When you have cash on hand in a business, one part of your treasury reserve strategy should be debt reduction. A balance of working capital, debt reduction, and short-term investment is a much better use of that cash than just a pile of it sitting in a savings account.
So how should your business deal with the debt part of that equation? Everyone wants to be debt-free when they retire, so making sure your business and personal accounts are settled up makes good sense.
But what is the best way to go about it? The two most common approaches are to go from smallest to largest or to go from highest interest rate to lowest interest rate. So, you are either tackling debts from the smallest dollar amount to the largest, or tackling the highest interest-rate loan and then moving on until you finish with the lowest.
Given a choice between these two methods, we prefer smallest to largest. There is a psychological boost when you close out one debt and don’t have to think about it again. Starting small and moving on gives you that boost as you move along to the bigger debts—and you can tackle them and move on again.
So, you can manage your business’ treasury reserves—in part—by a careful plan to eliminate debt. But there is a third way to do this that we like even more than tackling debt from smallest to largest. We’ll walk you through it.
The Uncommon Debt Reduction Ratio
Here’s how we utilize the Uncommon Debt Reduction Ratio to determine which loan to pay off first.
Uncommon Debt Reduction Ratio:
Remaining Debt Balance/Minimum Monthly Payment
The formula is simple. You just enter the numbers from each of your loans into the equation, then pay down the loan with the lowest ratio number before overpaying on any other debts. The closer the ratio score is to zero, the bigger the bang for the buck to pay off that debt.
Here are some examples:
So, the order in which you should pay things off is:
Why do we like this better than a simple “smallest to largest” strategy? As we said, it is a way of getting a bigger bang for your buck. You are (generally) getting rid of the high minimum payments quickly, leaving more of your cash on hand available to pay down the debts as the ratio climbs well above zero.
As part of your corporate treasury strategy, you want to make sure you have three to six months of cash on hand to manage the day-to-day of your business. Then you want to use a portion to pay down debts. Some financial advisors would insist on eliminating debt before putting money anywhere else. We are not that insistent. There can be good reasons for debt, especially in building up a business.
In our previous article, we talked about borrowing against cash-value life insurance policies owned by the business to pay off debts. That shifts the principal and interest payments back to the life insurance policy and thus the business all the while the insurance company owes you dividends and interest on the cash-value like it was still there!
The point is to manage that debt wisely. We think the Uncommon Debt Reduction Ratio is the best way to prioritize corporate debt while maintaining cash reserves and making other plans with your corporate treasury.