The Commandments of Borrowing

1.  Asking “How?” and “What are the proceeds used for?” is just as important as asking “How much?”  In the majority of borrowing situations, the business owner focuses only on how much money they need as their primary concern.  But understanding what the proceeds will be used for and how the loan will be repaid is equally important, because ignoring these issues could lead to borrowing wrong.

“Is borrowing wrong even possible?” you may ask.  It is not only possible, but it is probably likely, unless both the debtor and the lender approach each borrowing situation armed with a firm understanding of the basic financing patterns and the lending requirements for the correct structuring of liabilities.  Improper financing can be the death to a business. 

2.  Growing businesses and farms will often require an increased investment in both current and fixed assets.  It is incorrect to assume that growth in revenues will occur without any required growth in assets.  The only case where this is not true is if there is gap of unused capacity within the growing company and an increase in efficiency where the result is an increase in sales. But in most cases, if your borrower expects to double his sales, it will require an increase in resources to accomplish that.

3.  Fluctuating current assets should be financed by cash or short-term debt and paid off by cash flow.  Recently, I saw a financial statement from a company that had a large debt to a supplier that was over six years old!  This is a situation where the borrowing was improper.  If you borrow money from a lender or a vendor to get supplies that you need to manufacture your product, that debt should be paid off when you sell the product and are paid.  It should not be paid off from net profits after all other operating expenses are taken care of. 

Lenders can help manage this structure with using borrowing bases and other controls to force the business to pay back the operating lines in a timely manner.  This also requires understanding how and when cash flows through the business for proper structuring.  Lines should be reviewed at least annually and should be monitored at least monthly.

4.  Permanent current assets are financed by equity, permanent current liabilities or intermediate term debt and are paid off by net profits.  Any seasoned lender has been in a place where a line of credit becomes “evergreen,” in that it does not get paid off or reduced in outstanding balance.  This is a clue that the line is improperly structured.  These debts should be placed on an amortized payment and paid off by the net profits of the business over a reasonable period of time, perhaps up to 5-7 years.  The struggle here for the lender is how to properly collateralize this loan, since assets such as real estate, buildings and equipment may already be pledged.  Use of a government guarantee like the SBA may be a nice alternative to mitigate the risk. 

Permanent current assets are the base levels of cash, accounts receivable and inventory that these items never drop below.  If a company has an accounts receivable level of $50,000 and inventory of $50,000 with sales of $1MM, then it is expected that the company would need to have receivables of $100,000 and inventory of $100,000 to reach sales of $2MM.  This is assuming the accounts and inventory receivable turnover ratios remain constant. 

Of all the needs for lending, the most difficult may be the permanent current asset financing.  When a company has real growth, as opposed to a seasonal fluctuation, that represents a permanent increase in current assets, these will behave like a fixed asset.  This should be financed with equity, permanent current liabilities, expanded terms from suppliers, or intermediate term debt. 

5. Fixed assets are financed by equity and long-term debt and are paid by net profits of the business.  Most of these assets are capitalized and depreciated.  Fixed assets usually relate to fixed costs, those that do not change relative to sales over a reasonable range.  Increases in fixed assets should lead to greater capacity for the business to increase revenues. 

These are generally the easiest to finance.  The amortization term should not exceed the useful life of the asset.  Proper LTV, LTC, and terms are usually spelled out in your loan policy. 

6.  Ignoring these principles will lead to friction between the borrower and the lender.  It could lead to a business that fails and a lack of sleep as the loan officer worries about the customer.   Proper adherence to these ideas will give the business or farmer the best chances for success and also grant adequate cash flow to sustain the business.