There comes a time in business, where financing is required to take the business to the next level. Most of us do not like taking on new debt, however it becomes a necessary evil for the growth of the business. If the business does not make the right moves, the business has the potential to become mis-financed. When this happens, the risk of "growing broke" becomes an enormous possibility.
Unfortunately many lenders, no matter how capable they may be, do not understand the concept of matching the financing to the life of the asset. Most requests that we see from business owners is for a line of credit. Lines of credit are great tools for financing, but using the right tool the wrong way could be deadly!
When looking at loan structure, there are three asset classes to consider. These assets can be classified as long-term assets, intermediate-term assets, and short-term assets. Long term assets are classified as plant, property and equipment (with a depreciable life of six years or greater). If an asset has a useful depreciable life of six years or more, the asset should have a longer term loan or mortgage to match this life expectancy. For example, if a business is looking to finance a new aircraft hangar, and the depreciable life of the hangar is 20 years, the optimal financing for the hangar would be a twenty year loan against the building.
If an asset has a depreciable life of two to five years, the asset is considered an intermediate term asset. These assets are best served by a 24 to 60 month note. Here's where most businesses make the critical error that could potentially send them to a meeting with the US Bankruptcy Court. Most of the time, the business owner has a tendency to go to their lender asking for a line of credit. Using a line of credit in this fashion is like buying your home on credit card. If a business requires growth capital that will be invested for the growth of the company, chances are the business should be looking for a 60 month note.
Short-term assets, such as seasonal cash, should be financed by using lines of credit. This is the primary reason that lenders require a 30-day out of debt provision on most lines of credit. The 30-day out of debt provision shows that the business is capable of "revolving" the line and that the line is justified. For example, if a business that services commercial airlines and needs increased manpower during the holiday travel season, the line of credit should be used for the seasonal cash need. Once the additional revenue that this increased manpower generates is turned to cash, the cash should first go to paying down what was taken from the line of credit.
The best way to illustrate this concept is as follows:
As illustrated in the chart, with the correct debt structure, by matching the debt term to the life of the asset, the asset pays for itself and strengthens the financial position of the company. Since cash and short term assets are not being used to finance long term needs, the business will have increased solvency and a lower potential for an emergency cash crisis. The increased solvency will also boost the financial condition of the business and keep the business from "hitting the wall."
Brad Lipman is a principal of Business Credit Connection, a full service financial services firm in California, offering financing solutions to small and medium sized businesses. For more information on this concept or any other financial concerns, Brad may be reached at 805 275-0191 or by e-mailing him at [email protected].
