Managing Debt

Debt is a reality in Business operations.

Indeed when properly managed, debt can be a fundamental building block for increasing inventory, expanding into new markets, or financing new equipment.

Business growth often requires the owner/manager to seek a bank loan, a line of credit, trade credit or some other form of financing. With the current interest rates the lowest they have been since the 1950s, owner/managers may be taking on new debt to boost their company’s market presence, improve cash flow, enhance operations, or build a credit history for future borrowings.

How much debt should a company take on? Before seeking a loan or other financing, take time to review the company’s current financial situation and future prospects. You need to:

  • ensure you are taking on debt for the right reasons, at the right time
  • assess the impact of the new debt on the company’s future cash flow
  • determine whether you should opt for short-term or long-term financing, and
  • in some instances, consider leasing rather than buying.

Vehicle Debt

With car dealers advertising 0% financing and other incentives, vehicle sales have soared. However, consider that when financing payments do not include interest repayment, purchasers are tempted to purchase a higher priced vehicle than they might otherwise choose.

When you purchase a vehicle for company use, you need to consider the impact on your tax planning in view of the restrictions on the capital cost allowance, your personal use of the vehicle and other variables.

Determine the effect of the payments on the company’s projected cash flow and compare the cost-benefits of purchasing versus leasing.

Leasing is sometimes the better option as it preserves the availability of working capital and credit.

Charge Card Debt

While credit cards with financial institutions may have interest rates as high as 18%, credit cards with specific businesses such as ABC hardware may charge even higher interest. The appeal of credit cards is not only the ease of purchase and broad acceptance, but also the ability to pay a monthly minimum
when cash flow is tight.

However, if you can’t repay your credit card balance consistently and quickly, then this is a very expensive option for financing.

Tax Debt

Careful tax planning and regular payments of your instalments are critical to sound business operations. If
your instalments are late, consider that not only do you incur interest and penalties, but also you cannot expense any interest charged on outstanding balances.

Further, if a business fails to withhold at source or remit amounts withheld, it risks having its bank
accounts frozen.

If your business owes taxes, it is best to have your chartered accountant speak directly to the CCRA to determine terms of repayment or changes that may affect the company’s tax situation.

Line of Credit Debt

Most owner-managed businesses have a line of credit that moves up and down depending on the cash flow needs. A line of credit offers working capital on an as-needed basis, can be paid down without penalty when excess cash is available, and is usually provided at a reasonable rate of interest.

Ideally, a line of credit should be considered a current liability that will be repaid within the yearly operating cycle of the business. If you need to use the line of credit for a debt that cannot be paid within this time period, this financing source is too costly. It would be better to negotiate a term loan that
provides for affordable payments and a fixed interest rate.

Long-term Debt

Next to an operating line of credit, a commercial term loan is an important and fundamental form of financing for many businesses. These loans are available to businesses to finance the acquisition of medium- or long-term assets, working capital or debt consolidation. Without term loans, most businesses would have difficulty growing.

When financing capital acquisitions, you need to evaluate this debt in relation to the profitability, impact on cash flow and product or service cycles.

If the financing terms exceed the asset’s useful life span or its capacity to produce profits, the burden of this liability could affect the company’s future ability to obtain credit for additional property or equipment that is vital to business growth.

Accounts Payable Debt

Most businesses use the window of net 30 to 60 days that their suppliers provide to help their cash flow.

After all, if ten suppliers are owed $5,000 each, a temporary positive cash flow of $50,000 is created — provided you do not miss the accounts payable date.

Late payments risk interest charges and could damage your relationship, and credit arrangements, with your suppliers.

Before You Borrow

Before you borrow, analyze the capacity of your business. Your chartered accountant can help you prepare reliable forecasts outlining the required financing and prospective cash flow available for debt servicing as well as assess which sources of financing are the right solutions for your business needs.

MANAGEMENT

The Family Business

As the owner/manager’s family and business grow, the spouse and children often become employees of the business.

When family members are involved in the day-to-day operations of the business, conflicts can arise between the founding members of the company who worked hard to establish and nurture the business and the younger members of the family who may have new ideas, new energies and different management strategies.

Apart from the generation gap, constantly being in the business life from home life can also create tension and conflict. The stresses within a family business can cost dearly if family/business members do not address issues on a timely basis.

In an arm’s length business, the owners and employees work towards achieving goals with the knowledge that their personal efforts will be rewarded. In a family business, those same desires are often augmented with family dynamics that, at times, create difficulties that could affect the company’s ability to sustain working capital, maintain quality employees, and move the business forward.

Typically, many family-run businesses have trouble addressing operational problems because:

  • A formal plan for leadership succession does not exist.
  • The original founders of the business have all their assets tied up in the business.
  • Family members have not contributed equally in effort and/or finances and there is no written agreement as to how each is to be compensated.
  • Some family members want to take over operations immediately, while others are unsure as to what role, if any, they wish to assume in the business.
  • Quarrels amongst family members over matters such as responsibilities or compensation distract the founders so that they find themselves concentrating on family matters rather than tending to business.

The end result of family discord is too often lost business opportunities. In many instances, uncertainty may lead to a downturn in business that in turn creates longer-term difficulties both emotionally and financially for the current and future owners.

Here are some tips that can help you deal with family business concerns and issues.

Get to the root of the problem

A family member may fail to follow instructions, meet targets, or be unable to manage the responsibilities of a job. Arm’s-length employees are more likely to explain why they were unable to do so, whereas family employees may be hesitant to say anything because their bosses are also part of the family. Try to remove the business of the family from the family business and encourage open discussions and suggestions for resolution.

Address problems as soon as possible so as to avoid their becoming even bigger problems.

Get everyone involved in the decision-making process

Too often the decisions made in a family run business are made by those traditionally seen as the power brokers.

This could be Mom and Dad or one of their adult children who has worked in the business for a long time. If everyone acquiesces to the perceived power, not only do the silent members of the family lose opportunities, but others may be taking on responsibilities by default. Older entrepreneurs may actually wish to turn over the responsibility of running the business but may not be provided an opportunity if all family members are not involved.

Try to ensure that management meetings include every member of the family who is involved in the business to avoid a top-down management style. These meetings are an opportunity for every family member to receive feedback and to learn from the experience of the current management.

Formalize the process

In that families do not have instructions for their day-to-day lives, family members in the business may adopt an informal approach in their business dealings. Have clear criteria for selecting and promoting family members. To ensure that all family members understand their responsibilities, obligations and rewards, document what is expected or promised. This practice avoids any misunderstandings as well as provides a basis on which decisions such as compensation can be made.

Family members should have the same accountability as any other employee in the business.

Know when you need outside expertise

Trying to resolve business problems that involve family can be difficult because sometimes if you solve the business problem, you can create a family problem…. and conversely, if you solve a family problem, you may create a business problem.

Know when you need outside expertise to assist in determining family needs, arriving at solutions and setting goals and time frames for their achievement.

An outside party can guide the entire family in making a decision that, if not acceptable to all, is at least a workable compromise. Sometimes business growth will necessitate looking outside the company for professional management or technical expertise. In some instances, a family business may need to consider hiring a bridge manager to help the company through a time of dramatic change in the business such as when an heir must assume a senior position before he or she has gained sufficient experience or when family members are fighting for control of the business.

Keep everyone in the family informed

Running a business and participating in family life is a balancing act. To ensure that all members of the family, those participating in the business and those who do not participate, understand the successes and challenges facing the business, plan to have meetings two or more times throughout the year to summarize what has occurred in the business, what the plans are for the next few months, and the impact on the
immediate family.

This information will help everyone know the importance of their participation and avoid unpleasant surprises for rescheduling either family or client commitments.

Family businesses often have long operating histories and strong growth opportunities. Addressing problems, opening the lines of communication, and knowing when you need professional advice or assistance will lessen the difficulties associated with family disagreements, succession, and tax and estate planning.

TAXATION

Reviewing Instalment Payments

Corporations are required to make tax instalment payments at the end of each month commencing with the first month in the corporate taxation year.

The Income Tax Act provides that a corporation has three options for making instalment payments:

  • 12 instalments of 1/12 of the corporation’s “first instalment base” for the year
  • 2 instalments of 1/12 each (based upon the corporation’s “second instalment base” for the year) plus 10 instalments of 1/10 of the amount that remains after deducting the first 2 instalment payments from the first instalment base, or
  • 12 instalments of 1/12 of the current year’s estimated taxes.

Since a corporation can choose which of the instalment methods to use, it should choose the one that defers payments for as long as possible.

Instalment Base

Just what is the “instalment base”? The first instalment base is considered to be the tax payable for the immediate preceding taxation year and the second instalment base is the tax payable for the second preceding year.

What happens if one of the prior taxation years that are used to calculate current year instalment payments is less than 365 days? In this instance, the short year amount should be annualized to a yearly figure.

If the prior period is less than 183 days, then the instalment base for that year is the greater of the annualized amount and the adjusted base for the next preceding taxation year of more than 182 days. Thus, if the calculation were based upon an 8-month period that had taxes payable of $40,000, the instalment base would be calculated on a base of approximately $60,000.

Instalment payments may not be required if the corporation’s estimated taxes for the current year or the first instalment base are less than $1,000.

If there has been an amalgamation of two or more corporations, then the instalment bases of all predecessor corporations are combined to determine the amount of instalments required.

Similar rules apply where there has been a wind-up of a subsidiary that is at least 90% owned or there has been a non-arm’s transfer of all or substantially all (generally 90% or more) of the assets of a corporation.

Regardless of which base is used to calculate the current year instalment, the current year’s dividend refund will reduce the base. A dividend refund is received by a corporation that has refundable dividend taxes on hand at the rate of 1/3 of taxable dividends paid.

Estimated Taxes Payable

If your company’s income taxes have been increasing annually, the most sensible method of paying your income tax instalments is to base your current year’s payments on the previous two years’ income tax liabilities.

However, if the income tax liability of your business appears to be decreasing in the current year, why place this working capital in the hands of the CCRA?

Rather than compute your instalments on the prior years’ instalment bases, it may be advantageous to calculate them on the basis of estimated income taxes payable. There may be situations that create a lower income tax liability in the current year than in previous years that you become aware of as the fiscal year progresses such as:

  • Your company may increase capital expenditures, thereby, increasing capital cost allowance deductions and possibly investment tax credits
  • A decrease in market share may signal a significant loss or reduction in profits, or
  • A significant increase in financing may create interest expense that lowers your profit position.

Balance of Tax

A corporation is generally required to pay the balance of its corporate taxes due within two months of its corporate year-end. However, companies that are Canadian-controlled private corporations throughout the year and that claimed the small business deduction in the year or the immediately preceding year may pay by the end of the third month. This extension is available as long as the aggregate of the taxable incomes of all associated companies in the group for the immediately preceding year did not exceed the aggregate of their business limits for the purposes of the small business deduction (generally $200,000).

The instalment bases and estimated taxes payable include the Part I taxes on income and the large corporations tax. Part IV tax on dividends received from Canadian corporations is due three months after the end of the year.

No instalments are required on account of the Part IV tax liability.

Review your Tax Instalment Requirements. Be sure to monitor your income taxes payable situation carefully as the CCRA charges interest, compounded on a daily basis, on unpaid instalments.

If your budget information is incorrect and your taxable income is actually equal to or greater than the previous year’s amount, your company will be required to pay interest on the difference between the instalments based on historical income taxes payable and the instalments actually made. Unfortunately, the interest expense is not an allowable deduction for the purposes of calculating taxable income.

Note that an instalment that is paid before it is required will earn interest credits. If you have been late with one or more payments, try to pay future instalments early. While the CCRA will not refund interest credits, the interest credits earned on the early payments will help reduce the interest charges that have accrued from the late payments.

In addition to instalment interest, there is a penalty of 50% of the instalment interest to the extent that it exceeds the greater of $1,000 and 25% of the interest that would be payable if no instalments had been paid.

Although in many provinces the instalment requirements parallel the Federal requirements, you should also monitor these taxes payable to avoid interest payments that may accrue on unpaid provincial taxes.

Talk to your Chartered Accountant

Your chartered accountant can help you review your corporation’s tax instalments. Careful planning will not only help your company’s cash flow but also reduce the erosion of the bottom line that could occur if you are assessed for non-deductible interest on overdue amounts.

MANAGEMENT

Debt Ratios

A ratio is the mathematical relationship between two amounts on the financial statements expressed in the form of a fraction, a percentage, or a decimal.

Understanding the meaning of key financial statement ratios can help the owner/manager evaluate the company’s performance as well as better plan for the future.

The owner/manager should review the company’s financial data on a regular basis to ensure ratios are within the norms for similar businesses or if the industry data is complete enough, within the industry average. Creditors analyze a company’s financial statements when determining a company’s ability to meet its obligations.

Ratios that compare favourably or exceed the norms can enhance the company’s credit rating and its ability to obtain financing.

Working Capital

Working capital, which is the amount by which current assets exceed current liabilities, serves as an indicator of a company’s ability to meet its short-term obligations.

Current assets/Current liabilities

This ratio should be at least 2:1. The higher the ratio (e.g., 4:1, 5:1), the happier the creditors.

Quick Asset

Creditors will often review a company’s liquidity to determine its ability to turn assets into cash. An important measurement, the quick asset ratio (sometimes referred to as the asset test) compares assets that may be turned into cash in 30 days or less to meet the liabilities that must be paid within 30 days.

Cash+temporary investments+30 day accounts receivable:30 day accounts payable. Any ratio that is less than 1:1 would be of concern as it implies an inability to meet current debt.

Debt to Equity

The debt to equity ratio measures the company’s debt versus the amount of investment the owner/manager has in the business.

Total debt (long – term and short – term) Equity

This ratio helps creditors evaluate how secure the business is. If total debt amounts to $500,000 and equity $50,000, this ratio of 10:1 means that for every $10 of debt, the company only has $1 available to meet its obligations. Not a good sign.

Accounts Payable Turnover

Accounts payable turnover is an indicator of whether a company is meeting its obligations to creditors within normal time frames.

Accounts payable/Cost of goods sold x 365 days

This ratio indicates the number of days it takes the company to pay its bills. For example, $95,000/$370,000 x 365 indicates that it takes the company 93.7 days to pay its suppliers. If the trading terms are 30-60 days, the company is likely experiencing cash flow problems.

Interest Coverage

Interest coverage shows whether or not a company can meet the fixed interest charges on the debt. This is an especially useful ratio to examine if you are contemplating a significant loan.

Profit before taxes+Interest/Interest

Generally the acceptable ratio is 3:1; that is, if profits before taxes are not at least 3 times the interest cost, the company may need to make some adjustments in its operations.

Applying Ratios

A single ratio will not help you determine the relative health of your business. Neither will a ratio provide a solution to a problem. However, by understanding the significance of various ratios, you will be in a better position to address operational difficulties and work towards improvements that make a difference
when seeking credit.

Owner/managers seeking additional credit or wanting to ensure their debt obligations are within the norms of similar businesses are well advised to build an historical chart of the company’s debt ratios.

With today’s computerized accounting systems, you can mine your data for information that can help you monitor your debt structure on an ongoing basis.

As consistency is necessary to avoid skewing the results, discuss your reporting systems with your chartered accountant. With a consistent model and accounting allocation format in place, you can monitor the company’s debt in the best interest of the bottom line and ultimately the shareholders.

BUSINESS MATTERS deals with a number of complex issues in a concise manner; it is recommended that accounting, legal or other appropriate professional advice should be sought before acting upon any of the information contained therein.

Although every reasonable effort has been made to ensure the accuracy of the information contained in this letter, no individual or organization involved in either the preparation or distribution of this letter accepts any contractual, tortious, or any other form of liability for its contents or for any consequences arising from its use.

BUSINESS MATTERS is prepared bimonthly by The Canadian Institute of Chartered Accountants for the clients of its members.

Richard Fulcher, CA – Author; Kathleen Aldridge, B.A., Dip. Ed. – CICA Editor.