The Fallacy of the Middle-Class: Overcoming Social Resentment (XI). Debt as ACOT (part 2).
Have a beautiful week,
Last Friday we ended our publication with the following question: What happens when families do not have anything but a wage, do not have real estate assets, do not have savings neither investments, do not have remittances flows, but only depend on a salary or income per month from a fragile entrepreneurial activity? And on top of that, this family has financed its wants and needs with debt? This is a roadmap to disasters!
The United States of America is one of my favorite examples for this saga because I can connect the dots between the meaning of being poor in the US (median average low-class) and the Salvadoran LMIC status (Low Middle-Class Income Category). In addition, by analyzing our Salvadoran example, I am extending different ideas to recognized economists, public policy representatives, professors, and studious business researchers in the US (and the world) that might provoke in them the desire to think about how to solve our issues as a Middle-Class in a different manner. I hope that some of my ideas can provide hints or different approaches on how to fix the multidimensional poverty issues, which are as outstanding in the Middle-Class anywhere in the world.
Timing is everything. If an LMIC family with revenues or gross income of US$28,800 dollars per year begin to finance its wants and needs with short term debt (credit cards) or long term debt, without having a cushion of savings of the same quantity of US$ 28,800 in the bank, that anticipates the crucifixion path to return back to poverty again. As simple as that. As I wrote at the beginning of this saga, the big issue with using debt is not that is bad as a financial product, it means that debt (short or long term) has to be used wisely and in the context of the right timing. It signifies that using debt when families or companies do not have savings, sets them up for an economic organic failure, inevitably. And I express this because I have lived it in my own skin.
The new financial management approaches for the next generations have to start in primary school. We can´t wait to go to business school 20 years later, to try to learn the concepts of cash flows, working capital, debt, equity, or how to interpret balance sheets and income statements and cash-flows. It is not possible to continue educating people at school without providing at least the basics about financial education and management or financing decision making. Many of the Middle-Class members all over the world are self-made, many were and are and will not able to finish university degrees, many of them have not selected, are not and won´t choose a career in business administration. In consequence, there are basics that must be taught in the K-12 levels of education about earnings, expenses, the utilization of debt, or the importance of savings. More relevant is to teach the context of timing is everything when it comes to debt utilization, and that there are life-cycles in life for people in which debt must not be even be considered, particularly long term debt; meanwhile there are other times in which it is possible to get indebted. Schools have to teach us that we have to wait many years to get our savings, before considering long-term debt to buy our assets, and that we have to use short-term debt cautiously and wisely, knowing that our savings are always in our pocket.
Debt as a Cherry on Top (ACOT) for LMIC families. Last week I expressed that debt has to be utilized only as ACOT (As a cherry on top). Specifically when we are speaking about household members of the Middle-Class (Low-Middle, Mid-Middle, or High-Middle). When we are speaking about financial decisions in a household, debt (short term obligations below a year) has to be selected only when we have savings. In the case of long term debt, it should be reserved only to acquire the family house (long term debt), and only when the family savings have reached at least 28,800 dollars per year (as a minimum). For example, let´s see our LMIC Salvadoran family. This lovely family has an income of US$2,400 dollars per month. They are paying a rental of a house located in La Cima II, San Salvador, for a monthly check of US$550.00. This family has been dreaming to own their own apartment and they have been saving quite a lot diligently since the year 2015. During the last 5 years, their savings have been for an amount of US$350 dollars per month earning 3.5% annual interests year over year. In total at this point in time, this family has US$ 22,400 dollars in her bank savings account. The family has seen a beautiful option in a real estate project located outside the city, www.casasdelarbol.com. This residential unit costs US$110,000. The mortgage package is designed for monthly installments of US$650.00 dollars/month at a rate of 6.95% year. The option of swapping the rental payment of their current house at la CIMA II Neighborhood to a bank mortgage for an “owned home” is appealing. Nevertheless, the only way in which Mom can pay US$650 dollars at Casas del Arbol project will be by reducing savings in their 50/30/20 budget. They will be obliged to save only US$ 250.00 dollars per month, instead of the US$ 350.00 that is used to be deposited to the bank monthly. Would you advise her to get indebted instead of continuing to renting the shelter? Is it a good deal?
Eleonora Escalante Strategy would advise her to stop renting and apply for a bank loan, the mortgage to buy the new home. Why? (1) Because it is long-term debt and it is for an ASSETS NEEDS category (not for WANTS). It is better to switch the monthly rent payments for mortgage installments to the bank to acquire her new house. (2) We can ONLY advise this to her because she has US$22,400 dollars of savings that she has been informed to don´t touch at all for anything. This family deserves recognition for their discipline to save. They already have a financial cushion of 20.36% of the new asset to buy at Casas del Arbol (US$22,400 of savings divided by US$110,000 that corresponds to the new house cost x 100%). (3) The family is committed to keeping their savings growing (this will require for her to continue saving US$250/month until her income increases again in a few years, a future point in time in which as soon as she earns better, she has expressed to continue saving 20% of her future wages. (4) This family doesn’t have any other type of previous outstanding debt. This is a case in which we can advise you to get long-term debt. The family will invest in its own real estate asset. The family has 20.36% of the house in savings, and this mom is extremely disciplined to keep savings as a priority in her budget. Once this family reaches US$ 28,800 of savings (by the end of the year 2022). Then and only then I could advise her to consider beginning to invest her savings in a balanced conservative financial portfolio.
Debt is tricky in businesses. In addition, when we are talking about our businesses, we should consider debt only when we have enough evidence that our EBITDA numbers have been growing during the last 5 years, and our revenues and net profits have achieved a compounded annual growth rate of at least 10% or more (measured in real terms – inflation-adjusted). In addition, our average annual total shareholder return (stock price appreciation + dividends paid on each dollar invested) MINUS the cost of capital must be greater than zero. If these three measures are not in place, please do not consider to get debt, because your business has not been reaching profitable growth yet. If your company is not public (it is not listed on any stock exchange) then, at least your ROE and other critical financial analysis ratios have to be acceptable and healthy year over year.
Debt is slippery, and without proof of evidence that our businesses have reached a sustained value creation rhythm for at least 5 years, and so on a rising compounded profitable growth, it is not a good thing to consider debt in massive amounts for our capital expenditures growth plans. Particularly if we don´t have savings. Many companies reinvest their earnings, without saving anything year over year, and that is really a mistake. After COVID19, I hope you have understood this concept. In addition, business owners have to recognize when to use long term debt (only for long term projects) in comparison to short term debt (only for cash management and short term obligations that can be paid off with cash on hand). As a rule of thumb, if any of us (families or businesses) wish to raise debt to buy assets, we must hold at least between 20 to 30% in cash on hand (savings) in our pockets for the case of buying a home. And in general, for businesses, between 30% to 40% in cash and marketable securities or certificates of savings deposits, when considering long term debt related to expansion growth projects or capital expenditures. For example, a real estate company must not look for debt to build housing projects if it doesn’t have at least 40% of the total project value as cash in hand in its pockets.
I am very conservative when it comes to the utilization of debt. But I have learned through my own mistakes and I have seen disasters when it comes to debt practices not just in the small and medium enterprises level, but also with big corporations that were not ready for such a disaster as the COVID19. If these companies would have put in place a more conservative approach, I am sure that they would have been able to shut off their company for a year and keep all their personnel (without firing anyone) because they had enough savings to administer their short term working capital requirements, With enough precision to survive the pandemic between March 2019 until April 2020. The importance to save is crucial. After the pandemic, there will be enough company proceedings to analyze as Harvard study cases, that will be the subject of research and study to prove it.
On my next publication, that is tomorrow, I will develop the eighth theme of our outline “Multidimensional Poverty Still exists at the Middle-Class level”. Thank you for reading to me.
Sources of Reference utilized for this topic:
Eleonora Escalante Strategy Research Division.
Disclaimer: Illustrations in Watercolor are painted by Eleonora Escalante. Other types of illustrations or videos (which are not mine) are used for educational purposes ONLY. Nevertheless, the majority of the pictures, images, or videos shown on this blog are not mine. I do not own any of the lovely photos or images posted unless otherwise stated.
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