Financial Planning 6

In lesson 5 we looked at at debt management. We examined what is good and bad debt and how to responsibly get into debt.

This week we will examine how to manage existing debt with a view to getting out of debt.

Ok so lets examine the books of Ngozi, a 34 year old entrepreneur who owns Ngozi Restaurant in PortHarcourt. Ngozi’s cash flow comes from her restaurant, both discretionary and non-discretionary. Ngozi is in debt of N2,365,000, but  her restaurant only makes N100,000 a month net after paying her expenses, eg salaries, water DSTV etc., a schedule of her debts with interest charged on loan are listed below. All interest rates are assumed at per annum

1.Restaurant Delivery motorcycle loan,  N60,000 @10%

2.Startup loan for restaurant  from her Husband N500,000@ 0%

3. Ngozi’s N100,000.00 credit card balance @ 40%

4. Ngozi Restaurant Consumer credit from bank N300,000.00 @15%

5. Ngozi Restaurant Trade credit from rice supplier N1,000,000 @ 4%

6.Personal loan from market association N300,000 @5%

7. Ngozi Restaurant Overdraft with bank N100,000 @30%

8. Ngozi Musical Association levyN5000 @0%

First this we notice is that Ngozi has not separated the business debts from her personal debts. Ngozi and Ngozi Restaurant should be two separate legal entities, with separate cash flows.

YES Ngozi own Ngozi Restaurant 100%, but the cash generated by Ngozi restaurant should not be simply taken out by Ngozi. So first thing is to separate Ngozi Debts from the Restaurant debts as done below

Ngozi Personal Debts

1.Personal loan from market association N300,000.00 @5%

2. Credit card debt N100,000.00 @40%

3. Musical Association Levy bill N5000 @0%

Total N405,000.00

Ngozi Restaurant Debts

4.Restaurant Delivery motorcycle loan, N60,000 @10%

5.Start up loan for restaurant  from her Husband N500,000@ 0%

6.Restaurant Consumer credit N300,000@15%

7.Trade credit from rice supplier N1,000,000 @4%

8.Restaurant overdraft N100,000.00@30%

*Note Start up loan from her husband in NOT a personal loan buy Capital for the Business.

Total N1,960,000

So we have a clear picture, we can see Ngozi Restaurant is over geared meaning she is has over borrowed to finance her business. Her Husband gave her N500,000 to start the business but Ngozi Restaurant is owing N1,960,000. This are liability with interest bearing elements.

The next step after separating Ngozi personal liabilities from Ngozi Restaurant corporate liabilities, is to relist the liabilities, starting with those liabilities with the highest interest rate, so again

Ngozi Personal Loan

1.Credit card debt N100,000.00 @40%

2.Personal loan from market association N300,000.00 @5%

3.Musical Association Levy bill N5000 @0%

Total N405,000.00

Ngozi Restaurant

4 Restaurant overdraft N100,000.00@30%

5.Restaurant Consumer credit N300,000@15%

6.Restaurant Delivery motorcycle loan,  N60,000 @10%

7.Trade credit from rice supplier N1,000,000 @4%

8.Start up loan for restaurant  from her Husband N500,000@ 0%

Total N1,960,000

So Debt Management Strategies

Now Ngozi must from her budget, set aside a clear provision to pay down her debts starting with the debts with the highest interest rate charges, NOT the highest amount. Eg she pays down her 40% credit card debt before she pays down the personal loan. Note she can pay all down at the same time but not equally, she must apportion a higher percentage to higher interest debts

Ngozi restaurant should also cut down on Discretionary expenses or seek a cheaper source of funding to get out of the high interest bearing loan. For example, she can borrow from the market association and pay down the expensive overdraft from the bank.

In terms of good debt, the trade credit from her rice suppliers is good because she gets inputs at a low interest rate, so she must ensure she manages this relationship. Thus even though this loan is not a high cost, its impact on her operation is key.

Ngozi should not switch between accounts, she should not take cash from Ngozi restaurant to pay down her personal loans. She should pay herself a salary from her business. This makes cash withdrawals disciplined. As the owner she can also pay herself a cash dividend or profit sharing at the end of the year or quarter, but should not simply take cash from the business to fund her expenses. Yes even if she owns the business 100%.

Ngozi should pay down her personal loans from her salary which she will pay herself from Ngozi Restaurant, also starting with the loans with the highest interest rate.

Its ok to “borrow” cash from your business, but when you do, charge yourself interest, there is no free cash. Borrowing from your own business at “no cost” has a cost called Opportunity Cost. That simply means what your business would have earned if it did not borrow that “free” cash to you but simply invested it say in a bank. Thus the cost of borrowing cash from your business is the loss of earning if the cash stayed in a bank.

Note that when you get a “start up loan” from a family member or friend at 0% it still has a cost. When you do your accounts, do a second set of accounts and assume you’re paying an interest on that “free” loan, would you still make a profit? If you don’t make a profit when you charged that “free” money at a commercial interest then you have to rethink your business model, as your profit is generated via a subsidy. It is important you know this.

Ok we stop here and start a new topic on how to target save for children education, retirement etc

Technical Jargon of the Day

Zero Based Budget

A method of budgeting in which all expenses must be justified for each new period. Zero-based budgeting starts from a "zero base". As compared to traditional incremental budgeting.

In Incremental budgeting, there is a base year or amount and the next years budgets are based on that year or base amount ie an incremental to the last year.

Question Answered

I asked last week if Esusu was a good strategy. Sadly it’s not. Esusu is good if you “take” first i.e. you get the bulk contributions first. If you’re last on the queue to get the bulk contributions, you’re actually losing money because of Time Value of Money principle.