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If We Build It, Will They Come?

Posted on July 30th, 2017

Jack Kern
Owner, President
Outsourced Accounting Department, Inc.

Recently I was asked by a banker to prepare a set of projections for a loan they were considering for one of their customers.  The owner wished to expand his facility to increase sales, and wanted to borrow a large amount of money to purchase a new building. From the point of view of the owner, the purpose of the projections was to create a business plan the banker asked for. However, from the point of view of the banker, the unspoken purpose of the projections was to determine if the business could repay the loan.

The banker’s real question here is, “What if” they DON’T come?  In other words, how solid are the revenue forecasts, and what happens if they don’t materialize? Can the business still absorb the payments on the new debt?  Understanding this, rather than jumping into creating a fluffy business plan, I put on my CFO hat and prepared a preliminary set of projections based on the business’ existing sales pattern and cash flow.

To illustrate, below is the sample company I’ve used in my last few articles. I’ve now made the assumption that the company borrows $1.8 million to buy a new building. It’s also assumed that its sales forecast for the rest of the current fiscal year is NOT affected by its expansion into its new facility (i.e., the owner’s expected sales growth from expansion into its new facility is based purely on speculation, NOT on any firm sales orders).

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Note first on the company’s P&L the doubling of interest expense from July on. Then look at the Cash Flow Statement.  For the entire year, the projected “Cash Flow After Debt Service” is a negative $252,000 (rounded).  Now, look below at the projected “Over Advance” of $241,000 for the year. Obviously, no bank is going to (knowingly) lend more money to a business to help it pay back its existing loan. So, all this number indicates is that without an immediate boost in sales, this deal does not work.

The question now is, does either the owner, OR the bank, want to risk that this game plan will not work?  Hint: First, banks are not investment houses, and therefore, are traditionally risk averse. So the only remaining question is, what is the owner willing to risk if he is “lucky” enough to get his loan approved?

Again, this is the importance of financial planning. It’s always best to think these things through before incurring the time and expense of going through a loan application process only to get your loan turned down, or worse yet, getting your loan approved only to end up in bankruptcy or out of business.

 

Related Articles:

Analyzing the Components of Cash Flow

Larry’s Debt Repayment Strategies, Inc.

Securing a Small Business Loan- Part I:  Establishing the Relationship

Securing a Small Business Loan – Part II:  Positioning

Securing a Small Business Loan Part III:  The Application

Financial Planning or Business Turnaround – Your Choice

Larry’s Fairy Godmother Strategies, Inc.


The Effect of Funding Fixed Assets Out of Cash Flow

Posted on July 22nd, 2017

Jack Kern
Owner, President
Outsourced Accounting Department, Inc.

How many of you small business owners out there wrote a check to purchase your house?  If your answer is “not me,” then my next question is “Why not?”

I suspect that the vast majority of you would answer “not me” to this question. And as to the “why not,’ I suspect it’s because you didn’t happen to have enough cash sitting around to make a major purchase such as a house, nor a large enough annual income to be able to afford such a major purchase all at one time.

Yet, in my experience, I have occasionally seen small business owners attempt to do essentially just that – make major capital expenditures out of “cash flow,” as if there was enough cash flow in the business to enable them to do that.

In corporate finance terms, the principle I’m alluding to is the proper matching of sources and uses of funds, wherein long-term sources fund long-term uses (i.e. long-term debt is used to fund fixed asset purchases), and short-term sources fund short-term uses (i.e., a revolving bank line of credit is used to fund temporary increases in accounts receivable and inventory). To ignore this principle can have catastrophic consequences on your company’s liquidity.

To illustrate, assume your company purchases a piece of equipment for say $100,000.  And because your business is quite profitable, you decide to simply fund this purchase out of cash flow, meaning essentially the conversion of accounts receivable or other short-term assets. Here’s what this looks like:

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Note that even though this business is very profitable, its profit is NOT $100,000 per month. Consequently, an external funding requirement is created which exceeds what it can borrow on its line of credit (based on its available borrowing base against receivables and inventory), reflected here as an “over-advance” situation.

Obviously, the company’s bank is likely not going authorize an (unsecured) over-advance on the line of credit any sooner than it would authorize the business to become overdrawn on its checking account.  So, the reality is, the business may be forced to delay payments on accounts payable and run the risk of having its critical supplies cut off.  Or, the owner may be tempted to run to the bank for an emergency loan.  However, this idea is not advisable either, as banks don’t like surprises, and the owner may then lose creditability with his banker.

So to sum up, if you are contemplating funding a major capital expenditure, make absolutely sure your business’ cash flow can sustain it. If in doubt, seek long-term financing from your bank, or else plan to pay for it out of your own pocket.

 

Related Articles

Analyzing the Components of Cash Flow

Larry’s Debt Repayment Strategies, Inc.

Securing a Small Business Loan- Part I:  Establishing the Relationship

Securing a Small Business Loan – Part II:  Positioning

Securing a Small Business Loan Part III:  The Application

Financial Planning or Business Turnaround – Your Choice

Larry’s Fairy Godmother Strategies, Inc.


The Effect of Operating Losses on Cash Flow

Posted on July 15th, 2017

Jack Kern
Owner, President
Outsourced Accounting Department, Inc.

A while back I read an article on managing cash flow in which the author made this statement: “While they might seem similar, profit and cash flow are two entirely different concepts, each with entirely different results. The concept of profit is somewhat broad and only looks at income and expenses over a certain period, say a fiscal quarter. Profit is a useful figure for calculating your taxes and reporting to the IRS.”

Well, while I understand the author’s overall point, the last sentence above is one of the most shortsighted comments I have ever heard. This article was obviously written by someone who specializes in tax preparation vs. corporate finance. As I have talked about in several articles, profit is not just a “number,” it’s a critical component of cash flow, and without it, the business will eventually die.

To illustrate, let’s refer again to my sample company from my last two articles on the topic of improving cash flow by improving receivable collections and slowing payments on accounts payable. This time, however, let’s assume the business experiences operating losses, say from the loss of a major customer. The below Profit & Loss, Cash Flow Statement, and Asset-Based Credit Facility – Borrowing Availability, reflect the dramatic impact that operating losses have on cash flow:

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Note the large “over-advance” on the line of credit. This reflects the funding requirement from external sources caused by the operating losses. The reality however, is that a bank isn’t going to knowingly fund these losses, as profit is (ultimately) what repays debt in the first place, so in lender terminology, there is no “source of repayment.”  Nor will most investors who are also looking to the company’s earnings for a return on their investment.

One other comment about the author’s statement I quoted above, profit on a cash-basis tax return is actually “cash flow.” Thus, a company with declining sales and receivables can (temporarily) show a “profit” on a tax return, when behind those numbers, the company is actually losing money and on its way out of business.

 

Related Articles

Analyzing the Components of Cash Flow

Which is More Important, Profit or Cash Flow

The Relationship Between Turnover Ratios and Cash Flow

Case Study: The Risk of Sales Concentrations

Larry’s Debt Repayment Strategies, Inc.

Financial Planning or Business Turnaround – Your Choice


The Effect on Cash Flow of Slowing Payments on Accounts Payable

Posted on July 8th, 2017

Jack Kern
Owner, President
Outsourced Accounting Department, Inc.

In my previous article, “The Effect on Cash Flow of Improving Receivables Collections,” I referenced an article from Entrepreneur Magazine, “How to Better Manage Your Cash Flow,” in which the author explains, “At its simplest, cash flow management means delaying outlays of cash as long as possible, while encouraging anyone who owes you money to pay it as rapidly as possible.” I then illustrated how reducing accounts receivable turnover from 45 to 30 days reduced the company’s dependence on its line of credit, and eventually started to accumulate cash in its bank account.

In this article, I will now illustrate the effect of changes in accounts payable turnover on cash flow. Again, I’m using an alternative method of looking at “cash flow,” that is in terms of the company’s borrowing availability against accounts receivable and inventory.

To illustrate, first view the below projected cash flow with accounts payable turnover assumed to be 45 days.  Note the heavy dependence on the company’s line of credit to maintain this:

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Now look at what happens to cash flow if the company slows its payments on accounts payable to 90days.  Note the reducing dependence on the company’s line of credit through the end of the year until the line is almost paid off:

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Obviously, postponing payments on trade debt to 90 days is NOT recommended if you want to keep supplies coming in, unless of course you can persuade your suppliers to grant 90-day terms across-the-board, which is highly unlikely. But, as was pointed out in the above refenced article from Entrepreneur Magazine, in difficult times, your suppliers have more incentive to work with you than do banks.

The above incentive on the part of suppliers proved to be a life-saver for a client I worked with several years ago. Due to unforeseen developments, the company suddenly became “over-advanced” on its asset-based line of credit.  Unable to borrow more from the bank to pay down its payables, the only way it could keep supplies coming in was to negotiate extended payments terms with some critical suppliers.

 

Related Articles

Analyzing the Components of Cash Flow

Cash Flow Expressed as Asset-Based Borrowing Availability

The Relationship Between Turnover Ratios and Cash Flow

Financial Planning or Business Turnaround – Your Choice


The Effect on Cash Flow of Improving Receivables Collections

Posted on July 2nd, 2017

Jack Kern
Owner, President
Outsourced Accounting Department, Inc.

In this article from Entrepreneur Magazine, How to Better Manage Your Cash Flow, the author explains, “At its simplest, cash flow management means delaying outlays of cash as long as possible, while encouraging anyone who owes you money to pay it as rapidly as possible.” And the starting point is in measuring and projecting cash flow. He then lists various steps that can be taken to accelerate payments on accounts receivable, and delaying payments to vendors to the extent possible.

On the measurement of cash flow, in my previous article, “Cash Flow Expressed as Asset-Based Borrowing Availability,” I demonstrated an alternative way of looking at cash flow, by forecasting future borrowing availability against accounts receivable and inventory. This method is particularly useful for companies that are in a growth mode, or otherwise have heavy working capital requirements and are unable to maintain large cash reserves.

To illustrate the effect of accounts receivable on cash flow, first view the below projected cash flow with accounts receivable turnover assumed to be 45 days.  Note that for this company to maintain a minimum cash balance of $10,000, it must rely heavily on its “asset-based” (accounts receivable) line of credit.

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Now look at what happens to cash flow if the company is able to improve receivable collections from 45 to 30 days:

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Note that now under “Asset-Based Credit Facility – Borrowing Availability” the company is projecting a gradual paydown on its line of credit, to the point where by year-end, it is able to pay off its line and start to accumulate more cash in its bank account.

The above scenario proved to be critical for a client I worked with several years ago. For various reasons, the company was maxed out on its line of credit, and the only way it could free up borrowing availability was to ask its best customer (at the time) to pay down its receivable balance.

 

Related Articles

Analyzing the Components of Cash Flow

The Effect of Sales Growth on Cash Flow

The Relationship Between Turnover Ratios and Cash Flow