got a question: I’ve heard that a line of credit
should only be used to cover cash shortages to pay for
normal operating expenses in the months when we need
it...that we should NOT use it to buy inventory. Is this
Here's the BRS philosophy: Match the life of the loan to
the life of the asset. All assets require some source of
funds to acquire them in the first place. When the
source is borrowed funds, it is absolutely critical that
you match the length of the debt with the asset's
ability to generate cash flow or net profits and thus
repay the debt.
A short-term loan such as a credit line should be used
for short-term assets (also known as current assets)
with the logic being that you'll get the cash from the
sale of your inventory to pay off the loan within the
year. In most industries, inventory is a short-term
asset that's used up within the year. However, as we
know, that's not true for all industries.
assets (seasonal inventory, for example) and accounts
receivable represent short-term investments; thus, they
are financed with short-term debt and are repaid out of
the cash flow generated from liquidating the assets
without the need to replace them at the end of the
season, as illustrated by our working capital cycle.
So, if you need to beef up your inventory for a seasonal
sales increase, such as Christmas, using a credit line
is perfectly acceptable. However, if you're looking to
ratchet up your inventory for a permanent expansion
and/or new location, that's a longer-term use better
paid for by a term loan.
the most difficult concept to grasp is this idea of
permanent, base-level increases in current assets when a
company incurs real (vs. seasonal) growth. Since these
increases represent permanent increases, your current
assets will behave more like a fixed asset. Therefore,
they should be financed with equity, permanent current
liabilities (expanded credit from suppliers), and
intermediate-term debt (loans of 3-7 years in length).
Ignoring these principles - and incorrectly financing
the business - is the most frequent cause of trouble
between owners and lenders. It is essential that you do
not use short-term debt for permanent-type assets. When
this is done, the ensuing flail is often termed
"restructuring." This is banker talk that
usually means the financing was done wrong the first
time and now needs to be fixed.
"Borrowing wrong? Is that possible?" you ask.
Our answer is that it's not only possible, it's likely
unless both customer and lender approach each borrowing
situation armed with a firm understanding of not only
how much you’ll need to borrow but what you’re
buying with it and how you’ll pay it back.
Growing businesses often require an increased investment
in both current and fixed assets. If improperly managed,
growth can cause a shortage of cash; therefore, the
business owner must carefully assess future asset
investments and plan for their financing.
For example, if an accounts receivable level of $30,000
is required to support a revenue level of $240,000; then
accounts receivable of $60,000 will be required to
support revenue of $480,000 - assuming accounts
receivable turnover remains constant. If this sales
increase reflects long-term growth and not a seasonal
fluctuation, then the company will experience a
permanent increase in base level accounts receivable of
$30,000. The question then becomes: Do you have enough
excess cash to pay for that increase in accounts
receivable, or will you need to finance the increase?
loan proposal is very similar to a business plan - or at
least it should be. Among other similarities, both the
business plan and the loan proposal tell you (and your
banker) that you've figured out the answers to the five
key borrowing questions:
1. How much do you need?
2. What will you do with it?
3. When will you pay it back?
4. How will you pay it back? (that is, where will
the cash flow come from?)
5. What if something goes wrong?
To assist you with the loan process:
"Sample Loan Proposal" from the Toolkit
area of our website.
Download an evaluation
version of FIT (Financially In Tune) software