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Larry’s Fairy Godmother Strategies, Inc.

Posted on July 23rd, 2016

 

Jack Kern
Owner, President
Outsourced Accounting Department, Inc.

In a recent article, “Larry’s Debt Repayment Strategies, Inc.”,  I demonstrated how operating losses, combined with rapid sales growth, can produce a negative cash flow, requiring Larry to borrow on an “asset-based” line of credit in order repay other debt, not a good thing. But there was yet another phenomenon in his cash flow projections that could potentially create an even bigger problem than merely “robbing Peter to pay Paul.”

Note in the below analysis that borrowing under the company’s line of credit resulted in an “Over Advance” situation from months 6 through 11. So what does this mean?  It means that the “formula advance” (in this case, 85% of the company’s eligible accounts receivable established by the company’s lender), will not be adequate to fund the company’s total cash requirements during these months.  So during this period,  the company will likely fall behind with trade creditors, or on loan payments, and possibly may not even meet payroll.

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Of course if the lender doesn’t have such formula restrictions on their line, no problem, right?  Except for one thing – even if Larry is fortunate enough to find a lender like this (which I call “the greater fool”), when he does get into a cash bind, he’s going to find that his lender is very unsympathetic to his problem.  Instead, they’ll blame HIM for their own lax lending policy that helped create the problem in the first place, and then further compound his problems in all of the various ways that lenders do.

So, what is Larry to do?  In this case, as indicated below, the company’s “Cash Flow From Operations” is projected to be negative for most of the year, and that’s before its debt service requirements. So in order to keep everyone current and stay afloat, the only alternative Larry really has is to turn to who I call his “fairy godmother,” that being Larry himself.  In this case, it means that Larry should postpone paying himself back the funds he has previously lent to the company (see original “Monthly Cash Flow Statement” above, and revised below).

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Note that by leaving the owner’s funds in the company, it takes pressure off of the company’s line of credit to support its cash flow requirements, thus leaving more than adequate borrowing availability on the line. This is precisely why lenders often require that the repayment of loans from the shareholder be subordinated to repayment of the lender’s loan – it’s to make sure the business has adequate funds to operate and keep it out of financial trouble.

So the moral of the story is, the next time you think about taking “your” money out of your business and replacing it with bank debt, just remember who its “fairy godmother” is likely to be when it needs money again.

 


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