May 6, 2009
By Donald S. Paris, CPA, MST
Last month we talked about how you could use forecasting to both understand your business, as well as make critical decisions. We talked about how to "think outside of the box" and come up with ways to steer your business into profitability (and keep it there). This month we need to talk about one critical element in the process, i.e. financing your business.
A well balanced business is financed both by its owners, as well as considers the need to finance its assets via debt. It is not unusual for a business to need financing. If you take a straw poll of your business colleagues, you will find that the vast majority do have debt financing of their business. Retail has inventory that needs financing. Professionals have accounts receivable that likely need financing. Manufacturing has raw products that need to be paid for well in advance of receiving funds from customers that will need financing.
Typical business assets that need financing are cash flows, equipment, and infrastructure. The first thing you need to do here is determine just what the asset is and what the financing need is. We need to separate out the current assets from the long-term assets, as the financing of these is done very differently. For example, if you are financing accounts receivable or inventory (current assets), you typically have a line of credit. Accounts receivable and inventory are items that fluctuate all the time. You might bill your clients on the first of the month, and collect the receivables over that month, or even later. So, the balance is high at the beginning of the month, and goes down during the month, only to increase again next month and go through the same cycle all over again. Lines of credit are typically based on 80% of "eligible" accounts receivable, plus 33% of inventory. Eligible accounts receivable is usually defined as receivables under 90 days old. So, if your cash flows are suffering, and you are holding accounts receivable that is under 90 days old, you may wish to discuss a line of credit with your bank. Most of the lines of credit are structured with fluctuating interest rates, based on some baseline rate such as prime. And always ask for a line of credit larger than what you currently need. That way, when you need more funds due to slow payments of your clients, or if you grow, you don’t need to go back and ask for more. The worst thing is to call the bank relatively soon after making the initial request and say "Oops, we grew and need more of a line of credit". It makes you look like you don’t understand your own business.
So, let’s look at some numbers. Your business has gross revenue of $1.2 million per year. You have a pretty flat billing cycle, so you bill out $100,000 on the first of each month. Since this is the first of the month, you just billed $100,000. You have another $50,000 that is between 31 and 60 days old, you have another $25,000 61 to 90 days old, and you are carrying another $100,000 that is greater than 90 days. Yes, your customers owe you $275,000 (and you wondered why your cash flow was suffering?). You discuss this with your banker, and talk about the line of credit. 80% of your eligible receivables of $175,000 ($100,000 plus $50,000 plus $25,000), yields you $140,000. Wall Street Journal prime rate right now is 3.25%. So, if the bank charged you 2% above prime, you would be paying 5.25%. If you borrowed the full $140,000 (and who knows, you might not even need it all right now), you would pay about $600 per month to do it. If you are lying awake at night wondering how you are going to make payroll, or pay your vendors, I would think this is well worth it.
Never forget that you need to request debt financing when your numbers are good. You will have a much easier time obtaining the financing while your business is in good health, than when it is struggling. And lastly, never feel ashamed to ask for a line of credit. Most business needs some form of financing to deal with slow paying customers, and cash flow fluctuations.