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Larry’s Debt Repayment Strategies, Inc.

Posted on June 26th, 2016

Jack Kern
Owner/President
Outsourced Accounting Department, Inc.

In my previous article, Larry’s Funding Strategies, Inc.,” I demonstrated another way of looking at cash flow, by expressing it in terms of borrowing availability against accounts receivable in order to fund sales growth. I now would like to take another look at what was happening to the company’s ability to repay its debt on more of a “micro” (monthly) level. This is an extremely important issue, not only in how lenders analyze your financial statements, but more importantly, how you as the business owner manage your cash (or don’t).

In that previous scenario, the final outcome was a good one, because Larry planned ahead and was able to obtain outside financing to support the company’s sales growth before it occurred.  But let’s now take a look at what was going on behind the scenes:

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Note first on the company’s Projected Income Statement its operating losses during the first 6 months of the year.  Then look at the Monthly Cash Flow Statement and notice its negative cash flow before debt service (“Cash / Operations & Financing” line).

Now, also look at the “Financial Highlights and Ratios” on the last page, the “Cash Flow From Operations” and “Debt Service Coverage” lines. These negative numbers are further indicators that the company’s Cash Flow From Operations (in month 1, net loss of $18,946 plus depreciation of $48 = $18,898 in the numerator) obviously cannot service the company’s principal payments on long term debt ($1,105 in month one on Monthly Cash Flow Statement in the denominator).  Rather, the loan payments just add to its cash deficit each month.  Thus, due to it’s operating losses, combined with sales (receivable) growth, and various other cash drains, had it not been for its starting cash position (which is quickly depleted when the owner paid himself back in month 2), followed by advances under its new line of credit, the company would not have been able to meet its payment obligations on long-term-debt.

This issue is critical for a couple of reasons, one being that in effect, this company is borrowing money to meet its debt service obligations (i.e., “robbing Peter to pay Paul”), a big “no-no” in a traditional bank lending environment. The other reason is that most banks typically don’t like to lend money against accounts receivable if that is their only collateral. This is because unless the bank has absolute control over the company’s receivables, those receivables can quickly be diverted by the owner to other uses – including, but not limited to him or herself, or funding the company’s operating losses until it’s out of business and the bank has no more collateral. This is why there exists specialized lenders such as “asset-based” (accounts receivable and inventory) lenders and factors, a much more expensive form of financing than banks, but they serve a legitimate purpose.

Here again, the critical role of “profit” cannot be emphasized enough. As demonstrated above, ultimately, it’s what must fund the company’s debt service requirements among many other things, and to ignore this reality is why some companies go bankrupt.

 


Larry’s Funding Strategies, Inc.

Posted on June 20th, 2016

Jack Kern
Owner/President
Outsourced Accounting Department, Inc.  

As I indicated in my previous article, “Larry’s Exit Strategies, Inc.,” it will usually take a period of years (versus the one-year profit that was indicated in that scenario) for a business to reach the level of income where they command an attractive sales price. Most businesses I have worked with do not show a 30% net profit margin, maybe a pre-tax  margin 5 to 12% would be more typical, with some much higher, of course.  And at a lower net margin, many businesses must also finance their grow from external funds such as loans, or an infusion of capital by the owner or from other outside investors.  In this article, I will demonstrate a model I use to determine the amount of funding that will be required, and to identify the most appropriate source of funding.

First, using as a starting point the previous financials I created for my previous article (mentioned above), I made a few assumptions to increase the company’s funding requirement. These were (rounded):

  • Material Costs – Increased from 25% to 50%, thus reducing Gross Profit from $750,000 to $500,000.
  • Credit Cards – Paid off previous balance of $28,300.
  • Loans from Shareholder – Paid remaining balance of $44,000 back to owner.
  • Long Term Debt – Amortized previous loan balance over 24 months, resulting in principal reductions of $14,900, and increasing interest expense to $6,300.
  • Shareholder Distributions – Distributed $13,000 to owner to pay taxes (S-Corporation).
  • Accounts ReceivableSlowed turnover from 30 to 50 days, increasing accounts receivable by $19,000 (from where it would have been under the “exit” scenario).
  • Inventory – Increased $41,600 (from the previous “exit” scenario) due to the above increase in material costs.

Using the (simplified) profit and loss and cash flow formats that I’ve used for previous articles, below is what just those two statements now look like after making the above changes:

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Now, to introduce a slightly different way of looking at “cash flow,” below is a monthly Profit & Loss statement reflecting the accelerated sales growth, as well as changes in the various balance sheet items over the 12-month period.  Note first the net losses that occur from Month 1 through Month 6, adding to the above cash requirements (per several previous articles). This is due to the above increase in material costs at the lower sales volume during the first half of the year. Then also notice the ending cash balance, which is the same as the ending cash balance per the above simplified cash flow statement. (So don’t be confused by the different looking format, they both end up at the same place.)

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Also shown in the above is a section called “Borrowing Availability – Note Payable LOC.”  Basically, this analysis looks at the cash required from the cash flow statement above, and calculates the amount of funding against accounts receivable (only, which I will explain further in a future article) that would be available to fund this requirement.  If there is not enough borrowing availability, the resulting “Cash Over Advance” indicates the amount of money that must come from other external sources of funds, whether that be a different loan structure against the company’s fixed assets, money put back in by the owner, or an infusion of capital by outside investors.

Due to all of the above factors, for this company, a cumulative loan balance of $144,000 is indicated by year-end. But note in particular, the cash shortfall (“Cash Over Advance”) that occurs in the second half of the year, as profit and cash flow lag behind the company’s growth. Herein lies the financial risk relating to “growth,” and therefore the importance of “strategic financial planning.” otherwise, the business owner may very well find him or herself bouncing checks, or worse, being cut off by his bank and critical suppliers.  This will become the focal point of several of my future articles, and using this new model I have now introduced.

 


Larry’s Exit Strategies, Inc.

Posted on June 12th, 2016

 

Jack Kern
Owner /  President
Outsourced Accounting Department, Inc.

Let’s continue now with this series of articles on Larry’s journey through the various stages of business growth (or perhaps in his case, his “learning curve?”). In my last article, Financial Planning or Business Turnaround – Your Choice,” we assumed that Larry managed to survive his previous mistakes and was able to restore profitability and cash flow.  So now we’ll look at how he can reach his ultimate goal of selling the business and retiring.

To begin, we need to introduce a new financial term: “Earnings Before Interest, Taxes, Depreciation, and Amortization” (EBITDA). This is an extremely important number that is widely used by prospective buyers to determine a business’ value. One common way a business’ sales price is determined is based on some multiple of this number which will vary depending upon several factors, including things such as the company’s historical and expected growth rate, etc.

Below is a pro forma financial statement which assumes Larry’s company reaches $ 1.0 Million in sales and achieves a 30% net profit, or $300,000. Of course in reality this would most likely not occur in just one year, but rather, over a period of say three to five years, and that profitability trend is also what a prospective buyer wants to see.

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Larry’s Company is assumed to be an “S-Corporation” for tax purposes, which means it’s profit is taxed through the owner’s personal tax return rather than on the company’s P&L.  So that leaves us with just his net profit, interest expense (which is assumed to go away upon sale of the business), and depreciation expense.  Based on these pro forma numbers, Larry’s EBITDA would be his net profit of $300,000, plus interest expense of $1,324, plus depreciation expense of $575, or $301,899.

Now, let’s assume a commonly used capitalization rate of 15%, which is equivalent to a price-earnings multiple [1]of 6.7 (= reciprocal, 1 divided by 0.15). Based on the above EBITDA, the value of Larry’s business would then be approximately $2.0 million (6.7 x $301,899). If the business has excellent growth potential, then the capitalization rate might be lower meaning a higher multiple and, therefore, higher value. Or conversely if the business is mature with limited or no growth potential, a higher capitalization rate (lower multiple) might be used.  (And of course, once again, if you’ve been focused on showing losses in order to avoid taxes, you have now also established the value of your business – it’s zero).

Exactly where the final sales price comes out in the above range is where the due-diligence and negotiating process come into the picture. There are certified business appraisers who do these kinds of business valuations, and it may be well worth your while to consult one. (Our firm currently does not provide this type of service but we know professionals who do.) But the important point I’m making here is, most often, it’s your historical earnings and cash flow that determine the value of your business.
 

[1] Article – “What is An Earnings Multiple?” – Magellan Advisors, Inc. 


Financial Planning, or Business Turnaround – Your Choice

Posted on June 5th, 2016

 

Jack Kern
Owner / President
Outsourced Accounting Department, Inc.

In my last article, “The Effect of Sales Growth on Cash Flow,” our fictitious entrepreneur, Larry, got himself into quite a predicament by growing his business too fast, and not having sufficient profit or external funding to finance that growth.  So now let’s see what his cash flow would look like if he had planned ahead and done things a little differently.

In this scenario, which I now call Larry’s Turnaround Strategies, Inc., I assumed that Larry does a much better job of managing in two areas: 1) payroll, and 2) receivable collections:

Note on the pro forma P&L that his Net Income is now (rounding) $118,000, or 30% of sales, versus only $15,000 previously, and his monthly receivable turnover is reduced from 45 to 30 days, thus producing an additional $37,000 in cash flow as a result of improving receivable collections.

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Now, refer to the Statement of Cash Flows to see the impact these two improvements had.  The company goes from a cash deficit of about $11,500, to a cash surplus of $129,000.

The point is this: sales growth for the sake of sales growth is dangerous. Yes, there are times when a business can take on aggressive sales growth.  But from purely a financial perspective (vs. operational which is a whole different issue), doing so without having either adequate profitability, or outside capitalization in the form of financing from a receivable finance company (or other specialized lender), or investors, or both, is a sure “plan to fail.”  At the very least, you may wind up in a highly stressful turnaround situation where you are unable to obtain materials from critical past-due suppliers, and a bank breathing down your neck everyday either pressuring you to restore profitability, or worse, calling your loan and threatening to liquidate your company.

So the moral of the story is, if you’re going to grow the business, focus first on profitable growth, and then plan on how you’re going to fund that growth ahead of time, not after-the-fact when it’s too late.

In my next article in this series, we’ll take a look at what Larry’s financials need to look like to enable him to maybe someday retire.

Jack Kern
Owner / President
Outsourced Accounting Department, Inc.