Regardless of how profitable your business is on paper, without cash your business will starve if you are unable to meet payroll and vendor obligations. Most businesses fail because they are undercapitalized.
Managing and preserving your cash is an important part of running your business. You can use various methods to help improve your cash flow (see sidebar), including various financing options. Ideally you will have your cash in place before you need it since getting a loan when you desperately need one is going to be more difficult.
Financing provides you with access to cash to meet your short- and long-term business objectives. If you were forced to buy everything with cash on hand you may not be able to ramp up as quickly to take advantage of a new opportunity. For example, you may need several trucks for a new contract that will pay you over time for your services - but you need the trucks today to meet your commitment. You can use an equipment loan that is structured over a set term so you get the trucks you need while repaying the amount you owe over a period of time.
At the beginning of the snow season you are spending more money on equipment, materials and readiness labor than you are bringing in from your contracts. What if winter arrives early and requires high payroll and material purchases to service your clients? Do you have the cash to pay your workers and vendors? If your customers pay in 30 to 60 days from when you invoice, you could be working in November and not getting paid until January or later. Without sufficient savings, a line of credit allows you to borrow money to meet payroll and pay your bills until your customers pay you.
Types of financing
An upstart business may finance using personal lines of credits, credit cards and personal loans, while a more established business with history and resources may be able to negotiate an asset- or receivables-based line of credit.
Credit cards and vendor accounts with 30-day terms are simple forms of short-term financing that allow you to hold onto your cash by buying today but paying next month.
Private financing is an option if you have friends or family that are willing to loan you money; however, this can be tricky, and it is best to set up a written agreement with a payment schedule to formalize the loan and terms of the agreement to avoid misunderstandings.
There are different types of financing options from banks or traditional lending institutions. An asset-based loan for equipment or property will be different than a cash-based loan for working capital and short-term needs. When borrowing from the bank, it will evaluate your request for funding differently based on what you are requesting and what your financials look like. Typically, asset loans are considered long-term money (more than one year), and cash loans are generally used for short-term needs (less than one year) like payroll, inventory and other direct cost expenses.
A few years back, when banks began tightening lending standards, small businesses - particularly new businesses - found it difficult to get funding. Options like CAN Capital offer small business loans with short turnaround time frames. Amazon and PayPal have recently entered the small business lending market. Peer-to-peer websites like Prosper and Lendio provide a process to partner investors with borrowers. Peer-to-peer lending can be less expensive than bank loans because it eliminates the middleman (the banks and their overhead). Often, though, loans are made to individuals rather than businesses and will thus show up on the owner’s personal credit report.
Traditional banking formulas
Lenders will use a proprietary formula to determine the risk in the proposed loan. They will look at a number of factors, including the reason for the loan, the business owner’s personal credit, business history and financial ratios. Financial ratios, such as the loan to value, debt ratio, debt service coverage ratio, current ratio, acid ratio and others, are used to compare your company’s financial health with expected norms for your industry. Falling outside of “acceptable” parameters will raise red flags, and without a suitable explanation you may be considered a less desirable risk.
Criteria to evaluate whether you are an acceptable risk may change or become more stringent depending on the economy, as banks work to mitigate unnecessary risks. The target becomes narrower and more challenging to hit as scoring tightens. Maintaining good financial ratios and a healthy business will make it easier to find financing. If your loan is rejected, ask the lender for feedback on your application so you know what you need to improve on before reapplying.
It is best to secure financing when you are in a strong financial position, not when you are desperate. Maintain a good relationship with your banker and have periodic conversations about your business and your needs. Even if you aren’t burning to establish a line of credit, it may be worth exploring the option and putting one in place in case you ever need it.
Lenders may take your application directly, you can hire a broker, or you can use a consultant to assist you in the financing process.
Using a broker can be risky since he will shop your application to multiple lending sources to find you a better deal, but it also floods the market with your information and makes you look desperate. Brokers ultimately are paid by the lender for bringing them the business, so keep in mind that the broker is really working for the lender and not on your behalf.
A loan consultant can help prepare your loan and guide you to lending institutions that will be a good fit from the outset. Because you are paying the consultant, they are working for you and are accountable to you for results.
Approaching your bank or lender directly is OK if you have a working relationship and feel comfortable with the process, but this may change if you’re looking to do a deal that is not routine like buying property or another business.
Risks of financing
Buying with cash is a conservative way to make sure you don’t spend more than you have, but this isn’t always practical. Prudent use of credit can help a business manage the ebb and flow of cash and certain business cycles; however, it’s sometimes easier said than done (particularly for those who personally do not manage their money well). Often small businesses are a direct reflection of the owner’s habits and values. People who tend to live beyond their means personally may also find that similar buying habits in the business cause cash and credit crunches.
Purchases made on the assumption of growing or increased sales can be risky if market conditions change and/or revenue dries up. Borrowing money to buy equipment so you can grow may be a smart investment as long as the revenue continues and the rest of the business functions properly. However, if cash is tight, look first to cut overhead expenses. Borrowing on credit to pay your overhead expenses is like personally living beyond your means. If you’re running tight on cash, you should first look to solve the problem through adjusting business practices and look last at borrowing to solve a shortfall, which may consistently occur if you’re spending more money than you’re earning.
Financing should be used only when absolutely necessary. Over-leveraging yourself can put you into a tight position with market downturns that are out of your control. The housing bubble and subsequent recession created more financial stress for companies that leveraged themselves compared with those that had less debt and could afford to react to the market by becoming leaner until they could ramp up again.
Lease vs. own
Consider the option of leasing or renting to avoid associated ownership costs. Leasing is considered an expense, and the cost can be deducted 100% on your taxes as opposed to purchasing equipment, where only the interest expense is deductible and the value of the equipment must follow depreciation schedules. For example, it may be less beneficial to own equipment that is used five months of the year but comes with 12 months of payments and year-round maintenance. The monthly lease expense may seem high relative to what you pay monthly to purchase through a loan, but the reduced carrying costs in the off-season and the reduced debt burden may make leasing more attractive.
It is wise to have multiple sources of funding and options available. Protect your cash in case of emergencies - borrowing some money is not a bad thing as long as you can pay it back. With a highly volatile business like a snow business, it’s wise to have savings and access to cash to support your operations for three or four months while you wait for your receivables. You may need to develop a one-, two- or even three-year financial strategy to create the security you need, but you will be thankful you worked to improve your access to cash when the time comes that you need it.
Additional cash management strategies
- Invoice consistently and in a timely manner.
- Collect receivables according to your contract terms.
- Aggressively target past due receivables to prevent the account from becoming uncollectable.
- Stop working for clients who don’t pay within agreed upon terms.
- Negotiate more favorable payment terms with vendors.
- Review your overhead expenses and cut out what isn’t needed. Can you cut 10%?
- Credit cards make for easy expense tracking compared to paying with cash or check, and you can defer payment for approximately 30 days.
- As a last resort, have personal savings and home equity lines available to loan money to the business.
Douglas Freer, CSP, owns Blue Moose Snow Co. in Cleveland.