When you're looking to grow your business, the last thing you want to do is put off a project because of lack of cash flow or to have to increase pricing on your products to increase your profits. Thankfully, there are other ways to finance growth that don't involve selling equity in your company.
The story that projections tell
Cash flow projections are critical for growth. A cash flow projection is a key part of a business plan because it shows how much money will be available for growth and how much debt needs to be taken on to finance that growth. While many business owners may think that their company can simply borrow to finance their growth, banks have become very particular about the kind of companies they lend to in recent years. They want proof that the borrower can afford new debt payments before they will approve it, so cash flow projections play an important role in securing financing from banks or other lenders. Not only are the projections important, but the feasibility of hitting those targets, are also key. How will you ramp up with capital and without capital, and how disciplined will you be once money is available to you. Those are very important elements to the projections, because without the strategy to go along with the projections, it’s just a fictional document and interesting story telling.
External sources of Capital to finance growth
When a company is in the process of growing its business, it needs capital to fund new equipment, facilities, and employees. In other words, growth requires capital. Many times, entrepreneurs will fund that growth with cash from the business, which can then leave them in a working capital deficit. Other times, they will seek capital from investors close to them (friends, family, employees) to fill the gaps and help with the growth. This can be sticky because it injects other partners into the business and can create messiness later when it comes to repayment and share buyback options.
There are many forms of financing available for growing businesses. Debt is usually the most desirable since it eliminates the investor/equity part of the equation. Debt is based purely on the historical strength of the company, and some deciding factors include the projections that have been created using that company’s growth trajectory and predictions.
Debt options and benefits
You should look for a lender who will give you the most favorable terms possible, not just the lowest interest rate. This means that various alternatives may be available, depending on your financial situation and other factors.
Debt financing is nontaxed capital. Regardless of the amount of debt provided, this does not appear on the balance sheet as an asset, nor does it show up on your profit and loss statement as income, therefore it is not taxed as revenue generated into the business. For this reason alone, it should be used only to grow the business. Obviously, you need to speak with your tax advisor before making any assumptions about the tax deductions, but borrowed capital to grow your business is the best kind of capital from a tax perspective.
Debt financing does not dilute ownership. You can borrow money repeatedly, with lender limitations, of course, but the debt provider will never look for ownership in your business. Typically, dilution occurs when an investor injects capital into your business but does not seek repayment of it like a typical bank or lender would. An investor or equity partner plays a longer game and has more patient capital, which means they are investing in your growth and your long term goals, and for that investment, they will want some level of ownership of your company – minority or majority stake, active or passive investment, depending on the situation.
Debt options
Let’s explore three types of loans: term loans, lines of credit and accounts receivable financing.
Term loans are generally longer-term loans with fixed monthly payments. They're typically used for large purchases that require more money than what you may have in your cash reserves. Perhaps the company is looking to purchase a $300,000 backhoe for the company, or another $2,000,000 aircraft for its fleet, or maybe a new piece of machinery on the factory floor will increase output by 40%, but its cost is $4,000,000. These capital expenditures may all be very necessary for the business, but utilizing all the cashflow in the company would put the company in danger. A term loan is a perfect option, in this instance.
A line of credit is short-term financing that can be accessed as needed during business operations; and can float based on the need of the company at any given time. Many business lines of credit, or operating lines, run on a margin of the cash flow of the business. This means that they can fluctuate month by month depending on how the business operates. This provides flexibility to access capital to fill gasp quickly but protects the lender from having too much capital available which might put the borrower or business into a tough spot. Lines of credit can be drawn down, repaid, and then drawn down again, as many times as required. Since it is not a fixed term with fixed payments each month, the flexibility makes it easier for a business to access when needed and leave untouched when not needed. Many companies like this type of option because it provides piece of mind for the times when cash can be tight. It requires discipline though, as using up a line of credit and then not having the adequate cashflow to repay it quickly, can get the borrower into hot water. Many clients think they need a line of credit, when maybe they require a different debt product. Having someone to discuss this with, makes all the difference in the world.
Accounts receivable financing is a great product but must be managed carefully. Financing your AR means that you have provided a service or product, and the payment terms for receipt of the funds are longer than anticipated. Usually, your aged anywhere from 30-120 days. This means that you sold your product or service but won’t be paid for some time. During that gap, you continue to run your business and you are still providing services to other new customers, but you haven’t been paid yet by the previous customer due to that AR aging. Specialty lenders can come in and finance a large portion of that receivable for you, so you don’t have to wait 30-120 days, or longer in some cases. You can be paid as quickly as 7 days from issuance of that invoice to the customer. It’s a great product and helps many company’s grow without requiring a long term debt product.
The cost of Capital and impact on profitability
The effective cost of capital should be analyzed and compared to the rate of return on business activities financed by the money borrowed to determine the impact on profitability. This can be done by using financial ratios that compare debt with equity – the debt-to-equity ratio. A high-debt company will pay higher interest rates because it has greater risk for lenders and investors given its dependence on short-term financing. In contrast, low-debt companies may be able to borrow at lower interest rates because their long-term borrowing needs are relatively small and stable relative to their total assets (and cash flows).
Regardless of whether you are a high or low debt (risk) company, you can certainly take advantage of the debt options out there, but if you are a high-risk company, you will need to be far more careful of the cost of the capital and how it will both impact your balance sheet and cash flow, and if it will indeed increase your overall revenue year over year. If you are borrowing money just to stay afloat, that is a recipe for disaster and usually only ends in a “kick the can down the road” scenario. In that case, the problems have not been solved by the capital provided and have compounded due to additional debt being added without a sustainable plan to be more profitable.
Exploration of available Capital
Debt financing is an important source of capital for businesses, and it can be used to fund working capital, growth and research and development projects. It’s important to evaluate all costs associated with borrowing money when deciding how to fund their growth operations. It’s even more important to have a professional firm evaluate that for you, to ensure that no stone has been left unturned.
The UnBankers has consulted to, and helped finance and helped turnaround many companies who requested additional finance support. Reach out today to see how we can assist you and your growing company further.