Need Cash? Here’s the How, When, and Why

It’s well known that “Cash is King!” Liquidity and profitability are two separate issues. It’s possible to have one without the other. Many businesses are profitable but they are cash strapped and potentially face bankruptcy in the absence of liquidity.

Where does cash come from? The sources of cash are (1) paid in capital, (2) profits and (3) asset liquidation such as inventory. In some cases, however, cash is needed but is not available through profits, paid in capital or asset liquidation. Thus, there are appropriate times to secure cash through bank borrowing.

When to borrow

So, when is it appropriate to borrow from a bank and how does one assess the affordability of a loan, i.e. will you be able to pay the loan back on a timely basis?

If your cash needs are for short term issues (e.g. financing seasonal inventory peaks), before applying for bank financing, try to aggressively sell off surplus, obsolete and slow moving inventory first prior to seeking bank financing.

Generally speaking, it is suitable to seek out a bank loan when you have a short-term need for cash and you cannot or choose not to raise cash through asset liquidation or securing increased paid in capital. Examples might be to finance inventory increases; accommodate short term payroll requirements or to support unusually slow accounts receivables.

It is also suitable to obtain a bank loan to finance long-term capital needs such as a new store, new vehicles or major renovation. As a rule of thumb, use “revolving credit” instruments to support short term needs and a “term loan” to finance capital projects.

Revolving credit loans

A revolving credit loan is renewed from year to year and the borrower may take the loan amount up or down so long as the borrowed amount does not exceed the credit limit of the revolver. It is used strictly for short term needs (less than 1 year).

Term loans

A term loan is used to finance longer term capital needs and therefore the loan has a set monthly payback schedule and a final due date. Term loans generally run from five to seven years in length.

So, is it okay to take out a bank loan if the retailer needs cash for legitimate reasons? Sure, but the follow up question is how will the retailer afford to pay back the bank? Moreover, in today’s difficult credit environment, what are bankers looking at to assess credit worthiness? Does the retailer have a written business plan, does it make sense and are there accompanying pro forma income statements?

Loan repayment

From a numbers perspective, bankers need to determine (and so should the borrower) how the retailer will generate the cash to repay the loan. Loan repayment is known as debt service. The sources of cash for debt service are profits plus depreciation and amortization.

Profit is an obvious source but why depreciation and amortization? Both depreciation and amortization are non-cash expenses. On a profit and loss statement, they reduce profits but there was no actual cash outlay. The cash was paid out when the capital asset was first purchased but from an accounting point of view, only a specific amount can be expensed in any given year. Thus, both depreciation and amortization are non-cash expenses and are added back to profits to measure debt service ability.

In addition to evaluating the retailer’s ability to service the debt, historically bankers place great importance on the integrity of the borrower. Lending institutions make both qualitative and quantitative assessments on perspective borrowers. They also seek to do business with those who already have a business relationship with the bank.

In light of the current difficult retail environment and internet sales, it’s even tougher to get a loan particularly if the retailer has marginal financial credentials. If you need a business loan for short term or long term needs I suggest you begin planning well ahead of your need, spruce up your business plan, complete a pro forma income statement, measure your ability to service the debt, clean up your balance sheet and begin preliminary meetings with your banker.

There are genuine times and reasons to seek bank lending. Don’t wait until you need cash to begin a banking relationship. If you manage your inventory wisely, anticipate your needs, substantiate your request with creditable reports, you will have no problem arranging for either short-term or term loan financing.