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Chapter 13 -
Finding the right loan
Cash flow problems sometimes stem from poor financing decisions, which often result from a fundamental misunderstanding of how to best finance assets. If you learn the secrets of financing properly, you may solve some cash flow problems.
Table 13-1 shows the asset section of a typical trucking company’s balance sheet.
Notice that the major groupings of assets are “current assets” and “property and equipment,” each accounting for around 48 percent of the total assets.
Current assets are cash or other assets that will be converted to cash within the coming 12 months. They are financed with a combination of short-term bank debt and lines of credit, vendor trade payables, accrued expenses and a bit of permanent owner equity.
Property and equipment are assets that will last more than 12 months – often up to five or more years. Thus, they are segregated from current assets into their own section on the balance sheet. They are financed with a combination of long-term debt and permanent owner equity.
In the case of trucking companies, we include “capital leases” in long-term debt. Many business owners erroneously believe that leases are not the same thing as debt. Read the fine print. Bankers and accounting regulators usually consider a long-term lease that cannot be cancelled by another type of loan.
Table 13-1 – Balance Sheet Assets |
December 31, 1999 |
| ASSETS |
| Current assets |
| Cash and cash equivalents |
$263,500 |
Trade accounts receivable,
Net of allowance
For doubtful accounts of |
$0
$967,000
|
| Receivables from related parties |
$65,000 |
| Inventories |
$25,000 |
| Prepaid expenses and other |
$35,000 |
| Total current assets |
$1,355,500 |
| Property and equipment (fixed assets) |
| Transportation vehicles |
$1,475,000 |
| Transportation vehicles – capital leases |
$475,000 |
| Other vehicles and equipment |
$235,000 |
| Leasehold improvements |
$215,000 |
| Sub-total-property and equipment |
$2,400,000 |
| Less: Accumulated depreciation and amortization |
($1,025,000) |
| Total property and equipment |
$1,375,000 |
| Other assets |
| Cash value of life insurance |
$47,000 |
| Deposits |
$45,000 |
Other
|
$7,500 |
| Total other assets |
$99,500 |
| TOTAL ASSETS |
$2,830,000 |
Avoiding debt can be harmful
Many business owners fear debt. To relieve themselves of the monthly note payments and cash flow strain, they would choose not to owe anyone a dime if possible. For others, the reverse is true, but we’ll cover them later.
Fear of debt creates the tendency to want to purchase your equipment outright, without borrowing. Perhaps that’s rare with new trucks, but with other, lower-priced equipment, when cash flow is good, it is easy just to pay for it and not hassle with obtaining bank financing.
Over time, purchasing equipment outright drains cash reserves. As the cash balances shrink, current liabilities must grow to help finance the current assets. The line of credit goes to maximum, vendor payables stretch out and payroll tax deposits become harder to make. Without realizing it, the business owner systematically has begun to finance five-year assets with 30-day money.
This creates an imbalance between short-term debt and long-term debt. The strains are evident, yet the cause is almost unseen because so few business owners focus on their balance sheet and financing structure.
Match financing terms with asset lives
A truck will produce income for four to six years, so it makes sense to pay for that truck over that time period. Receivables and advances, however, must turn over in 30 to 60 days, so you should finance these with shorter-term debts and permanent owner equity.
In our illustration,CCU Trucking Co. has the assets summarized in Table 13-2. What is the proper amount of financing for the property and equipment? There is no precise answer, as each owner and banker must decide based on the age and condition of the fleet and the bank’s specific lending criteria.
But to get a rough idea, we must first subtract the financing we provide as owners through equity, in the form of common stock, paid-in capital and retained earnings. A good range is 30 to 35 percent; we will use 30 percent.
After you determine optimal total debt, it’s time to split the debt between current and long-term. Bankers usually like to see equity in the equipment of at least 20 percent. If we target long-term debt at 80 percent of net property and equipment, we can determine the approximate amount that could be loaned on the equipment, with the balance to finance current assets. Numbers are approximate, of course, since current assets include part of long-term debt.
Table 13-2 – SCU Trucking’s Assets |
| Total current assets |
$1,355,500
|
47. 9 percent |
Total property and equipment (net) |
$1,375,000 |
48.6 percent
|
| Total other assets |
$99,500 |
3.5 percent |
| TOTAL OF ABOVE |
$2,830,000 |
100.0 percent |
Less: Amount financed by
Equity or permanent shareholder
Loans with no repayment scheduled |
($849,000) |
(30.0 percent) |
| EQUALS OPTIMAL TOTAL DEBT |
$1,981,000 |
70.0 percent
2.3 to 1.0 Debt to equity ratio |
| LONG-TERM DEBT TO FINANCE |
| Property & equipment |
$1,100,000 |
80 percent of net property |
Remainder for current liabilities,
which includes bank lines of credit,
payables, accruals |
$881,000 |
Creates a 1.5 to 1.0 current ratio |
Align debt to target
good financial ratios
Note the financial ratios shown in the right column of Table 13-2 (refer to Chapter 2 for an explanation). Proper financing would bring your debt structure within ranges acceptable to your lenders.
Compare this to the company’s actual debt. If, for example, the total long-term debt was $800,000, you potentially could refinance your debt at a total of $1.1 million and inject $300,000 into your working capital or cash reserves to improve your ability to pay vendors, take discounts and expand business.
Inadequate owner capital
starves the business
The reverse could occur. Many business owners never met a debt they didn’t like and attempt to finance 100 percent of power units and trailers. This can work, as long as you are still building owner’s equity and have a low rate of current liabilities relative to current assets.
But financing all assets, including current assets, exclusively with debt is a recipe for disaster. This happens when owners have contributed little capital or when operating losses have depleted capital. Your only choice in this situation is “bootstrap financing” and lower owner pay levels. There are rare instances in which someone has started a successful company with no equity, but don’t count on it.
In Summary
When setting up the financing of your company – or when continuing your expansion, match the term of the loan and the type and life of the collateral with the proper credit vehicle. Don’t make the mistake of financing a five-year asset with 30-day money.
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