How to Get the Money You Need to Finance Your Business
By: Larry Herrmann
A significant challenge for businesses today is getting Lines of Credit (LOC) renewed…let alone increased. Being a “good customer”, that is making your payments on time, isn’t good enough. In today’s banking environment many factors come into play in the decision to increase a LOC …not simply payment history.
It’s commonplace today for banks to focus on cash flow but also look to collateral and overall credit worthiness in making credit decisions. As a result it’s critical that business owners understand their Balance Sheet, Income Statement, and cash flow from operations.
Key factors to be considered in trying to increase a LOC:
- How much is needed, why is it needed, & how much of it will be used
- What are the financial covenants; can you meet them
- Collateral
- Communication
HOW MUCH IS NEEDED, WHY, & HOW MUCH WILL BE USED
In order to calculate how much funding is needed requires a twelve month cash flow forecast incorporating the expected average Accounts Receivable DaysSales Outstanding (DSO), Inventory turns, and sales forecast. The exact amount of funding required can only be determined by including the fluctuations in all Balance Sheet accounts. Knowing exactly how much is needed demonstrates to the bank that you know your business and increases the likelihood of approval.
The true purpose of a LOC is to fund the cyclical nature of a business, e.g. increases in accounts receivable or inventories because of increased sales, preferably not slow paying customers or obsolete inventory. Lines of Credit should never be used for the purchase of long term assets or to fund losses. These amounts generally can’t be repaid within one year, which most banks prefer. The first indicator that a LOC is not being used for cyclical purposes is the outstanding balance will not significantly fluctuate.
It’s important not to request more financing then is needed. The unused portion of the LOC will eventually carry a cost even though interest is not paid on this amount. Banks don’t like providing unused lines because it impacts the amount of funding they can provide to the rest of their customers and they aren’t earning any income on these amounts. Eventually the unused balance will be incorporated into the pricing the bank is willing to provide. If a company asks for more financing than is needed the bank questions whether the management team really knows what they’re doing…confidence is very important.
WHAT ARE THE FINANCIAL COVENANTS
Virtually every LOC comes with financial covenants. Many of these covenants, or benchmarks, don’t appear in the Income Statement which is why you must pay attention to and understand your Balance Sheet. The most common covenants are: Working Capital, Liquidity & Debt Coverage. However, they can include anything else the bank feels increases their risk, e.g. owner compensation, capital spending, retained earnings, owner distributions, tangible net worth, etc.
Working Capital – this is an indication of the company’s ability to pay its bill in a timely manner. Simply put it is Current Assets – Current Liabilities. In determining what accounts are current you must only include those that will turn over within one year. If you have Receivables that won’t be repaid within one year they are considered Long Term Assets. Conversely you must include the portion of any term debt that will be paid in the next year. Typically this covenant is stated as such: “The Company will not let their working capital ratio fall below x:1”. Most loan agreements will include a definition of items to be included in the ratio and in some instances how to calculate the covenant.
Liquidity – this is an indication of the overall strength of the company and how well they can sustain downturns in the economy. Typically this includes Total Liabilities / Tangible Net Worth.Where this gets complicated is in defining what is considered a liability and what is Tangible Net Worth. Again, most agreements will define both items. Generally most banks will not consider Subordinated Debt as a liability but rather Equity.This is an area for some strategic planning and negotiating with the bank. Not only is Subordinated Debt subtracted from your liabilities but it’s added to Equity…a double bonus. The more complicated issue is Tangible Net Worth. In calculating this all Intangible Assets are subtracted from Equity. These will include such items as Goodwill, Receivables with related parties, long term assets that the bank deems have no value upon liquidation, etc. In rare circumstances this can include Trade Receivables and inventory that are older than a certain date. Typically this covenant is stated as such: “The Company will not have a Debt / Tangible Net Worth greater than x:1”
Debt Coverage – this covenant is an indication of the company’s ability to pay the bank. This calculation varies but is typically defined in the loan agreement. It is extremely critical that the company know where they stand relative to this at the time of closing and into the future, which means the company must have a reliable forecast. If any covenant will cause a loan to be in default more than the others it’s Debt Coverage. Banks today are extremely focused on cash flow. Generally this calculation is EBITDA, or a modified EBITDA, divided by Interest + Principal Debt payments. If the company is in an equipment intensive industry EBITDA may be reduced by an expected “equipment allowance”, often referred to as CAPEX. Some calculations may also include principal debt + capital leasepayments. Typically this covenant is stated as such: “The Company will maintain a debt service coverage ratio of x:1 or greater”.
COLLATERAL
Even though cash flow is very important to banks they are also concerned about the quality of the collateral. For this reason banks never lend up to 100% of the collateral. LOC’s are secured by trade receivables and inventory.A typical scenario is 80% of qualified receivables and 50% of qualified inventory. The definition of “qualified” assets is generally included in the loan agreement. Some of the issues that concern banks with regard to receivables and typicallyare deducted: receivables over 60 days old, related party receivables, receivables from vendors, bonded receivables, and some government receivables. With regard to inventory banks will only lend on good, usable items, which excludes slow moving & obsolete inventory. With a revolving LOC the bank will typically require a “Borrowing Base Certificate” to be filed on a monthly basis which calculates the value of the collateral, receivables and inventory, and determines how much the company can have outstanding on the LOC. This calculation can be critical for a company looking to increase its LOC. If the calculation demonstrates that the collateral is consistently greater than the approved LOC the bank is more likely to increase the amount.
COMMUNICATION
Possibly the most understated issue to consider in trying to increase a LOC is the communication the business owner has with the Banker. It’s never a good idea to only talk with your Banker when you want to borrow money. It’s critical that the Banker understand the company and its needs, and as the primary advocate for the company within the Bank the Banker must have the information necessary to “go to bat” for the company. If the Banker can’t make a good case for an increase in a LOC it will never get approved. It’s a good idea for business owners to meet with their Banker several times a year to simply talk about the business…and not ask for money. Another important communication issue is providing the documents on a timely basis that are spelled out in the financing agreements. In some agreements not providing the information could be a default of the loan. It’s the owners’ responsibility to make the Banker’s job as easy as possible.
If a business owner wants to increase their LOC they need to take the emotions out of the process and look at the situation as they would a customer asking for credit on open account…would you lend money to someone that doesn’t need it, can’t prove they can pay it back, and make you fight to lend them the money. Bankers really want to lend money…owners need to give them a good reason to do it.