Part 2: Dude, Where’s My Cash?

I considered calling this post “Be Nice to Your Banker,” which is good advice, but the following will encompass more than just borrowing from banks.   We are still on the subject of Cash Flow and Business Financing.  In Part 1, “Dude, Where’s My Cash”, we tackled the highly informative Statement of Cash Flows and how it can help you understand how cash is moving in and out of your business.

Today, we will talk about how we can get cash in the door, to cover all that cash that keeps going out the door, what is meant by “leverage”, what types of financing are available, and why you should be prudent but not fearful of debt.

Let’s start with “leverage”, which is another word for debt, but more descriptive.   Think of a simple machine like a lever or a pulley.   With your own strength, you can only lift a certain amount of weight.   But due to the laws of physics, a simple machine can generate more work (output) with the same amount of input.   This also applies to money.   Suppose you have $1.00, and that for every dollar you invest in your business, you can generate $2.00 in sales.   That’s a 2:1 ratio.   But if you can persuade a bank to lend you $3.00 for every $1.00 of capital that you have, then you now have $4.00 to invest – and with that $4.00, you can generate $8.00 in sales.   That’s $8.00 in sales from 1.00 of capital – a “leveraged” return of 8:1, not 2:1!   So, “leverage” is not just debt  – it is the process of using our capital to gain access to more capital, for the purpose of growing business more quickly.

Now, you may point out that the debt must be paid back from profits.   Yes, quite true.   The reason why leverage works is that the bank (lender) allows you to pay back the loan over time.   This leads us to the necessity of understanding the difference between “short-term” debt and “long-term” debt.

Principle A:   Short-Term Debt should finance Short-Term Assets.

The primary example of Short-Term Debt is a Line of Credit.   Generally, a Line of Credit is designed to fund your short-term cash flow needs.   Remember our Statement of Cash Flows – if you sell product (or service) on credit terms, you are always waiting for cash to come in (Accounts Receivable).  While you wait, how do you keep all the bills paid?   Well, you can stretch out your suppliers to a certain extent, but that may not be enough and besides, you may have opportunities to get purchase discounts by paying early.   Your banker may give you a Line of Credit – subject to certain limitations – that can be tapped to cover your cash needs while you wait for payments to roll in.     When you get paid, you can pay down the Line of Credit balance.

Lines of credit can also finance Inventory.   If you have a business what relies on keeping Inventory on-hand, this can be critical to your success because your Line of Credit enables you to buy “x” amount more product that you can then sell at a profit – and pay back the balance when those sales occur.

Bankers feel more secure with Accounts Receivable than they do with Inventory.   This has to do with risk.   By definition, Accounts Receivable are amounts owed to you on sales you have already made.   If your customers are financially solvent, they will usually pay you.   Inventory requires a future sale to be made in order to turn that inventory into cash – and that carries more risk.   When a bank grants you a line of credit, it will collateralize that line of credit by having you sign over a security interest in your “business assets” which includes your Receivables, Inventory, and all other assets that are not already pledged to someone else.

Most Lines of Credit offered by lenders are “revolving” Lines of Credit – which simply means that you can borrow, repay, and re-borrow the same funds, over and over again, subject to certain limits.

Summary of Short-Term Debt:

• Purpose is to finance “short-term” assets such as Accounts Receivable and Inventory
• Loan balances should be repaid in the near-term, but can be borrowed again (revolving credit)
• Usually priced based on “short-term” indices such as the Prime Rate of interest. This means it will have a “floating interest rate” which will change every time the Index changes.

Other Types of Short-Term Debt:

• Credit Cards. In your business, these can be useful but they are usually “unsecured” (no collateral) and, as a result, carry a higher rate of interest.
• Time Notes. These are usually very short-term (3-12 month) loans that essentially function as Bridge Loans – that is, they are used to finance a specific cash need (perhaps a large purchase or project that will turn into a large sale) and will be repaid entirely from that one specific event.
• Shareholder Loans. Sometimes, if bank credit is not available in a given situation, it is possible for the business owner(s) to lend their own money into the business to solve a short-term cash flow need.   Generally, these loans should be repaid as quickly as possible, and they should always accrue interest at some reasonable minimum rate, in order to avoid adverse tax consequences (consult your tax advisor on this).

Principle B:   Long-Term Debt should finance Long-Term Assets.

This principle is somewhat easier to understand.   For purchases of long-term assets such as real estate, machinery, or expensive equipment, most lenders offer loans that can be repaid over several years.   For equipment or machinery, the lender will consider the estimate useful life of the asset, and set the repayment (amortization) period accordingly (usually, 5-7 years, but could be more or less).   For real estate, the loan may amortize over a period ranging from 15-25 years, depending on the bank’s policies and the characteristics of the property.

Summary of Long-Term Debt:

• Purpose is to finance “long-term” assets such as Equipment, Machinery, or Real Estate
• Loans are disbursed entirely at settlement, and are repaid gradually over several years
• Usually priced based on “long-term” rates which could be based on bond rates. Most lenders will offer a fixed interest rate, which can be locked in for 5-10 years at a time, depending on the bank’s policies and the risk profile of the loan.

If you are struggling or confused with finding the proper access to capital in your business, give us a call.   I always tell business owners to approach debt financing the same way they would approach swimming in the Atlantic Ocean – respect it, because it can carry you away, but there is no need for fear if you are prudent and have trusted guidance.