The Life Blood for Your Business: Working Capital

Contributing Author: Dennis Platipodis of Hometown National Bank

Businesses’ life blood for sustained operations and current growth objectives is working capital.  Working capital helps a business pay its employees and its vendors.  In short, it is the cash that you have immediate access to that allows you to open the doors daily for business.

Businesses should be determining on a regular basis the need for working capital, perhaps as often as monthly.

Net Working Capital is determined by Subtracting CURRENT LIABILITIES from CURRENT ASSETS

Current assets are defined as:

• Cash
• Accounts Receivable (represents the money your customers owe you)
• Inventory
• Assets you expect to convert to cash within the next twelve months

Current liabilities are defined as:

• Amounts owed in the next twelve months
• Accounts payable (owed to vendors and perhaps other creditors)
• Accrued expenses such as salaries and taxes
• Short-term debt payments.

BUSINESS CYCLES

Are there times during the year that your sales slow down?  This is known as seasonality.  Access to working capital during these times to help maintain operations can be critical.  When business ramps up, the timing difference between generating an invoice, collecting on those invoices and paying vendors, employees and the “tax man” can create short term cash needs.  Have you ever been afforded the opportunity by a vendor to make a special purchase at a discount which will help you improve your margins?  These are some examples of when working capital is critical for a business.

WHY HAVE A LINE OF CREDIT?

Some businesses are strong and efficient, and receivables and inventory are turned into cash quickly on a sustained basis and can comfortably get through the issues outlined above.  However, this doesn’t mean you shouldn’t have a line of credit in place as a safety net.  If your business experiences stress (diminished liquidity) during these circumstances, you should consider obtaining and utilizing a line of credit.

TWO TYPES OF LINES OF CREDIT TO CONSIDER

1. UNSECURED CREDIT CARD

   The limitations here are the size of line (the limit) and the cost (interest rate).  Because this is an unsecured means of borrowing, the costs are typically much higher than conventional secured borrowing.  In order to have access to the availability in the future, you will have to quickly reduce or pay off the balance.

2. SECURED LINE OF CREDIT

A business will have to pledge assets to a financial institution as collateral.  This type of borrowing is more cost effective for businesses due to the request being secured by collateral.  As a result, the interest rate is generally more favorable.

HOW DO YOU QUALIFY FOR A CONVENTIONAL LINE OF CREDIT?

Financial institutions determine a business’ capacity to borrow money by analyzing historical performance and collecting the following information:

• Financial Statements
• Corporate Tax Returns
• Accounts Receivable Aging Report
• Accounts Payable Aging Report
• Inventory Report
• Personal Financial Statements
• Personal Tax Returns for owners.

The personal information is collected from those individuals with at least a 20% share of the business and in most cases, these owners will be required to provide personal guarantees. The financial wherewithal of the guarantors will be analyzed as well. Quality financial reporting will help move the process along.

BORROWER EXPECTATIONS?

Depending on the size of the line of credit, financial institutions may require a periodic Borrowing Base Certificate to be submitted for review.  This will help to determine a business’ ability to access credit through an analysis of its receivables and inventory position.  Receivables that are 90 days or older are generally excluded from the borrowing base as they are deemed at risk for collection. This analysis will help keep a business “in formula”, which means that the line used at any given time stays within the prescribed advance limits against receivables and inventory.  Because lines of credit are considered a short-term credit facility, they are secured by assets that are easily converted to cash (receivables and inventory) – hence the borrowing base analysis.

PITFALLS?

Lines of credit for working capital purposes are not meant to be used to purchase equipment. This defeats the purpose of meeting the short-term liquidity needs of a business. A good banker will see this and determine how much of the line was used for capital expenditures (CAPEX) and carve that amount out and amortize to the capacity of the cash flow.  Ideally, if your business is capital equipment intensive, a separate equipment line or guidance line should be in place. Invoices are submitted and the line is accessed based on the expected advance rates and generally a separate amortizing loan is created shortly thereafter.

In some cases, businesses use their own cash to make an equipment purchase without applying this excess cash towards the working capital line balance, which causes the line to remain static and not revolve and once again, defeats the intent of meeting the short-term liquidity needs of a business. Your banker should determine the unfunded CAPEX (not borrowed) and carve out the line and amortize accordingly.  Ideally, this line of credit should “revolve.”

Working capital credit facilities are a temporary means to inject capital into your business.  As you collect on your receivables, you should make every effort to reduce your outstanding line balance, replenishing your availability to allow you to borrow again.  Some institutions may require a “rest period” or “clean-up” provision to encourage proper line usage to help avoid using the line as a permanent injection of capital into the business.

Use your line of credit in the spirit it was intended – to provide short term access to working capital and revolve the balance periodically through the year.  Communicate regularly with your banker to help understand your cash flow cycle and your CAPEX needs.

Dennis Platipodis

Vice President –  Commerical Lender of Hometown National Bank

Dennis Platipodis has been in the banking industry for over 35 years providing customized banking solutions to closely-held businesses and real estate investors, both owner-occupied and non-owner occupied. He enjoys helping people meet their objectives and sharing in the vision they have for their businesses.  He works tirelessly to become a trusted advisor to business owners in Chicagoland.

Hometown National Bank’s roots go back to the 1880s and evolved into strong, independent community bank with branches in LaSalle, Peru and Joliet.  Throughout the years, Hometown has remained dedicated to serving the communities in which it does business and is committed to providing unsurpassed banking services that fit business’s ever-changing needs and prides itself on being a true, locally-owned community bank.  Hometown provides common-sense solutions in what has become a complex world.