In Part 1, we talked about the importance of improving cash flow and the cash balance in your company’s bank account.
Today we’re going to talk about establishing working capital, specifically obtaining a line of credit from the bank. A line of credit provides cash to supplement any working capital needs you have that you can’t meet internally. How do you understand and meet the bank’s criteria for credit and get the best terms available?
If you haven't read some of my other articles on finding financing, here’s what you need to know:
To be bankable, it requires a solid financial foundation for your business.
- Profitable- You should have profits sufficient to cover the interest expense for the line and more. Preferably, you should have consistent profits for the past three years.
- Activity-You collect your receivables within normal terms for your company and industry, with little to no bad debt experience.
- Leverage-You have a well proportioned balance sheet with $3 of debt or less to every $1 of equity.
- Liquidity-You have sufficient cash balances to handle normal business with between 7-30 days of sales in cash.
Your bank package and presentation should meet the bank’s criteria for credit and you should understand the bank’s criteria for credit which include the above items and the following:
5 C’s of credit:
- Character-You should be a person of integrity and run your business on principals consistent with that.
- Collateral-You have sufficient collateral to cover the line of credit amount with the appropriate bank margin applied. (ex. 80% of AR < 90 days)
- Cash flow-You have adequate cash flow to repay this debt and any other debt outstanding with at least at 25_30% cushion. The bank’s call this 1.25-1.3 debt coverage.
- Credit-You should have a business and personal history of repaying credit on time and within the terms established by the lender.
- Conditions-You should be able to explain the economic conditions of your industry in a way to minimize any perceived risk of the bank loaning to you or others in your industry.
You might be thinking this is a lot of information. You’re right, it is. Banks can only afford to lose about 1% on the loans they make. Remember they’re not loaning their money, they’re loaning their depositors' money. It can take as many as 10 loans made and paid back for every loan where there’s a loss. For these reasons, it’s hard to borrow from a bank, but following these steps should help in providing the working capital you need.
So, how much of a line do you need? One month’s revenue or expenses would be a good place to start. Your request may be more or less depending on your specific situation.
Cash flow ebbs and flows based on the characteristics of your business (growth, seasonality etc). A line of credit can smooth out some of the ups and downs.
How have you established working capital for your business?
Step 1: Improve your cash flow
Improving your cash flow can be defined as either having more cash or being more profitable. Some people mix the terms cash flow and profits. For business valuations, most people agree that a business can be bought and sold based on a multiple of cash flow (earnings before interest, taxes, depreciation and amortization or EBITDA). Earnings/profit is a big component of cash flow.
Many business owners are so busy working in the business; they haven’t taken the time to identify the drivers in their business that can dramatically improve cash or cash flow. By doing some financial statement analysis, you can uncover what those are and then decide to implement strategies that have the greatest impact. Your analysis should include not only your historical performance, but also some benchmarking of how you compare to your industry peers.
Verne Harnisch, author of Scaling Up has a Cash: The Power of One document that shows the effect of either a 1% or 1 day improvement on cash or cash flow.
Cash flow improvements
Sales $12 million a 1% volume or price increase has a $120,000 effect on cash flow
COGS $8.4 million a 1% decrease in COGS has a $84,000 effect
Overhead $7.6 million a1% decrease has a $78,000 effect
Improve AR collection period ($12 million/360 days in a year, $33,333) 1 day improvement is $33,333 more in cash
Improve AP payment period ($8.4 million/360 days in a year, $23,333) 1 day improvement is $23,333 more in cash
As you can see in the above examples, the total opportunity for improved cash flow is $402,000 if you were able to influence a 1% volume and price increases along with a 1% decrease in COGS and Overhead.
You could improve your cash position by almost $57,000 if you could collect AR 1 days faster and pay AP 1 day slower.
This approach to managing by the numbers can give some understanding of the impact of various decisions you make in your business.
How do you improve cash and cash flow?
Part 1: Are you ready to sell your business?
If you’re really thinking about selling your business, the business must ready and the business owner(s) must also be ready. If you have a partner, please be sure you have agreement on:
- A timetable when to sell the business
- A minimum sales price; factoring in taxes, any debt repayment and closing costs
- The amount of time needed to get the business ready for sale
To get the business ready,
- the business owner needs to successfully create a leadership team so the business can run successfully without him/her for an extended period of time.
- the business should be able to prepare financial statements that are timely and accurate. In most instances, the owner should consider obtaining audited financial statements by an independent CPA to give the buyer confidence.
- A written business plan with detailed projections that meet the criteria of your exit plans are critical for any potential purchaser.
- Budgets with actual performance can give weight to the management team’s ability to project future business.
- The owner should consider financial incentives to the leadership team for two years after the exit. Some call these stay bonuses or phantom stock is an option.
To get the business owner ready,
- He/she should have an idea of what amount of income is wanted from the business to provide an annuity based on a certain rate of return and life expectancy.
- What will you do to replace the time? Selling can be difficult, if you don’t have something to go to. There’s only so much golf, fishing or traveling you can do. When you’ve done all that, what gives your life purpose and meaning?
- Generally, you only sell your business once. These are many of the items needed to consider a successful sale of your business.
- Nobody times the market, but try to sell at peak time when your business is extremely attractive.
I’ve had several clients recently who have been or are being approached by potential purchasers. Have you thought about selling your business? If so, to an insider/outsider? Maybe you just want to close doors once you decide to retire.
Maybe you’ve been so busy running the business, you have no idea how to sell your business or what number you’d like to get from it in order to retire. Here’s some things to think about.
Selling your business:
- Most owners will sell either to an insider (key employee, manager) or an outsider (competitor, financial buyer looking to diversify their holdings)
- This could be an article all by itself, but it’s a long distracting process.
- Make sure you have a good attorney (legal documents, non disclosures, letter of intent) and a good CPA (tax consequences of the transaction) and a business broker/advisor to guide you through the process.
- Most businesses sold are an asset purchase which means the seller pays off the debt of the company and pays taxes on the gain from the sale (sales price-company basis). Your CPA can tell you your basis.
What’s your number:
- Most businesses are going to sell for a multiple of revenue or cash flow. Typically, this is somewhere around 1x revenue or 3-5x cash flow.
- Could be higher or lower depending on the industry or the strategic fit for the buyer. “Beauty is in the eye of the beholder” How bad does the buyer really want it?
What do you want/need:
- Of course, this can be two different answers. Most sellers are looking for a way to monetize the investment in their business approaching retirement or when they ready to do something different.
- One way to look at it, is what amount of income do you want the business to give you after taxes and paying off debt? You have to assume a rate of return and whether the income includes dipping in to the proceeds from the sale.
- In many instances, your business will not generate the level of income you want because the value is too low or the rate of return is unrealistic given market conditions.
- You’re then faced with a choice. Should I keep running the business to make it more valuable or do I sell and look to other investments to give me the income I’m looking for? The choice is yours.
Over the past 90 days, we've seen credit start to tighten. Credit underwriting has become stricter, interest rates and fees have started to increase and it's just harder to borrow money than earlier in 2014 and the year before.
The Quantitative Easing Program initiated by the Fed was officially terminated in October 2014. In a recent survey, about 50% of the banks believe either this will cause mortgage interest rates to rise, which will in turn curb housing growth this year, or the increase in interest rates will cause financial distress in those institutions that did refinances in a lower interest rate environment.
About 78% of lenders believe that unstable energy prices and the housing market have the potential to create the greatest negative impact on the economy in 2015. The drop in oil prices will force energy companies to cut back on production until supply decreases or demand increases. Also, an increase in interest rates will have a negative impact on home purchasing which could cause home prices to drop or newly constructed homes to sit in inventory much longer than expected.
For the first time in the past 5 years, more lenders expect to tighten their loan structures than relax them. This seems to indicate a more cautious credit outlook than we have seen in recent years. Further, more lenders indicate that they plan to increase interest rates and fees than maintain or decrease them in 2015. The combination of tighter loan structures combined with interest rate and fee increases indicate a less attractive borrowing market for 2015. Lenders appear to be moderating their aggressive structure and pricing over the past couple of years. The question remains if they can successfully do this on their strongest credits or just limit it to marginal ones.
In an industry outlook by one of the major consulting firms in the country, banks have been positioning themselves for growth and profitability. An increase in GDP should drive greater loan originations, which will boost profitability. However, new liquidity and leverage standards for banks enforced by regulatory agencies could force banks to hold on to low yielding assets and place additional capital burdens for some assets. Even with the increased demand and more favorable interest rates, some banks may not be able to take advantage of the market due to these new regulatory requirements. It's interesting to note that loans made up 56% of the total assets mix of banking across the country. During the Great Recession with declining interest rates and more regulatory requirements, loans now total only 51% of total assets 7 years later. These circumstances will continue to create consolidation in the banking industry where banks that are marginally profitable and only moderately capitalized will merge with larger banks due to economies of scale.
C&I Lending (commercial and industrial) will be a primary driver of growth for many commercial banks. Wealth management remains an attractive line of business due to the fee income potential. Mortgage lending will be depressed due to an expected increase in interest rates and the lull created by the refinance boom when interest rates were low.
So, with the demise of Quantative Easing, banks expect a more favorable interest rate envirnoment and will expect to increase interest rates and fees. However, banks are still concerned about unstable energy prices and the potential of another housing bubble that could burst. More banks are reporting that they intend to tighten credit structures than relax them going forward. This is the reversal of a five year trend. In a favorable rate and economic environment, regulators are increasing leverage and liquidity requirements for banks, which could impact the supply of loans available in the market. It can also increase M&A activity in the banking industry for leveraged, illiquid banks to be acquired.
So, what does this mean for your business?
Unfortunately, any improvement in the rate and economic environment could be offset by increased regulatory requirements. It appears that the business owner needing to borrow money to finance his/her business, could expect a potentially tighter credit structure with higher interest rates and fees based on data from lender surveys and leading consultants in the banking industry.
Credit structure is very difficult to negotiate with a bank. The loan amount, covenants and term are all part of the credit structure. Do the best job you can to negotiate the largest loan amount you need for the most favorable term (1 year for a line of credit) with the least number of covenants, but realize when the bank delivers your commitment letter, the credit structure is pretty much cast in concrete. However, interest rate and fees are negotiable. Non-interest bearing deposits are a great negotiating tool for you. What's the best way for a bank to increase liquidity? Give them deposits. Because 90% of a bank's loan funding source is deposits, you can trade deposits for a lower interest rate and fees. Let's pretend the bank is loaning you money at 6% and they pay you 0% on your checking account of $100,000, that's a 6% spread or $6,000 a year benefit to the bank. If the bank is willing to give you credit for 1% of that 6% spread, that's a $1,000 benefit you can use to offset your interest rate or fees.
Have questions or concerns about your banking relationship or line of credit? Leave us a comment or contact us here.
You might be dissatisfied with your performance last year and want to increase revenues and profits or you want to continue to grow in the upcoming year. What are your options? Here are 5 ways to consider:
- Increase leads. You have a solid customer base, but you would like to add more customers. The best way is to increase the number of leads your sales people are calling on. Nobody likes to cold call, but have your sales people really done a good job of asking their customers for referrals? People do business with people they know. So, ask your existing customers for introductions to help add to your customer base.
- Improve your close rate. If you see 10 leads and make 3 proposals and get 1 client out of those, you're batting average on proposals is .333. What if you could increase the number of proposals to 5 and get 2 clients? You've just increased your batting average to .400. Most of the time, you can improve your close rate by asking good questions, listening well and seeing the benefit of doing business together from your customer's point of view. Always be sure you're dealing with the decision maker and you understand the customer's decision making process.
- Expand your relationship with each customer. If you have other products that your customer may use, be sure he/she knows about them. Also, your customer may be using one of your competitors and you don't have all their business. If you don't ask for that business, you definitely won't get it. So, ask for additional business from your customers. If you have 5 customers doing $100,000 each and you increase each customers volume to $200,000, you've just doubled your revenue from that customer base.
- Increase your average $ sale. If you feel your business is close to capacity, it may be time to look at the bottom 20% of your customer base. Remember the 80-20 rule. 80% of your business comes from 20% of your customers typically. That means that 80% of your customers only comprise 20% of your revenues. To create capacity, look at which customers generate only small orders and look for ways to replace them with customers that make high dollar orders. This takes some courage, but the benefits outweigh the risk.
- Increase margin. When's the last time you had a price increase? Also, are your vendors increasing prices and you're absorbing those increases without passing them on to your customers for fear of losing their business? If you're not losing a few orders because of price, then it's likely your prices are low and you need to consider an increase.
How do you boost revenues and profits? For additional articles on related topics, these posts may be helpful. I wish you a prosperous New Year!
In case you missed it here's Part 1: What To Do When the Bank Says "No" and
Part 2: What Are Your Options When the Bank Says "No"
You've been turned down by your bank for a line of credit. You've evaluated your options. Now how do you decide which alternative is best?
I have a client that wasn't turned by their bank, they just weren't given all they asked for. The bank gave two lines of credit, one was for $75,000 and one was an SBA line secured by specific accounts receivable for one of their clients. They still had accounts receivable available to pledge to another lender.
Their choices could be an asset based lender, a factoring company or taking on a partner. They looked at it from this point of view:
- The capital needed to be available quickly. So, speed was important to them.
- While the cost for an asset based lender or factor was high, they decided to go with the factor because it was invoice specific.
- The company had struggled with cash flow the first half of the year. So, any valuation for equity would have come at a significant discount off the true value. Plus, taking on a partner can easily take up to 3-6 months to arrive at any deal and they really didn't want a third partner.
Management is hopeful they can consolidate their factoring arrangement in to a line of credit increase with their bank and reduce their overall cost of capital. This would alleviate the need for an additional lender in their collateral pool with less paperwork. Ultimately, in making a decision like this you have to weigh the costs against the benefits. Speed of access was also important here.
You've heard the expression that "time is money." Sometimes you have to pay up for access to capital until you can reach a better long term solution. Ideally, I think all borrowers would prefer to have access to capital with a quick turnaround time at the least expensive cost.
In case, you missed it here's Part 1: What To Do When the Bank Says "No"
You've just been turned down by your bank for a line of credit. What are your options?
I have a client who was unable to get a line of credit because his company was unprofitable last year and the bank wasn't comfortable with his cash flow. You should go back to the 5 C's of credit and determine why you were turned down.
- Cash flow
Depending on which C was the culprit will determine what your options are.
If character, credit or cash flow were the issue(s), asset based lending may be an option. Asset based lending is where the lender is looking at the quality of the collateral (typically accounts receivable and inventory) as the basis for their loan versus these other factors.
There are two options:
First, is a company that factors your accounts receivable. With factoring, the lender doesn't loan, they purchase your account(s) receivable at a discount and include service charges and fees that increase their yield.
The second is a lender that loans you money against your accounts receivable, typically at a margin between 75-85%. They also charge interest, services charges and fees that increase the cost of money. Usually, this type of lender will charge an interest rate (when you include the service charges and fees that could be anywhere from 18%-30%. This is expensive financing and should be considered carefully.
Let's say you have all the C's covered except cash flow. Many times SBA lending programs provide an option due to the terms provided. SBA allows working capital to be repaid over 10 years, same with business acquisitions. The longer term calls for a lower payment which may help improve your cash flow. You pay more interest expense because it's over a longer period of time, but this option may be attractive.
Maybe you're short on collateral in your business? To make a collateral shortfall work, you may pledge personal assets to secure your loan, real estate, cash value life insurance, listed securities (non-retirement accounts).
If these options don't work, then you may not be a candidate for a loan right now. You can either put in the equity yourself or take on a partner.
If you're a credit card merchant, the credit card company you deal with may be willing to give you a cash advance on the merchant credit card volume you generate. But be careful, because you are mortgaging your future for the present and this program is expensive just like asset based lending.
In any situation, consider the cost of capital in your financing decision. The more expensive the financing option, the more impact it has on your profitability. Don't let financing costs eat up all your profits.
What options have you pursued? Which ones have you found work best for you? Please share your successes.
When the bank says "no" to your line of credit that could be the initial signal to you that your business may have a problem borrowing money.
I have a client who is experiencing cash flow issues. She doesn't have a revenue problem, she has an expense problem. We are in the process of correcting it, but the company will show a loss for the year unless some really big revenues hit between now and year end. If you approach a bank while you're losing money, the bank will tell you that they want to see a full year of profitability before they issue a line of credit. Banks don't want to fund operating losses with their line of credit. They want you to take that risk.
If the bank says no, it's likely that one or several of the "5 C's of Credit" are the culprit:
- Cash Flow- The bank is looking for cash flow (net income + plus interest and depreciation expense) to cover loan payments with a 30% cushion. This means that $130,000 of cash flow is needed to cover $100,000 of loan payments. If you have losses or your cushion is significantly less than 30% the bank will not approve your request.
- Character- For whatever reason, the banker didn't feel confident in your ability to run the business. You could have said something that caused the bank to lose confidence in you. Banks want to loan to people of good character.
- Collateral- Banks want the loan to be 100% secured with margined collateral. The collateral can be business or personal assets. They will not loan dollar for dollar. They will assign a margin requirement in the event of liquidation. 75-80% of eligible accounts receivable for example. If you don't have enough collateral to support your loan request, they will not approve it.
- Credit- Your personal credit score is the bank's indicator for how you will repay your loan. They believe you will handle your business credit the same way you handle your personal credit.
- Conditions (primarily, industry or economic) If you're in an industry that is declining or if economic conditions (GDP and job growth, consumer spending) are trending negatively, the bank may choose not to loan to your company. This one is especially tough because it may have nothing to do with you and your company.
Sometimes the problem is not you and your company. The bank may be the issue. If a bank is having capital adequacy or liquidity issues, they may have turned down the lending faucet temporarily. Another reason could be they may have too much of the loan type you're asking for on their books already (investment real estate for example).
However, if the bank says no, it's time for some self awareness and reflection to determine the reason(s) why.
Your banker might have mentioned that they underwrite your loan using global cash flow analysis. What is that and why do you care? Let me tell a story and hopefully illustrate it along the way.
I'm currently working with a personal services firm that has three affiliates. They have 4 partners and at least 4 different product lines. The firm wants to borrow $500,000 to payoff an existing line of credit and provide working capital to expand their practice in different areas of geography. In presenting their package to the bank it occurred to me, what if the affiliates are losing money and the firm has no cash flow to service debt? What's the impact if the partners pull all the money out of the firm and there's no cash flow left to service debt? I carefully looked at the income statement of all the affiliates. They are making good money and are not a drag on the firm. I looked at the personal tax returns of the partners and determined that they are drawing ample salaries to cover their personal lifestyles and don't need to distribute profits. I concluded a global cash flow analysis was not necessary in this circumstance.
Professional and personal service firms (doctors, dentists, attorneys, consultants) are potential candidates for global cash flow analysis. Global cash flow takes income from all personal and business sources, (salary, business profits, real estate, rental income etc.) and then takes the loan amount requested plus all other business debt and personal debt. Since the cash flow of the business and the business owner are entwined, a banker wants to be sure that his business loan can be repaid without issue. Additional items like interest expense from the business and non-cash charges (depreciation and amortization) are included. Most bankers will take all income taxes paid (federal and state) out of their cash flow because they're not available for debt service. Also, most lenders will make an allotment for living expenses too.
I hope I'm not getting too technical, but here is how you can calculate your global cash flow. Lenders will take the AGI (bottom of page 1 on your personal tax return) and add interest expense and depreciation from your business return, any other affiliate business tax returns you have and from your Schedule E. The total of all that is the global cash flow. You take the principal and interest payments of all business and personal loans. That is your debt service. You divide global cash flow by all payments to come up with your global debt coverage.
The same standard for debt coverage applies for global cash flow analysis. Banks are looking for a 1.2-1.3 cash flow coverage.
You might be thinking so why do I care? Well, my client I mentioned has a debt coverage of 2 to 1 much greater than the 1.2 required. However, let's pretend that after you factor in personal loan payments that debt coverage is reduced to 1 to 1. All of a sudden, this borrower doesn't have the capacity to take on additional debt because all of the cash flow is being used to cover personal loan payments. It's important to know what your borrowing capacity is and if your bank underwrites this way. You want to be sure you're asking for a loan that will be approved.
If you are one of the professional firms I mentioned above, it's likely that your bank will use a global cash flow analysis to approve your loan(s).