The July 30, 2011 Wall Street Journal had a headline of, “For Investors, Cash Is King.” Of course, business owners and business buyers have known that forever. There is no substitute for cash in the bank.
I speak regularly to groups of [possible] business buyers. I always tell them that in business buying and ownership, “Cash and cash flow are king.” The most common lament from business owners is, “We’re undercapitalized.” When buying a business, banks have debt coverage ratios and they are usually 1.25-1.35:1 (meaning for every $100 of debt repayment the business needs $125-135 of profit). That’s not a lot of cushion given taxes, growth and hiccups.
Not a lot of cushion is why you read about private equity firms over-leveraged. The most recent one was the owners of Dunkin’ Donuts who recently had an IPO. They were paying 75% of operating earnings to interest and needed relief. That was probably acceptable to the lenders but it didn’t leave much for growth. Small business owners in the same position don’t have the option of going public which is why it’s important to not be over-leveraged.
It’s also why banks like the deals my clients bring to them because we shoot for a debt coverage ratio of 1.8-2.2:1. This provides lots of cushion and provides growth capital. Business buyers don’t buy a company to keep it the same. Every one of them buys it to grow it and do better. To let their excitement, skills and passion drive growth. Having enough cash flow after debt repayment gives them a better chance to grow.