Debt is a curious little word. Despite its straightforward meaning, it’s slowly climbed the linguistic ranks to now sit alongside other, more colorful four-letter words sprinkled throughout our robust and vibrant language. However, although debt can undoubtedly lead to significant issues if not delicately balanced with cash flow and other considerations, as any accountant or financial wizard worth their weight would attest, a little bit of debt is what makes the world go ‘round, companies grow, and the markets bloom like daffodils in spring.

To help you utilize debt in the healthiest, most effective way possible and leverage its benefits without taking on too much water, Embark has put together some simple best practices to consider when entering into a new debt agreement. Proceed with hopeful caution, always read the fine print, and be mindful of weighing sufficient aggressiveness with financial tom-foolery. The world wants to see what your company is capable of accomplishing, and these considerations can help ensure any new debt agreement is in your best interest, fully understood, and is a necessary stepping stone to bigger and better things. 

There Are No Cliffs Notes to Your Debt Agreement

Unlike a dreaded Russian novel from your collegiate days, there are no shortcuts to passing a metaphorical debt agreement exam. There’s no one to copy notes from, internet sites to save your bacon with insightful summaries, or make-up exams if you happen to fall a standard deviation or two to the left side of the bell curve. With a debt agreement, a failing grade could have devastating consequences for the entire company.

That isn’t to say, however, that debt agreements should be feared and, therefore, avoided. In fact, it’s really just a matter of doing all of the necessary homework. That, our friends, is the critical first step to consider when entering into a new debt agreement -- read your documents. Granted, many agreements read like the instruction manual to a new refrigerator, but that doesn’t make them any less important or vital to your company’s well-being. In other words, keep the coffee flowing, take copious notes, and hunker down because understanding your debt agreement is just as important as the time and effort you devote to customer service or your financials.

Specifically, understand what you’re using as collateral for the debt. Is it a specific property? Maybe the general assets of the company? In a worst-case scenario, a company doesn’t want to be surprised if a lender suddenly freezes all of its cash after a default, effectively forcing all operations to come to a grinding halt. Put more simply, understand what you’re getting into because surprises lead to premature gray hair and flop sweats.

Likewise, be sure to understand the debt covenants included in the agreement. These covenants could involve keeping a certain amount of cash available to ensure liquidity, or a variety of other baseline requirements. In that worst-case scenario, a thorough understanding of the legal ramifications in failing to satisfy the debt covenants might not have avoided cash being frozen, but would have at least eliminated the surprise element. Also, take note of any ongoing reporting or audit requirements while the debt is still outstanding. Smaller or newer companies should not be shocked if they are obligated to conduct an annual audit and provide a lender with the results every year while the debt revolves.

Understanding the nature of the debt is another important consideration when entering into a debt agreement. In the instances where multiple lines of credit with numerous lenders are open at the same time, always know who is a secured lender and if each line is either senior or junior debt. Knowing who gets paid first if the company hits a pothole in the road is critical to satisfying any outstanding obligations.

Don’t Stumble Out of the Blocks

While this might seem like an instance of stating what’s already obvious, it’s impossible to overstate the importance of establishing sound accounting for the new debt agreement from the very beginning. Bad accounting will have a cascading effect that, to put it mildly, is absolutely no fun. Establish any needed schedules and internal processes to properly record the cash received from a new debt agreement, as well as the principal of the debt itself, the discount or premium, and any debt issuance costs.

Stay Organized and Informed

Obviously, understanding the intricacies of a new debt agreement and establishing sound initial accounting are critical first steps. Going forward, you should focus on tracking the impact of the debt on your financials, particularly with a Debt Roll-Forward schedule. While the inputs and even design of such a schedule can vary widely between companies, industries, and according to the nature of the debt itself, Embark has prepared a simple example of a typical Debt Roll-Forward schedule to give you an idea of what to include on yours. You’re welcome.

Use our example as the basis for conversation between your accounting and finance departments to develop a schedule that includes all inputs and insights appropriate for your specific needs. Of course, it should consist of the interest rate(s) and payments, providing sufficient detail to demonstrate the incremental impact of those payments or absorption of additional debt.

Depending on the circumstances and your particular preferences, you can include amortization of the discount or premium as well as debt issuance costs on your Debt Roll-Forward schedule -- as in our example -- or record them separately. The amortization details also provide the opportunity to calculate and analyze the effective interest rate which, given the depths of that particular rabbit hole, we’ll discuss more thoroughly down the road. We would both need financial spelunking gear to adequately navigate those depths at the moment.

Lastly, make sure the debt is classified correctly on the balance sheet, categorizing it as either long or short-term debt, based on when the principal payments are scheduled to occur. Part of using debt to the most benefit is understanding what’s involved in the agreement and recording all of the moving parts appropriately. Give our sample Debt Roll-Forward schedule a look, decide what inputs and format best suit your needs, and give your company every opportunity to reach its potential. As always, we have faith in you, kiddo.