Avoid the pitfall of trying to cover long term investments with short term credit facilities.
Cash management is a crucial part of running a company, to avoid being unable to meet your financial obligations at any time. As part of this function, you should be careful to differentiate your short term needs from your medium to long term funding requirements, and to discuss with your bank so as to set up the appropriate facilities to effectively cover each type of need.
"Can the business operate and meet its obligations without extra funding?" asks Mark Hobson, Financial Director at Advent Software EMEA. "If not, that is when you will look at short or medium-term credit, to meet your working capital requirements."
"It can be tricky though, because if anything happens like a drop in sales or insolvent customers, you will find yourself unable to meet your obligations. It's better to use short-term credit for a specific seasonal need, such as a particular time of year when your cash requirements are more important than usual, because you need to build up stock before your biggest sales season for example."
On the other hand, you will need long term credit, or an investment from your shareholders, to finance projects or operations which will not yield an immediate return, such as buying machinery, balancing your accounts or covering your stocks.
"Long-term credit revolves around the plans you have for your company's future," details Hobson, "either to continue operating in the long run - e.g. replacing machinery or moving offices - or to grow the business significantly - with more machines, R&D or entering new markets for example."
INVENTORY
Stocks are particularly difficult to cover and should be given due attention: part of your stock will be sold in under 30 days, the cost of which you can then cover through the facilities obtained from your suppliers, without even the need to apply to your banker. Another part will be sold in one to 12 months, to pay for which you will need short-term facilities. Finally, around 30% of the stock (on average, depending on your industry) will take over a year to sell.
This part of your inventory will therefore appear on your balance sheet and will require you to obtain medium term facilities to cover it and balance your accounts. If in this case you only have short term credit you will be at risk of not being able to pay your suppliers, not to mention making your lenders and investors nervous about your solvency levels. You should therefore carefully analyze your stock turnover rates, to determine the right levels of coverage.
However, to obtain medium or long term loans, you will have to work harder to convince lenders or investors to back you.
"To be in a good position to get this kind of three to five-year loans," explains Hobson, "you need to demonstrate what returns are expected over that time, although if business is going reasonably well, at the end of the period an extension is generally negotiable."
RETURN ON INVESTMENT
In fact, whatever the duration of the funding you are considering, you need to plan for it and make sure you will be able to repay your loans or give your investors good ROI.
"Ensuring you can pay back your loans, short or long-term, requires good objective planning, to determine what your return on investment, or ROI, will be by the time the loan matures," underlines Hobson. "There are also important metrics to look at on your interest coverage: if your firm's profits cover your interests by four to five times, then your situation is healthy. Any lower and you should think about trying to reduce your loans, so as to lower your interest payments."
In a continuous cycle, sound cash management - budgeting, forecasting and managing your cash flows - will once again be crucial to ensure your financial situation remains healthy.
"Assessing the metrics, forecasting, budgeting and ensuring your cash-flows will be adequate are important steps to take before you sign up for a loan," concludes Hobson. "You need to make sure your return on investment will be sufficient to repay both the interest and the capital."
PRESENTING ACCOUNTS
Having a clean set of accounts will enable you to create the type of credible forecast expected, demonstrating your professionalism and good governance. By maintaining accurate accounts you will be able to prepare a credible business plan, demonstrating to your lender or investor what type of funding you need, what you need it for, and how you are planning on reimbursing your loan or start giving a return on investment to your shareholders.
Hobson explains that to present your accounts, you can follow one of the standard formats to present your Profit and Loss account, balance sheet and cash-flow statements. Depending on your objectives, there is a wealth of additional information you might need to present to investors or lenders, from information on the collateral you can provide to financial analyses of the markets to which your company sells. Your accounting firm, if you use one, can give you good advice and explain the different formats available. You can also find information on where to start in our article on 'Exploring the power of your own checkbook - part one'.
Once you have put in place your Profit and Loss, balance sheet, cash-flow statements, business plan and forecasts, you will be well armed to approach any type of lender or investor to secure the funding you need to maintain and develop your operations.
As your company grows, you should remember to grow your accounting team so they can keep up with the additional inflow of data. Your firm will start needing financial control to enable you to keep a firm hand on the necessary checks and procedures, as well as treasury management when you start having cash reserves, to ensure you make the most of them. Moreover, if one day you decide to list your company you will need to have your accounts fully audited by an independent expert before their annual publication, which you will need a qualified internal team to manage.
© Zawya BusinessPulse 2014
