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Business Finance I found myself in a puzzling situation in my business in August of 1989. We had just come off a year where we made $125,000 profit before tax, and by February of 1989 I had collected almost all of the accounts receivables due us and had $100,000 cash in the bank. Sales from January to August were unusually good for a gift company – an industry where upwards of 60% of sales happen after September 1st. While we hadn’t made a huge profit, we were not showing a loss on our Income Statement. By August 15th, however, I had $5,000 in the bank and was unsure of how I was going to make the month-end payroll. I remember sitting in my office wondering: How can this happen? |
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I will explain what I did to fix the problem in my business a little later, but first I want to give you an understanding of the world of Business Finance. Business Finance Financing for a business involves two things: Cash Flow Management and Financial Planning.
The purpose of Cash Flow Management is to manage inflows and outflows of cash to insure that adequate funds are available for the daily and monthly operations of the business. The key element in this is timing; when will money be needed to pay bills, and do we have enough coming in from operations to meet the need. Look at your own personal finances for a moment. You have either rent or a house payment due at the first of the month. If you have a job, you have probably earmarked your paycheck of the latter part of the month to pay this bill. If you’re not working, you have probably made arrangements to borrow the money to pay the bill, knowing that future cash flow will be used to pay off the debt you’re temporarily taking on. To look at the example at the beginning of the lesson, my company had a cash flow timing problem that is common with businesses – seasonality. Most of our sales came in the last four months of the year, but we spent the first eight months buying raw materials and manufacturing them into products that would be sold later. The following chart shows sales in red and cash received in green. |
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Notice how sales pick up early in the year, peaking in September. Cash flow, on the other hand, peaks in early January – four months later! Let’s take a deeper look at how this happens. Two things are at work; at the beginning of the year, while sales are slow, purchases of raw materials are underway in earnest in order to have adequate finished goods inventory available when sales peak. This creates a net outflow of cash. Later, when sales are going strong, there is a lag caused by the extension of sales terms (Net 30 – meaning the bill is due in 30 days) that delays cash inflow. By the time I was out of cash in August of 1989, I had invested $100,000 in raw materials, and had already accumulated accounts receivable from sales of $100,000. Ready, liquid cash, however, was in very short supply. What do companies do in this sort of situation? There are generally two reasons businesses need cash – short term operating expenses, and longer term capital expenditures. We will first look at short term operating expenses and the sources of cash to cover them. Types of Short Term Expenses a. Accounts Payable – as explained above, these are the purchases of inventory or raw materials that a company needs to stay in operation. There are also the monthly bills for overhead – rent, utilities, staff payroll, etc. b. Accounts Receivable – in many businesses, cash is not generated on the sale of the item. A receivable is created, with the cash due in approximately 30 days. c. Inventories – in any business there is typically a lag between buying the product and selling it. In manufacturing businesses it is even more complicated because of the lag time between raw material arrival and sale of the finished product. Sources of Short Term Financing a. Trade Credit–for purchases of merchandise and raw materials, most businesses will ask to be extended sales terms so that payment of bills is delayed for 30 days. This helps, but does not guarantee, matching the outflow of cash with an inflow generated by sales. Some businesses will delay payment on bills because this creates essentially an interest-free loan from the supplier. I have strong ethical feelings that this is improper, because the supplier has bills to pay too. b. Secured short term loan – a bank or finance company may be willing to lend money short term when offered a piece of equipment as collateral. This type of loan is “secure” for the lender because they can repossess (take back) the equipment if the borrower cannot pay the loan back. c. Inventory Loan – if the raw materials or merchandise are considered good collateral, a lender will sometimes allow a loan to be secured in this way. Car dealers are an example of this type of loan. They pay back the bank each time a car is sold. d. Account Receivable Loan – here the lender takes ownership of the accounts due, and is paid back on the loan as customers pay on their accounts. This is called “factoring”. e. Unsecured Loan – a bank will sometimes offer to lend money unsecured, but may request “compensating balances” – an equal amount in a certificate of deposit or savings account. Obviously, this may not help cash flow in all cases. f. Line of Credit – and here we see what I did in my troubled company in August of 1989. I approached my bank and explained the situation, and they extended me a Line of Credit. They said I could borrow a maximum of $50,000 in increments of at least $1,000. I wanted to minimize the total amount I borrowed, so asked for a “draw” from the credit line once a month after I had calculated how much I would need over the coming month. A bank Note was prepared, and I signed it and received the cash. By December I had begun to pay back the Notes, one at a time (with interest), and completely repaid the Line of Credit by the end of February. Knowing a similar situation would probably happen again in the summer, we left the Line of Credit open. g. Revolving Credit Line – this is essentially a credit card, with no set amount to draw or to pay back. The interest rate is, well, high, but the convenience is a plus. Since there are so many “introductory rates” out there, many small businesses are utilizing this source of short term cash. PITFALL: you’ve got to remember to pay it back, as after the special rate period the interest charges are staggering. Types of Long Term Expenditures Long term expenditures are generally to finance fixed assets – land, buildings, equipment, etc. Sources of Long Term Financing There are generally two sources: 1. Debt Financing – borrowing money from the bank on a long term note or contract that is tied to the useful life of the item. Large corporations may also issue BONDS – essentially a Certificate of Deposit issued by a company rather than a bank. 2. Equity Financing – corporations may sell stock that has been retained in its treasury, or it may issue new stock to finance long term expenditures. There are several types of stock: Common stock, with no guaranteed dividend, and Preferred stock, which generally has a guaranteed dividend amount, but costs more than Common stock. Venture Capital – is a form of equity financing where a corporation sells a percentage of itself to one firm, who underwrites operations for a period of time, then may exercise its right to purchase stock at an earlier agreed upon price. 2. Financial Planning In my business situation in 1989, I had an acute need for cash, and solved the problem via a Line of Credit. I had not anticipated the problem much before it happened, and was lucky to survive the cash crunch. What do large companies do (and what should ALL businesses, big and small, do)? PLAN! Financial planners prepare projections of a company’s operations for periods of time into the future – a year, five years, ten years, maybe more. They then analyze and predict needs for cash by asking three questions: 1. What amount of funds is needed in the short term? 2. When will we need additional funds? 3. Where can we receive funding to match our needs? All of the options discussed in Cash Flow Management may be utilized to match amount and length of time needed. The idea is to NEVER spend a bright sunny August day wondering – How am I going to make payroll tomorrow? |
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