal credit. That involves showing financial maturity on your own in order to get a good credit score. But remember, you can get credit scoring bonds now. Get bonds up to a million dollars, sometimes more, based on just your personal credit score.

So say you’re starting off your own construction company. You’re gonna have expenses and debts. Eventually you’re gonna take on employees, and you’ve got payroll, and then you’re gonna need some equipment and you’re gonna need this and that. Well, a lot of that is financed through debt on projected profits you think you’re gonna make. And if you don’t know whether you’re gonna make those profits or not, you can’t make those debt payments.

How much debt is too much?

[00:06:53] Stephen Brown: We talked about this and we talk about the fact that you have certain equipment and other items that you need to do the job, and it needs to be acquired to do the job and it’s built into job cost. So it’s either gonna be rented or leased or purchased outright, that decision has to be made. We talked about that in another podcast. But as far as debt is concerned, folks understand that most people have a general degree of debt. And I think it’d be important for us to talk, too, about kind of when is too much, when is considered too much?

For personal credit it’s if you’re using more than 30% of your available credit on a regular basis. So think about that. The personal folks who are really out on a limb extending credit to folks they don’t know, it’s 30%. Wade, what are you recommending? Where’s the red flag when you’re looking at someone’s financials?

[00:07:49] Wade Carpenter: Well, typically what I define as a healthy company is no more than three to one debt to equity. That’s general rule of thumb that I usually tell a lot of people and it would be different for like a heavy equipment guy that needs to finance a whole bunch of heavy equipment. Versus a general contractor, but generally speaking, the bonding companies and the bankers start getting nervous, especially when you get above three to one.

[00:08:15] Stephen Brown: So, give an example of three to one debt.

[00:08:18] Wade Carpenter: Let’s just say you had $300,000 of debt and a hundred thousand dollars of equity. That’s three to one debt.

$301,000, you’re getting into the danger zone.

[00:08:29] Rob Williams: Yeah. And what is equity? Because I think a lot of our guys don’t understand what equity means. It’s not, what will you value your company, you know, as an appraisal. What is equity your assets minus your liabilities, or?

[00:08:41] Wade Carpenter: Well, you just said it.

[00:08:43] Rob Williams: Yeah.

[00:08:44] Wade Carpenter: And we obviously could go down a rabbit hole there too, but essentially it’s whatever profit or capital you’ve put into the company, or profit that you’ve retained in that company.

[00:08:55] Rob Williams: Yeah.

[00:08:56] Wade Carpenter: And the biggest thing again, you gotta have profit to pay off debt. So when you’re growing, you gotta have more cash than you normally would. And typically it does end up with things like, you’ve gotta borrow the money to get there. And traps like credit cards or, having a line of credit that’s too big, and sometimes you forget whether we’re using this in a smart way or a healthy way.

[00:09:25] Stephen Brown: Yeah, credit cards are the definition of short-term debt. Because you gotta pay at the end of the month or else you’re paying 22% interest on your money. So it’s terrifying debt. It’s the worst kind. Now you have credit cards for your employees to meet their travel expenses and stuff. That’s a different animal. But you also have debt that comes from your equipment uses.

Debt in survival mode

[00:09:48] Stephen Brown: What about a debt when you’re in survival mode, what do most contractors do when you notice that they’re in survival mode? What do you see with that?

[00:09:59] Wade Carpenter: Well, what do they do? I mean, they’ll max out those credit cards, but in the last few years, what’s really been scary is all these pay by the day or pay by the week things that are, people have no idea how expensive these things really are. But they need the cash flow and they get desperate. And if you look at the interest rate on these things, it’s amazing how, how much these things cost you. So.

[00:10:23] Stephen Brown: Yeah, but they look so friendly in all their ads, Wade. I mean–

[00:10:27] Wade Carpenter: I know. And when you’re desperate for cash and you gotta pay the people, sometimes we do some things we shouldn’t necessarily do, but the idea is let’s get out of that cycle.

[00:10:39] Stephen Brown: Wow. Get out of the cycle. Rob, how would you as a Profit First coach for contractors, how would you help someone that was over their head in debt?

[00:10:51] Rob Williams: Well, it depends on why they were over their head in debt. I think you, you start looking to see–

[00:10:57] Stephen Brown: Well you gotta realize you have a problem first.

[00:10:59] Rob Williams: You identify the problem, what is it? Is it because your cash flow cycle is wrong? Is your just receivables too long? And actually I’m seeing a lot of that with COVID. We’re seeing some unbelievably long average receivables, even though they might have their ongoing jobs that they’re just some really long term ones, which that’s a different answer that when you see they’re not profitable. I mean, they’re not making enough gross margin to cover their own overhead and their expenses.

That’s the one that I’m more worried about, the first one we were mentioning about, I figured they’re actually making progress and that’s the other thing. Can you figure out when somebody comes to you, have they already solved it and they just don’t realize they’re already coming out of the problem? Or are they not getting out of the problem? And sometimes I don’t have history to know. So those are the first things that I look at, is it receivables, payables and the difference.

And are their jobs? That’s another thing we’re seeing, especially with COVID did their job cycle just go out so long, even though they’re receivable may not long, their WIP, their Work In Process is just taking so long so their cash flow cycle is crazy long. Because these jobs are taken five times longer than they’re supposed to. And people don’t realize that.

[00:12:18] Stephen Brown: So is that smart debt, if you realize that and you try to finance that or?

[00:12:23] Rob Williams: Yeah, if you do that. I mean, honestly right now the problems are starting to fix themselves when we get that because their jobs are starting to speed up now that the material supplies are in there. I’m thinking of some particular people and their jobs are flowing now. And we think they’re fixing themselves, but you’ve gotta watch out because some things have happened in their overhead.

Maybe as they’re doing this, I know for me, I would spend and add overhead, trying to fix this job and push these jobs. So I’m seeing now their overhead is too much because they were trying to do something about it. And what do you do about it? You spend money to fix something. And so now they’ve got these miscellaneous expenses that are in there. So we gotta get that back under control and figure out that plan for the next few months so your cash flow cycles are coming in to where your money’s being turned over better. And that’s the one time hit that you get in, but now you need the recurring constantly improving cash flow of profitability.

Are you now profitable where you were not because we were temporarily not profitable because we didn’t pre-buy our materials or something, and we had that price escalation and our margins were deteriorating. So profitability, is it returning if you didn’t have it during COVID? Some people were plenty profitable during COVID, but some were not. We look at that versus your one time getting your cash flow cycle back together.

Debt and Profit First

[00:13:55] Wade Carpenter: You made some great points there. The one thing, the beauty of Profit First, I know we talk about that a lot on this show, but as far as debt is, with construction, a lot of times you’ve got some big dollars coming in. But 60, 70, 80% of it may be going out to subcontractors, materials.

And when you see these big checks, it’s easy to say, hey, I’ve got all this money. I can easily do this or whatever. But when you put it in the buckets that Profit First says, we gotta have something for us to eat off of and something to pay our people off of and something to cover our taxes, and you start putting in these buckets, that is a big realization that, hey, all this money that came in, I can’t go spend it out. And I gotta put something back to be able to finance this debt.

[00:14:43] Stephen Brown: We talked a lot and I’ve learned a lot from both of you guys about just the psychology. The psychology of managing your business and managing money. How you think when you have a huge bank balance. How you feel about taking on debt. It’s a personal issue and it doesn’t have to be.

[00:15:01] Rob Williams: Yeah. I wanna add on to what Wade just said, piggyback off of that. Because the first thing that came to mind, communicating that to somebody is, what envelope are you putting that money in? And when all this money is coming back in, that’s a really good point. How do you control that? And what do you use that for? When it comes back, do you immediately pay off your debt?

I’ve actually seen some contractors that were really doing well, just because they got it. They didn’t have the envelope because they knew to not pay all their credit cards, for example, all down right now, because they knew that they needed it in their material envelope. They’ve got bills to pay. So they pay those before just, oh, here’s this debt. A lot of people’s first reaction would be let’s pay the credit card off. And maybe the credit card’s not a good example. because you can charge it back on a credit card. Let’s say bank loan because the credit card’s revolving, you could get it back.

But the smart use of it, when you get that money in, use your bank accounts in Profit First like they’re the envelopes. So divvy that money up into the right envelope and then you know where to spend it. Yeah, Wade, that was a really good point. That’s probably one of the most important things to think about right now is when that money’s coming and going and you get big chunks. It’s not a big chunk. It’s a bunch of small chunks. Chunk it down into smaller envelopes.

[00:16:27] Stephen Brown: Chunk it down. I like.

[00:16:29] Rob Williams: Chunk it down. Yeah.

[00:16:32] Stephen Brown: We need to change the title to chunk it down. I love that.

[00:16:36] Wade Carpenter: Okay. Well, that big bank account, just having that one big bank account can, you can get drunk looking at that thing. Basically you feel like you can conquer the world. You ever go on a cruise or you have like all-you-can-eat buffets? I don’t know what you got there in Memphis, Golden Corral or something?

[00:16:53] Rob Williams: Most of them have closed because of COVID. I don’t know if–

[00:16:55] Wade Carpenter: Yeah. Well, I, like I said. But I mean, when you have a buffet style and you’ve got all the money there, you’re gonna overeat. I’ve never known anybody that goes on a cruise and comes back weighing anything less than when they left.

It’s the same thing. When you got all this money there, you’re gonna go grabbing at it and everybody has their hand in it. But if you put it in these buckets, you’re more likely to say, hey, I only have this money to spend for this. And that’s where I think the power and Profit First comes in.

[00:17:25] Stephen Brown: Yeah. Chunk it in that bucket where it needs to go.

[00:17:29] Wade Carpenter: Chunk it.

[00:17:30] Rob Williams: Chunk it. Yeah, from the big chunk right here.

Long-term vs. short-term debt

[00:17:34] Wade Carpenter: I know we talked about the long-term debt versus short-term debt. And I know we were making the point about we probably should say this because I don’t know that everybody necessarily knows that, but what short-term debt is, should be what is due in principle in the next 12 months, whether you’re doing a year end statement or a, say, six month, June statement.

So that definitely has an effect on your working capital. And when you’re using long-term debt to grow your business, if you’re leveraging, that’s the difference. Are you trying to stay outta survival mode? Versus leveraging somebody else’s capital to be able to grow? If you’re doing it a smart way and if you’re doing it with a plan to pay it back, then that is smart debt.

[00:18:21] Rob Williams: Yep.

[00:18:21] Stephen Brown: I agree.

[00:18:22] Rob Williams: I thought of one other way that I used to think of smart debt was, well, if the bank looked at my books and they gave me a loan, then it must be smart because they know everything and I don’t. So we just thought that is well, the bank said, they think it’s okay. So it must be all right. That was another way of thinking it versus taking like a personal loan for your business or something. I would’ve thought of that as not smart debt because the bank wouldn’t loan me the money, which is not true.

But what you were just saying that long-term short-term debt. That’s another thing to think about. You guys were pointing it out this morning. I was like, oh yeah, I need to keep remembering that because it’s important, especially for our guys that are bonded contractors. Those ratios are very important to know where that’s categorized. Debt is not just debt.

If you bring that to long term debt, Stephen and them are better because that means you don’t have to pay that cash back in the next 12 months. Even though you keep revolving it. I know most of us don’t consider these short term loans. We don’t think about them that we’re gonna have to pay them back in 12 months because we know they’re gonna renew them. You know, they’re just gonna renew it over and over again. But that’s not how the people that are studying our balance sheets look at it. So terming some of those out. If you’re looking for more bonding capacity or worried about how good your balance sheet looks, that those other, what is it? Quick ratio or what are the other ratios, Wade? That–

[00:19:54] Wade Carpenter: Working capital and the quick ratio. Yeah.

[00:19:57] Rob Williams: That

[00:19:57] Stephen Brown: Quick ratio, current assets minus current liabilities.

Current assets are defined as anything liquid. Can be converted to cash. Cash, accounts receivable, cash value of life insurance, investments that are publicly traded. Anything that can be turned into cash quickly is considered a current asset.

And a current liability is anything you owe within the next twelve months. So from a bonding company’s perspective, we look at your fiscal year-end, say it’s December 31st. Look at a snapshot of how things look at that time and what the CPA has put in their financial statement. And then we take that as a starting point and start talking about what your needs are for your bond program.

[00:20:40] Rob Williams: I just don’t think I ever really tried to move those things to longer term debt. I mean, I might have for some reason, but when I was looking at my balance sheet, I didn’t think about that.

You know, so I think that would be a really good thing that could be a game changer for some of these guys, especially where we are in this time period with these crazy changes that are happening.

So if you guys are talking to your bankers and stuff, negotiate those things that they’re not short term, and that could be the difference between getting a bond and not getting a bond or getting another loan versus not getting a loan. Then that could be your cash flow.

[00:21:15] Stephen Brown: We were talking about the cost benefits of making a decision, like to buy or purchase equipment for example. What’s the useful life of that piece of equipment? What piece of equipment can you get that you perceive has a longer period of life? Can you get parts for that? That’s a big issue right now. Can I get parts for that piece of equipment? Do I wanna be tied to a note on a piece of equipment for five years or more? But that’s something to talk to your CPA about.

[00:21:46] Wade Carpenter: And I guess to piggyback off what you were saying about the working capital, and it’s probably not a topic for today, but that working capital means something very different to a bonding company versus a banker. Typically a bonding company would throw out certain things like prepaids and stuff like that. So those are kind of things that you probably should know if you’re approaching a bonding company or a banker like, you know, loans to shareholders and things like that, that we probably shouldn’t go into today.

Profit First’s system for getting out of debt

[00:22:13] Wade Carpenter: One last thing I thought, I didn’t know if I wanted to touch on this, but Profit First has a system for getting out of debt. And, it’s somewhat a modification of the Dave Ramsey thing. So, Rob, do you wanna talk about that real quick?

[00:22:28] Rob Williams: Yeah. It’s the debt snowball. It’s not always paying the highest interest rate first, it’s taking those small ones and eliminate them and it’s the psychology of it. And what do I do, honestly? I mean, I will look at it. I won’t always do the strict debt snowball, but if you’ve got some small loans, get rid of those first and you’re making some progress. And it does actually make some sense, even logically, because you get to remove that principle payment once you get rid of that and apply that towards some of the other ones faster, but you pay not your highest interest rate first, but your smallest loans off first and snowball those. And then once you pay that off, you take whatever that payment was and then you add that payment to that next one. And then that’s what seems to make a lot of sense for you guys that insist on paying the highest one first, you might actually get out of debt faster because if you’re paying that highest interest rate first, you may not erase that for a long time, because it might be one of your larger loans. So pay those smaller loans.

But I tell you where, I don’t know if you’ve made some exceptions of these. Some of them, the interest rate is just so low that sometimes we’ll break the debt snowball rule just to go after some of these big ones. But that’s basically how the debt snowball works. I’m not a real strict advocate of it, but I think Wade, you probably do it more than I.

[00:23:47] Wade Carpenter: Well, I mean, I think it does make some sense when you continue to use that principle and roll it into the next one. And the Profit First spin on it is like, hey, let’s do this. And then when we take our profit allocations end of the quarter, let’s put an additional amount to it.

But again, it doesn’t work if like you go and pay one off and then that money goes right back in your cash flow cycle and we just start using it for something else. So, you never–

[00:24:17] Rob Williams: –know, one of, one of the other things you were talking about these longer term versus shorter term debt. I do kind of like to look at the shorter term principle payment that they’re forcing you to do those principle payments because you can get cash flow. Sometimes I’ll actually look, where do we make an exception on the debt snowball sometimes? When I see somebody’s got a really long term debt, that principle payment is not forced very long. I like to pay the ones off first that are already forcing you to pay that principle down really quickly, which tend to be the smallest ones. I mean, it kinda matches. But sometimes not because if you’re paying that one off, then you get a better voluntary cash flow. If you can pay those force principles off first, then tomorrow in the next few months, if you get a big cash flow, that longer term payoff is not gonna be as great of a cash flow difference as paying off the quick amortization loans first.

[00:25:13] Stephen Brown: So, do you have to look at each and every debt that you have in the terms and conditions of your payments? But as a general rule, you know, how to eat an elephant one bite at a time? Just take a bite. Don’t be afraid. I, I rented a stump grinder last weekend and I thought, man–

[00:25:29] Rob Williams: You didn’t call me? A stump– I wanted to operate a stump grinder. I wanna learn to operate a–

[00:25:35] Stephen Brown: Well, I’ve, I’ve got another one coming up, but anyway, I just thought I could throw this bad boy on the top of the stump and just destroy it in 10 minutes and go about my business. But actually it doesn’t work that way. You gotta kind of chip away at the outside and sweep back and forth and take little bites out of it. So, you can’t just chunk it down, you know, you gotta take little bites out of it. So take out little chunks.

[00:26:00] Wade Carpenter: Phrase of the day.

[00:26:01] Stephen Brown: Chunk it down. There you go.

[00:26:03] Rob Williams: All right. has been a great this is a really good episode. Right now, this is probably one of the most influential topics that we can have right now. Cause we’re seeing big needs for debt. We’re gonna, we’re seeing tremendous growth in certain areas and we’re seeing tremendous negative cashflow in other areas.

It’s just been a crazy last couple of years where these balance sheets are. So critical to where we had such a long run of just looking at profitability and everything was so steady that now, man, we’ve got to be balance sheet experts.

[00:26:45] Stephen Brown: Right.

[00:26:45] Rob Williams: Look at our debt. any other closing statements?

[00:26:50] Stephen Brown: No. Chunk it down.

[00:26:52] Wade Carpenter: I mean, the only thing I would say is, um, talk to one of us if you’re concerned about your debt. And sometimes it takes an outside view of like, hey, let’s look at this a little different to get out of debt.

[00:27:03] Stephen Brown: Chunk it.

[00:27:04] Rob Williams: Well, that’s great. And that’s what we do on the Contractor Success Forum. We chunk it down to make your business more profitable and successful. So thank you for listening to the Contractor Success Forum from Wade Carpenter, Stephen Brown, and Rob Williams, your Contractor Success Forum advocates here. So listen to us again and check out our next episode.

We’ll see you then.

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