Critical Issues — Financial: Debt Management

Is there such a thing as good debt?

 

Owning a restaurant means incurring debt — it goes with the territory. But not all debt is created equal; certain kinds can move you forward, other kinds can tilt you towards disaster. What spells the difference between good debt and bad?

“Debt isn’t inherently bad or good,” explains Chris Alberta, senior managing director of Conway MacKenzie, Inc., a Detroit-based consulting firm providing turnaround/crisis management services. “It depends on the intent of its use. Debt used to mask deficiencies in the operations is bad, but debt taken on as growth capital to expand a profitable concept can be a very good thing.”

Fred Wolfe, who drives the operations and executive leadership team for Orange County, California-based Synergy Restaurant Consultants, says good debt doesn’t exceed low income expectations. Debt turns dangerous when paying it back depends on maximum cash flow and everything going right.

“This raises the risk level substantially and increases the likelihood of a default,” he explains. “Bad debt also carries a high interest rate because of risk or lack of a financial history. Leveraged debt always carries an inherent risk and can be exemplified by the high number of restaurant company bankruptcies.”

When undertaken sensibly to move the business forward in a planned way, and there’s a sustainable way to pay it back, taking on debt can work in your favor, says restaurant consultant John T. Self, a professor at the Collins College of Hospitality Management at Cal Poly Pomona. Bad debt is unplanned and unsustainable. Depending on the circumstances it can be a mere annoyance or it can become catastrophic, he adds.

Nick Sarillo, owner of two Nick’s Pizza Pub restaurants located in Illinois (one in Crystal Lake and one in Elgin), knows firsthand how quickly debt can turn surly. Sales at both sites were strong, so good that he began the process of opening a third location. However, around 2007/2008, business started to roller coaster, especially at the Elgin location (where the dips hit the double-digits). At times, Sarillo says he couldn’t cover the mortgage or overhead.

To keep the business going he tapped into a line of credit. His predicament worsened. The third restaurant didn’t pan out, thanks to a change of lenders, and he lost over $300,000. The opening of a Super Wal-Mart across the street from the Elgin site was delayed, depriving Sarillo of an anticipated boost in traffic. He began offering steep discounts on Monday and Tuesday nights, running this program for almost two years. This initially helped profitability, but when it began eroding the weekend business he ended it.

By 2011, thanks to severe winter storms and disruptive road construction at both locations, things were dire. Barely hanging on, this September Sarillo emailed a letter to the frequent diners in his database explaining his situation, asking for their support. It posted on Facebook within minutes. His phone began ringing and customers poured in. Now, says Sarillo, they’re about 75 percent out of the woods.

But Sarillo isn’t banking on this alone to keep him going; he started taking a different approach to running his business. He began monitoring operating costs. He reduced overhead by streamlining his management staff, which he had kept too high in anticipation of opening more locations. And he hired a consultant, who pointed out a major error — Sarillo hadn’t been looking at the balance sheet as a whole, looking instead at each restaurant’s individual performance. Consequently, he hadn’t realized how negatively the Elgin site was impacting the entire business.

By not analyzing the contribution each store was making to the corporate overhead, Sarillo made a common error. Alberta says restaurant owners/operators often fail to look at every aspect of each site’s performance — what he calls doing a “four-wall” analysis. With this data it’s possible to compare one location to another and identify problems before more debt is incurred and profitability is further eroded.

“If on a store-level basis, the operations are cash-flow negative, new debt would be unlikely to improve the overall cash flow and could compound the cash-flow problem,” Alberta says. And “if they’re not generating a positive cash flow on a four-wall basis, adding new stores could actually lead to decreased profitability.”

The biggest mistake Self sees owners make is not having a budget income statement. “They don’t do inventory, they don’t do cost of sales or food costs, they don’t do P&Ls. They just sense they’re losing money but they don’t know how much or where.”

They also fail to plan — and save — for debt, maintaining sufficient cash reserves to handle equipment breakdowns or replacements, Self says. Instead of being proactive, they react — never a good strategy.

“Another error is failing to do a cost/benefit analysis when they need to purchase something, asking why they’re taking on the debt and how they’re
going to pay for it,” he says.

Perhaps the biggest downfall is being overly optimistic in their sales forecasts and/or cost management, says Wolfe. Sarillo says he did this, but no longer.

“Now I’ve started operating as the two-restaurant business we are rather than as the five-restaurant business I wanted to be,” he says. “I got real.”