We are often asked: “I’ve heard that a line of credit should only be used to cover cash shortages to pay for normal operating expenses in the months when we need it…that we should NOT use it to buy inventory. Is this true?”
Here’s our philosophy: Match the life of the loan to the life of the asset. All assets require some source of funds to acquire them in the first place. When the source is borrowed funds, it is absolutely critical that you match the length of the debt with the asset’s ability to generate cash flow or net profits and thus repay the debt.
A short-term loan such as a credit line should be used for short-term assets (also known as current assets) with the logic being that you’ll get the cash from the sale of your inventory to pay off the loan within the year. In most industries, inventory is a short-term asset that’s used up within the year. However, as we know, that’s not true for all industries.
Seasonal assets (seasonal inventory, for example) and accounts receivable represent short-term investments; thus, they are financed with short-term debt and are repaid out of the cash flow generated from liquidating the assets without the need to replace them at the end of the season, as illustrated by our working capital cycle.
So, if you need to beef up your inventory for a seasonal sales increase, such as Christmas, using a credit line is perfectly acceptable. However, if you’re looking to ratchet up your inventory for a permanent expansion and/or new location, that’s a longer-term use better paid for by a term loan.
Perhaps the most difficult concept to grasp is this idea of permanent, base-level increases in current assets when a company incurs real (vs. seasonal) growth. Since these increases represent permanent increases, your current assets will behave more like a fixed asset. Therefore, they should be financed with equity, permanent current liabilities (expanded credit from suppliers), and intermediate-term debt (loans of 3-7 years in length).
Ignoring these principles – and incorrectly financing the business – is the most frequent cause of trouble between owners and lenders. It is essential that you do not use short-term debt for permanent-type assets. When this is done, the ensuing flail is often termed “restructuring.” This is banker talk that usually means the financing was done wrong the first time and now needs to be fixed.
“Borrowing wrong? Is that possible?” you ask. Our answer is that it’s not only possible, it’s likely unless both customer and lender approach each borrowing situation armed with a firm understanding of not only how much you’ll need to borrow but what you’re buying with it and how you’ll pay it back.
Growing businesses often require an increased investment in both current and fixed assets. If improperly managed, growth can cause a shortage of cash; therefore, the business owner must carefully assess future asset investments and plan for their financing.
For example, if an accounts receivable level of $30,000 is required to support a revenue level of $240,000; then accounts receivable of $60,000 will be required to support revenue of $480,000 – assuming accounts receivable turnover remains constant. If this sales increase reflects long-term growth and not a seasonal fluctuation, then the company will experience a permanent increase in base level accounts receivable of $30,000. The question then becomes: Do you have enough excess cash to pay for that increase in accounts receivable, or will you need to finance the increase?
A loan proposal is very similar to a business plan – or at least it should be. Among other similarities, both the business plan and the loan proposal tell you (and your banker) that you’ve figured out the answers to the five key borrowing questions:
1. How much do you need?
2. What will you do with it?
3. When will you pay it back?
4. How will you pay it back? (that is, where will the cash flow come from?)
5. What if something goes wrong?
note: Back up your loan proposal with Profit Gap – Profit Mastery’s financial reporting system puts the financial information your banker will need to see at your fingertips…you can make the report available to your banker on a regular (monthly) basis so you have an “automatic update” in place.