If you assume the bank is going to renew your line of credit when it matures, you may be in for a rude awakening. Let me share with you a conversation I had with someone.
- The bank approved a line of credit
- The company had a loss.
- The bank reacted to the loss, by renewing the line for only 90 days and said that a new account officer would be assigned.
- They increased rates and fees for the renewal.
These are red flags for business owners to be aware of. The bank was not totally forthcoming about the state of the situation.
- Short renewals (90 days vs 1 year) and an increase in rate signal a change in the bank's point of view on the risk of this loan.
- A change in account officers can be (not always) another red flag.
- The bank renews the line to keep it off the past due list, but a short renewal means that something else is about to happen.
- The change in account officer could signal that the new account officer is in the workout department, (Special Assets) especially since the company lost money last year.
- The change in rate and fees signals a change in the perceived risk on the bank's part.
- It's conceivable that at the end of 90 days, the bank could declare a default at the maturity and enter in to a forbearance agreement rather than liquidate assets.
There are five things you should do prior to your line maturity:
1) Review your commitment letter and loan agreement to be sure you're in compliance with all the terms and conditions.
2) Don't assume the bank will automatically renew. Have a back up plan to repay the bank if they ask for it.
3) Did you have loan covenants? If you did, are you in compliance or can the bank declare a covenant default? (Cash flow and leverage covenants or change of ownership or management are common covenants.)
4) If you are in default, ask the bank to consider a covenant waiver. Yes, banks can waive covenant violations if you have a good reason.
5) If they won't waive a violation, can you offer additional collateral, agree to a lower line of credit amount or provide something of value in exchange for the bank's renewal?
We all know the danger of making assumptions, don't wait for the bank to react to your situation. Either be proactive yourself, or hire someone with the right expertise to help you understand your options.
During this series on Growing Your Business, we’ve talked about Getting the Right People, Getting the Right Strategy and Getting the Right Processes. Our final article is on Getting the Right Execution.
The standards for the right execution are efficiency (doing things right) and effectiveness (doing the right things). Your execution will begin to break down if you’re doing things poorly or doing the wrong things. The financial data that you look at monthly will be an indicator of how things are going.
- I have a client who wants to increase revenue. His revenues for the last 3 years have hovered around $8-9 million.
- He has changed his strategy and has changed his sales process, but his people have struggled to implement.
- Because the sales process has changed, their efficiency has suffered. This is because they’ve been doing it the same way for a long period of time and the old process yielded results.
- In the past, their close rate on business has been about 16%.
- To improve their close rate, their focus is on calling on the right clients with a high likelihood of doing business to increase their effectiveness.
Your execution can focus on any critical numbers on your balance sheet or income statement.
1) If want to have more cash in the bank, focus on being more profitable or collecting faster.
2) If you want to collect faster, focus on days in accounts receivable.
3) If you want to increase sales and profit, focus on revenue, gross or net profit.
4) If you want to reduce debt, focus on accounts or notes payable to banks or others.
All of the above strategies mentioned will require getting the right people involved, and could include process changes. However, the execution or lack of execution will be reflected in the critical numbers on your balance sheet or income statement.
We’ve talked in this series about Growing Your Business- Getting the Right People and Getting the Right Strategy. Today, we’re going to talk about Getting the Right Processes.
Growth always increases the complexity of your business. So, to get the right people, doing the right things right, you need processes in place to maximize your efficiency and effectiveness.
Here are three things you need to know about processes:
1) Process makes a business competitive. Companies with defined processes are better able to evaluate their strengths and weaknesses and identify opportunities for improvement.
2) Process enables growth. By leveraging defined processes, it become easier to deliver new products and services quickly and efficiently. Processes provide a blueprint for new employees and enable cross training to minimize business interruption.
3) Process drives profitability. A company with defined processes can find opportunities to improve efficiency without sacrificing quality and consistency. They can identify duplication of effort and spot areas that are being overlooked.
Here’s a story of how implementing new processes made a huge impact on my client’s profitability. This company was losing money in 2014. They had bootstrapped the company, but now had to borrow money from different sources just to fund payroll. They didn’t know where the losses were coming from.
- Process 1: They hadn’t taken the time to be sure there financial statements were accurate and that revenue and expenses were properly categorized. They established a month end close where part of their closing procedure was verifying that all revenue and expenses were properly categorized so their financials were timely and accurate.
- Process 2: They didn’t have a process to examine what portion of their payroll was converted to billable revenue. So, they didn’t really know how much of their payroll was unprofitable. They created an excel spreadsheet to show monthly payroll and how much of that could be allocated to their contracts.
- Process 3: This Company did not have a process to make sure their completion schedule of their projects matched their billing schedule. They didn’t know if they were over billed or under billed on any of their projects. So, they created a second excel spreadsheet to show what percentage they were complete on each project and then billed accordingly.
The process changes, in this case, yielded a huge change in the profitability and efficiency of the company. They had accurate and timely financial statements to make good business decisions and they cut payroll and increased billing based on the new excel spreadsheets, which in turn dramatically improved profitability.
What process changes have you made or need to make to enable your growth and increase profitability?
I heard a speaker at a conference say that many business owners feel that their most important assets are their clients. However, he disagreed. He stated that our most important assets are our people/employees. Our brand rises and falls on their efforts.
This is not intended to be written from a human resources perspective, but from a financial perspective. If we invest in people, how do we measure our return on dollars spent? Is there a formula for fixed vs variable compensation?
Here are a few things to think about:
1) Watch out for high dollar fixed expense. If you're hiring top talent, and alot of it, make sure, you are getting the proper return. For example, if you just hired a VP of Sales with a $100,000 and you have a 35% gross profit margin. You would have to see an increase of over $285,000 in revenue just to break even on their salary. Watch out that fixed compensation doesn't eat up your profits.
2) For sales people, when possible, implement an element of performance based compensation. Employees love for a large portion of their compensation to be fixed. A business owner would prefer for a large portion to be variable. Why? Because you can tie their compensation to actual performance, revenue or gross profit. The lower the fixed portion, the lower your overhead and the higher their variable piece if they're really good sales. If they're not, they won't last long.
3) Everyone has their own metrics or measurements on return on people investment. When possible, I really try to shoot for a 20-30% return (I call it return on spending)on compensation dollars spent. For example, if I hire a controller and pay them a salary of $50,000, I would hope there would be ways I could see a $60-65,000 improvement in business (efficiency, faster collections, taking discounts etc.)
I think one the biggest challenges most business owners have right now is finding the right people for their organization. Make sure you're doing things to attract top talent to your organization and continue to invest in their future.
Part 1- Cash Flow
Part 2- Establish Working Capital
"Growth always requires cash and increases complexity," says a popular business growth guru. Statistically, only about 4% of the companies make it above $10 million in annual sales in the US.
Doug Tatum, in his book, No Man's Land will tell you it's because of one of 5 M's.
- You have the wrong operating Model
- Your company is not properly aligned to the Market
- You've outgrown your Management
- You've outgrown your Money
- Your company has lost Momentum
Vern Harnisch, in his book, Scaling Up will tell you that there's a breakdown in one or several of the following areas:
His approach is that a business determines the strategic priorities for each month, quarter, year and then uses his/her data to keep score on the level of success. Getting your people engaged in the process using critical numbers or key performance indicators (KPI's) to create focus is key to gain alignment of thinking between shareholders and employees. The concept here is to determine the barriers you need to overcome to expand the business and either add people, create processes or improve execution.
What I've found is that both are true and both these points of view are necessary when evaluating your business.
Many times, companies need to add people in middle management to handle duties that correspond to changing complexity of the organization. Often, one person may be handling sales, operations and finance. Over time, many businesses have one person handling each of these three areas. A lack of any one person can cause the business to breakdown in the area that lacks management.
Due to a positive economic environment, many businesses are expanding geographically or increasing product lines, but they don't have a strategy, processes or execution in place to make those successful. Therefore, they may have added resources, but they're not getting a return on their investment (people, systems) which causes margin to decline or they become less profitable.
When you start your business it may merely require a good technician to complete the work. In later stages, management is needed to create processes and monitor performance. Finally, a mature company really needs entrpreneurial vision to understand the changing dynamics of the company and its market. This requires vision to create strategies to implement.
How do you grow you business? More often than not, most of us spend too much time working in the business instead of working on the business.
Are there ways for you to upgrade your people, improve processes and capitalize on new opportunities? These items are critical for you to overcome barriers to expansion and prepare your company for financial success.
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.