1. What are the benefits to entrepreneurs who use debt capital (leverage) to finance their companies' growth?
2. What are the risks associated with debt financing?
3. Why is using ratio analysis to keep track of their companies' financial performance over time so important for entrepreneurs?
4. What lessons concerning the use of debt financing can entrepreneurs learn from Charles Kuhn's experience?
5. Assume the role of a small business banker. Suppose that Kuhn were to approach you for a bank loan to refinance his debt. Which financial ratios would you be most interested in? Why? What advice would you offer him?
6. Assume the role of a small business counselor. What advice would you offer him to ensure the long-term survival of Kopp's Cycle?
The Challenges of Debt Charles Kuhn's business, Kopp's Cycle, is a part of bicycling history. E. C. Kopp founded Kopp's Cycle in Princeton, New Jersey, in 1891. The Kopp family operated the business until the Kuhn family purchased it. Eventually Charles took over the store from his father in the late 1970s. Celebrities from Albert Einstein to Brooke Shields have purchased bicycles from Kopp's Cycle. Legendary road racing cyclist Greg LeMond was a customer from the time he was a junior racer. Kopp's Cycle looks like a typical bike shop. The front of the retail store displays high-end bicycles and accessories. In the back of the store is a repair shop that looks the same as it did when Kuhn's father first purchased the business. Charles Kuhn purchased the building that houses Kuhn's Cycle in 2004 for about $800,000, which he financed with a $775,000 loan secured by an SBA guarantee. Kuhn was not happy with SBA financing, however, because it came with significant additional paperwork. In addition, the SBA loan had an adjustable rate, which made him worry about the actual long-term cost of the loan and the uncertainty about payments as the interest rate changed. As a result, Kuhn refinanced the loan through another bank that offered him a conventional fixed-rate loan for $825,000. This new loan was not an SBA-guaranteed loan, which pleased Kuhn. At the time of the refinancing, the building was appraised at $1.3 million. Although the loan was amortized over 25 years, it had a balloon pay ent of $775,000 due in three years. Balloon payments are a common feature of loans to small business owners. At the time of the balloon payment, the borrower must refinance, either with the current lender or with a new lender. The economic downturn in 2008 hit Kopp's Cycle hard-as it did many other small businesses. In addition, online sales of high-end bicycles were increasing significantly. Online retailers were able to offer prices that a small business like Kopp's Cycle could not compete with due to its lower sales volume and higher overhead. Revenues dropped from $498,000 in 2008 to $393,000 in 2009. Kuhn cut prices in 2010 to compete with online retailers, which did bring his sales levels back up. However, the price cuts resulted in profit margins dropping from 10 to 15 percent down to 1 percent. To manage cash flow during this time, Kuhn relied on credit cards as a funding source for the business. He amassed credit card debt of more than $100,000. With the growth in online sales, Kopp's Cycle has created an increase in demand for service. To address this change in the industry, Kuhn has doubled the number of employees in the service department and streamlined the process for accessing service in his store. When the focus was more on bicycle sales, customers often waited up to a month to get their bicycles back from service. With the new focus on service as a key part of its business model, Kopp's Cycle now gets service done in less than a week. Kuhn decided to seek new financing for his business. His plan was to borrow $1 million to pay off the $800,000 balance on the building loan, pay off the credit card balances, and provide $100,000 in working capital to help manage cash flow. Kuhn estimated that his building is now worth about $1.5 million, which he believed should be more than enough equity to support the loan. The first bank Kuhn contacted about a loan declined to make a loan. After reviewing Kopp's Cycle's financial statements, the loan officer said Kopp's Cycle's debt coverage ratio, the ratio of monthly net cash flow divided by debt payments, did not meet the bank's minimum of 1.1 to 1.5. With Kopp's Cycle's declining profit margins, it could not meet the required debt coverage ratio. Bankers want to see a significant cushion in a company's monthly cash flow to ensure that even if the company's financial position declines, it can maintain payments on the loan. The second bank Kuhn approached gave him the same answer. A third banker did not even return Kuhn's phone calls. Kuhn then turned to a loan broker, to whom he paid an upfront fee and who would take 10 percent of the loan amount once a loan was closed. However, the bank the loan broker found for Kuhn to talk with also passed on the loan, citing concerns over the true market value of Kuhn's building. Although Kuhn did not believe that a new loan was essential for the survival of the business, he had hoped he could secure new financing to bolster Kopp's Cycle's financial position. In addition, Kuhn must address the balloon payment that is part of his current building loan sooner than later. There is no guarantee that his current bank will renew this loan, and he has not had much luck finding alternative financing
