Have you ever had that brief experience where you started driving in the dark without your headlights on? It was dark and you couldn't see where you're going. Running your business without timely and accurate financial statements is just as risky as driving with your headlights off.
I was having lunch recently with a CPA that I share clients with. He and I were discussing the fact that some clients don't see the importance of providing financial statements that are timely and accurate. Here's why it's important:
1) Running an income statement and balance sheet on a quarterly basis doesn't give you the granularity you need. You need to know month to month what your cash requirements are going to be (receipts - disbursements) so you can order inventory or meet payroll. That's the reason for timeliness.
2) Accuracy is needed to tell you the real facts about your business. If financial reports are inaccurate, it could cause you to make incorrect decisions about moving the business forward. Financial reports are not intended to keep you in the dark.
3) Having timely, accurate reports allows you to make comparisons against your budget, same month last year or same period year to date against last year. Are there any trends (positive or negative) that are developing? Can you expand or are your financials giving you a warning that you may need to layoff people or contract the business?
4) Inaccurate reports lead to trouble. If accounts receivable or accounts payable are either overstated or understated, it could lead to a cash crunch or you could be missing opportunities to take purchasing discounts which would improve your profit margin.
Providing financial statements that are timely and accurate is a process. It takes time to build the process and it gets more difficult the larger the business gets. But, it's a process worth implementing for all the reasons I've mentioned.
How are you doing in this area? Are there ways I can help you improve?
You’ve got a loan request. How do you decide if you pursue traditional bank financing or an SBA (Small Business Administration) loan through your bank?
We’ve closed several SBA loans this year. One was a debt consolidation loan with working capital, one was a new location for an existing business and one was a commercial mortgage refinance.
Remember that the credit standards that a bank requires are no different in an SBA loan and a traditional bank loan. You still have to have the 5C’s covered. (character, cash flow, credit, collateral and conditions). The biggest difference to an SBA loan versus traditional bank financing is the term and in one case the equity requirement. I’ll talk more about that in a moment.
Here’s the pros and cons of SBA financing:
- An SBA loan has a fee of 2.75 to 3.5% of the SBA guaranteed amount charged by the bank to pay the SBA for their guarantee. For a $1 million SBA guaranteed portion (typically 75% of the loan amount), that can be $27,000-$35,000. SBA guarantees up to -90% of the loan amount under import/export programs.
- The SBA 7a program offers up to 10 year terms on any loan that includes working capital. In some cases, that can have a debt consolidation component, a business acquisition, or a line of credit.
- The SBA 7a program when financing real estate can go up to a 25 year amortization.
- In the case of the purchase of an owner occupied building, the SBA 504 program offers 90% financing. The owner is only required to put 10% down.
The longer terms of the SBA programs make the cash flow easier to qualify for because the payments are going to be lower than traditional bank financing. In the case of the 504 program, if you’re buying a building that costs $1 million, the normal equity requirement could be $200-250,000. With the SBA 504 program, it’s only $100,000.
Remember the credit requirements are going to be the same for the most part. The big differences are the longer terms. Pursue traditional bank financing when you can handle the higher payments and avoid paying the guaranty fee. When you don’t have enough of a down payment for that building purchase, consider the SBA 504 program.
How have you used SBA financing in your business? Please share your experience in the comments section below.
How do you know it's time to restructure your debt? When your cash flow has changed and your payments haven't, it may be time to restructure.
I'm working with several professional practices that are looking to restructure their debt. All the practices are in growth mode and/or need additional cash for that growth. Growth ALWAYS requires cash because the investment you make in the form of increased people and salaries or equipment purchases occurs before the cash from increased collections comes in. In this case, the investment doesn't pay for itself. You will have a decrease in profit which decreases your ability to pay back loans. During the time you're working "on" your business conduct a debt review.
1) Calculate your cash flow coverage ratio based on your last year's financial statement or tax return. Banks are comfortable lending in to a situation where cash flow is 125% or greater of loan payments. Be sure you understand how your bank calculates cash flow (before or after distributions). I had one client that tripped his covenant over distributions.
2) If you don't have 1.25 coverage, can you consolidate some debts and extend the amortization so that your payments are lower? For one client, we were able to refinance their debts, provide $165,000 in working capital and extend the amortization. They needed the working capital for additional marketing and were able to do this and keep their payments about the same.
3) Sometimes restructuring your debt can accomplish a rate reduction and lower your payments. At that point, you have the option of keeping the payment the same and decrease the amortization (pay it back faster) or lower the payment and give yourself room to take on additional debt.
If you're going to restructure your debt, have a goal in mind. The most common ones are:
- Lower rate to acheive a lower payment
- Lower rate to pay the loan off faster
- Consolidate existing loans and lower your payment to take on additional debt for working capital or equipment purchases
Have your restructured your debt lately? Share your experience in the comments section below.
If something is too good to be true it usually is. Right? So, if you think you’re going to get a fixed rate from a bank and not pay anything for it, that would be too good to be true. Beware of the prepayment penalty.
I have a medical professional that is looking at options for buying a building. The lender is a big bank that is proposing two SBA options, the 7A and 504 programs. Big banks are willing to provide long term fixed rates because they have a lower cost of funds. Sometimes a bank can provide interest rate swaps through their capital markets department. An interest rate swap is where the bank and borrower swap cash flows (bank wants a floating rate and the borrower wants a fixed rate) and they use a third party to accomplish it. Even interest rate swaps have prepayment penalties. It's just referred to as a make whole provision.
The bank is offering a fixed rate of 5% for 20 years with the 504 and 4.75% for the same period thru the 7A program. Both are very attractive.
You have to know where to look in the commitment letter, but both options had a prepayment penalty of 2% in the first two years in option 1 and a three year prepayment penalty of 5% in year 1, 3% in year 2 and 1% in year 3 in option 2. The range of prepayment cost in both options is a low of $26,000 and a high of $120,000.
While it’s unlikely that interest rates would fall further, we have seen circumstances recently where interest rates moved against the commonly held view which triggered a significant number of refinances and in this case triggers the prepayment penalty.
If the fixed rate offer you have is attractive, go the extra mile to see if there’s a prepayment penalty in the fine print of the commitment letter. If you don’t see one, then ask your lender to be sure you don’t give them a good faith deposit only to be surprised when you sign loan documents.
What do a business owner buying a second business, a professional practice wanting to get a line of credit and someone buying a large piece of special purpose real estate have in common? They all want to know if their particular deal is bankable.
'Are you bankable?' is a common question for severals reasons:
- Most business owners don't know if they can borrow.
- They don't know how much they can borrow.
- They don't know at what rate and terms they can borrow.
There are five things you need to be bankable:
- Banks are information junkies. They need three years of financial information to evaluate your company. Your ability to produce complete and accurate financials in a timely manner is critical to your success. I have had clients that gave me a balance sheet that didn't balance!
- Spend some time with your balance sheet. Banks look at how much skin you have in the game (your net worth) versus how much your lenders have. If you're greater than $3 of debt to $1 of net worth you're approaching the unbankable line.
- Cash and cash flow are king. It's how much you keep that pays back loans, not how much goes out in taxes or distributions. Bankers are looking to cover any loan payments with cash flow and have a 25-30% cushion.
- What's your credit rating? Most banks use the owner's personal credit score as the proxy for a business credit rating. They feel if you pay your bills on time, the company will too. Banks also view your ability to pay on time as a testimony to your character.
- Collateral is required in every situation and the loan should be covered 100% by margined collateral. Most banks will loan 75-80% of AR, equipment and real estate. Other types of collateral carry higher or lower margins depending on the type.
If you have these items nailed then you shouldn't have a problem finding financing
unless something is wrong with the bank. Whatever situations you are struggling with in these areas will affect your answer to the bankable question.
to discuss the details of your deal and find out if you're bankable.
Are you bankable? If so, what amount can you afford to borrow? And at what rate, terms and collateral? Also, which bank(s) do this type of loan? Business owners don't understand the variables or the metrics. It takes a guide.
Within the last two weeks, I've talked to a doctor wanting to do a debt consolidation loan for his practice, a pastor about how much his church can borrow to build a building, and a restauranteur that is being offered the real estate that his restaurant sits on. All these questions come up and business owners really don't understand their options.
So, what are the 5 tips that make your deal bankable or not? Here we go:
1. Do you have skin in the game? The days of banks doing 100% financing (if they ever did) are gone. For real estate 20-25% equity is a rule of thumb, there are exceptions. The same is true with equipment and the same with buying a business.
2. Do you have the cash flow to repay the loan with ample cushion? Banks are looking for your historical cash flow to repay the loan with a 20-30% cushion. Cash flow can be defined from the business only or from the business and the owner combined.
3. Does the collateral you're providing (when margined) cover the full loan amount? Banks are willing to loan 75-80% of real estate, equipment and accounts receivable; less on inventory, but more on cash value life insurance or some listed securities.
4. Does your company have a well proportioned balance sheet and a history of profits? What does well proportioned mean? A fair amount of liquidity (5-7 days sales in cash for example) and less than $4 of debt for every $1 of equity. The last year should be profitable, preferably the last three, in order to obtain financing.
5. What are the prevailing economic conditions in your industry? During the Great Recession, residential and commercial contractors really struggled, many went out of business. Now, these industries are really doing quite well. Is your industry cyclical? Where are we in the cycle and is it expanding or contracting?
Once you've answered these questions, you're halfway home. The next step is to find a bank(s) that is doing the type of lending that you're looking for. Stay tuned for part 2, finding the right bank for your loan.
Recently, I’ve had several churches that are either looking for a building to purchase or refinancing an existing loan to improve and free up dollars for ministry. It occurred to me that most of my tips and advice are intended for profit companies, but what about the non-profits? If you are one, this article is for you. Here's the top 3 tips non-profits need to know about borrowing money.
1) It’s hard to borrow for operating expenses from a bank. Since the nature of your business is to collect donations from individual and corporate donors, most banks will not loan you money for operating expenses because their repayment will come from the same donations that are employed for your operating budget.
Banks will loan money for buildings or equipment where there is money earmarked in the budget to repay the mortgage or loan whether from excess funds or from a capital campaign of some type.
2) A bank will want to spread the risk of the loan over as many members as possible. The rule of thumb for most banks is they will not finance a building to a church with less than 100 members. Depending on the size of the loan, a rule of thumb for many banks is no one donor makes up more than $50/month of debt service and no one donor contributes more than $2,000 of annual budget. Also, banks look for the total debt to be less than $3,000 per donor.
3) Due to the ministry aspect of your non-profit, most banks will not lend you more than 2.5 to 4 times your annual budget for a building mortgage. They also want to be sure that less than 30% of your annual budget goes toward the mortgage leaving 70% to go toward your ministry budget.
Applying these metrics will go a long way toward helping you be successful on how much a bank would be willing to loan your church and how much you can afford to repay from the bank’s point of view.
I'm going to talk about a four letter word that makes some squirm, especially when you have to apply for it. Debt. So how much debt is enough and how much is too much? How do you restructure it and under what circumstances is the bank willing?
I have a client with a mortgage on his building at a failed bank. He used his line of credit to get through the economic downturn and needed additional working capital to fund his growth after the recession. We were able to restructure his mortgage, fold the line of credit in to the balance and obtain additional working capital to finance his sales growth. The bank got a good loan and he got the working capital he needed, placed his mortgage with a well capitalized bank and reduced his payments in the process.
Bankers want to be sure you have skin in the game before they loan you money. A good rule of thumb is 25% you, 75% bank and other liabilities. So, if you have $1 million in assets, the liabilities should not be more than $750,000 and your equity should be at least $250,000.
Watch out for intangible assets (goodwill) or shareholder notes or receivables. Depending on the situation, those could be subtracted from your equity which changes the percentages.
There needs to be a good reason to restructure debt. A lower interest rate or payments or obtaining additional credit that wouldn't be available otherwise are all good reasons to restructure. Recently, many banks have not granted credit based on their financial health. So, relocating to a healthy bank to have access to debt would also be a good reason.
Are there any other debt stories out there that may have been a little sticky, but had a happy ending? If so, please share them.
Probably not. Banks believe that the best indicator of the future is the past. If you lost money last year, the bank thinks you’re going to lose money this year. Even if you are showing good trends in the interim, it’s unlikely that the bank will give you credit for just a partial year. You need to show a full year of profits to get the bank to go along. Here’s a story of how one my clients handled this situation.
2010 and 2011 were not kind to this client who wholesales products tied to residential construction. Seeing over $200,000 in losses for these two years left their company starved for cash. To make matters worse, the industry was starting to recover and my client was predicting an 18% growth rate. Growth requires cash they didn’t have. Mid year 2012, the company was showing nice progress and we showed financials to the bank only to be told “Wait until you have a full 12 months of profit and we’ll consider it.”
The growth created higher levels of inventory and receivables. The only alternative was to ride payables and have the owners put a little money in the company. However, after a full year in 2012, the company did have a 20% increase in revenue made a nice profit and had a $180,000 positive swing in earnings.
Finally in 2013, we were able to obtain a loan that consolidated the mortgage on the company building, paid off the existing line of credit with the previous bank and obtained $150,000 in additional working capital. The additional working capital and decrease in monthly payments was a huge help to the company cash flow. Problem solved!
Avoid the pain of asking the bank to increase your line of credit when you only have 3 to 9 months of improvement. Wait until you have a full year, then go see them.
Have you ever had the experience where you need to fund payroll on Friday and there's not enough cash in the bank? You may have a line of credit, but there's not enough there either. If this is you, maybe you've outgrown your money.
I have a client in a service industry that is growing rapidly this year. We negotiated a nice line of credit, but they quickly used it and were looking for funds to fuel their growth. They negotiated short term loans with shareholders, but their cash flow projections showed they wouldn't have the money to repay the shareholders. It would be sitting in accounts receivable and would need to be spent on the expenses necessary to fund that growth.
Growth requires cash. If your revenue grows at 20%, it's likely your receivables will also grow about 20%. They can grow more or less depending on your collections and timing, but the more you have sitting in receivables, the less you probably have in cash.
Many business owners experience a funding gap when they reach funding requirements between $250,000 and $5 million. The funding gap is created by the funds they have available and the funds they need. These businesses that are too big to be small and too small to be big are experiencing very limited access to capital and their business borrowing exceeds their personal assets they have available to borrow from. Bank consolidation, bank reregulation and tight credit markets make this even more difficult.
To get the capital you need to finance your business, you have to reduce the amount of actual or perceived risk for the lender/investor. Here's a couple of things to help with that:
- Have skin in the game. If you're aren't taking your share of the risk, it's hard to get people to take their share and yours. Skin in the game = shareholders equity/net worth. Most banks are willing to accept you having 25% of your capitalization as equity, but not less than that.
- If you're in a difficult industry, (contracting) provide industry outlooks that show a favorable economic outlook for your industry.
- Profits and liquidity. If a lender sees a profitable, liquid company (cash in the bank) that goes a long way to reducing the risk.
Can you think of any other ways to reduce real or perceived risk? If so, please comment.
Here are a couple of other articles related to cash flow planning and money.