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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.


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